THE FUTURE OF BANKING : HUNT FOR A COMMON FRONT / THE FINANCIAL TIMES MARKET ANALYSIS ( A MUST READ )

September 7, 2011 10:17 pm

The future of banking: Hunt for a common front

By Patrick Jenkins, Brooke Masters and Tom Braithwaite

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Dorotea, a thirty-something one-woman ceramics entrepreneur based in the remote forests of Peru, knows all about the global financial crisis. She might not be familiar with the intricacies of Lehman Brothers’ demise in 2008, nor with the succeeding slew of regulations intended to fix a broken banking system. But she knows she is lucky.

If she were trying today to get the loan of 1,200 sol for a new kiln that she secured a few years ago, she would be disappointed.
Like virtually every bank worldwide, her micro-lender, Mibanco, has had to reduce the risks to which it is exposed, and is no longer granting credit to poverty-stricken businesspeople such as Dorotea. “We’re still lending,” says her local manager. “But we’re looking for lower risks – not so poor, not so micro.”

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Three years after the depths of the worst financial crash in eight decades, it is clearer than ever that the crisis many thought ended two years ago is dragging on – and in some ways, particularly in the US and across the eurozone, intensifying. Businesses and politicians say credit is either unavailable or too expensive. Banks complain that profits are being squeezed so hard that investors are deserting them.

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Regulators, stranded in the middle, are left wondering whether their natural crisis response – to draft tough new rules – is building a stronger system as intended or rather exacerbating the problems of a fragile global economy.

In the first of a week-long series of analysis and comment articles, video interviews and multimedia graphics, the Financial Times here begins an in-depth examination of the future of banking.

With hindsight, it is clear the structure of the sector in the years before 2007 was an accident waiting to happen. Institutions had grown distorted in the pursuit of bumper profits. They held little equity capital to protect themselves – and what they did have was in many cases amplified by as much as 50 times with debt instruments. Vast profits were made from borrowing cheaply, often short-term, and assuming that the risks inherent in products from domestic mortgages to complex derivatives were negligible.

Today, those building blocks of profitability – generating returns on equity of up to 25 or 30 per cent, five times the norm for many blue-chip industrial companies – are gone. Many banks now hold triple the equity they used to, and as much as six times the liquid funding. Typical leverage multiples are down to 20. Risks have been reassessed. And profits have slumped. On the banks’ own preferred measure, ROE, which has historically flattered performance by relating returns only to those thin equity cushions, the best they can aspire to now is half the pre-crisis range.

Citigroup, a big US casualty, has shrunk its assets – loans, mortgages and other credit – dramatically. “The world has changed,” says Alberto Verme, joint chief executive of its European operations. “Banks are going back to basics – getting deposits, lending them on and managing what are increasingly important requirements for customers – cash management, trade finance, foreign exchange.”

Regulators in turn have pushed through a raft of rules on the amount of equity and liquidity institutions should hold. Though most are part of the new standards from the Basel committee, the global regulator, to be phased in by 2019, analysts and investors have applied pressure for early compliance. Their maxim for the past couple of years has been simple: the higher the capital ratio – specifically equity as a proportion of risk-weighted assets – the better.

“It’s quite clear that the banking system today is safer than it was a few years ago,” says Bob Penn, partner at global law firm Allen & Overy. “Is it regulatory action or simply market response to a crisis?”

Either way, the crisis has found a second wind. The direct costs borne by governments three years ago of bailing out broken banks, combined with the indirect costs of the economic slowdown that accompanied the crash in the sector and long-term overborrowing coming home to roost, have shown up in unsustainable sovereign debt burdens from Europe to the US. That is feeding back into the still-fragile banking system, as parts of institutions’ traditionally safe portfolios of government bond investments have slumped in value.

“In this balance-sheet restructuring process, the uncertainties right now are within housing and with governments,” says Richard Brown, chief economist at the Federal Deposit Insurance Corporation, which guarantees US bank deposits and supervises the industry. “The irony is that one of the balance sheets that is furthest along in being repaired is that of US financial institutions. That is one of the plusses on the ledger for the economy.”

Some believe the root problem is that reforms have been insufficient. “The structural changes that have been introduced and planned will not make [the system] safe enough,” says Professor Anat Admati of Stanford University.

By way of example, the latest targets of the markets’ bearishness are French banks that, with the support of their national regulator, have resisted following the drive led by Switzerland, Sweden and the UK to boost capital levels to new heights. At the same time, BNP Paribas, Société Générale and Crédit Agricole all have outsized exposures to Greece.

Policymakers are struggling to fix the flawed fundamentals of eurozone economies without burning through banks’ capital cushions. But in the mean time, the supply of short-term liquid funding to many institutions across the continent is drying up, in a re-enactment of the jitters that killed off the likes of Northern Rock in the UK and Lehman in the US in 2007-08.

“The fundamental problems in the euro area are only worsening over time,” says Ulf Riese, finance director at Sweden’s Handelsbanken, whose low-risk business model has made it a rare safe haven among European peers. “Liquidity for many banks is getting shorter-term or is reliant on government measures.”

Friday’s deadline for private sector holders of Greek sovereign bonds to sign up to a voluntary deal to extend the term for up to 10 years could trigger another round of bearishness across the eurozone. Bankers predict participation will fall short of the 90 per cent target, which could endanger the next tranche of Greek bail-out money if politicians feel the burden is not being shared fairly. The fragility of the markets has prompted some normally hardline reformers apparently to question the wisdom of an unbending approach. Andrew Haldane, executive director for financial stability at the Bank of England, last month praised the handling of bank regulation in the 1930s by US President Franklin Roosevelt – specifically loosening rules during the Great Depression in a successful bid to boost lending.

Bankers, unsurprisingly, agree. They point out, for example, that lenders’ traditional role of mediating between the capital markets and corporate borrowers may no longer be economically viable, now that so many have been downgraded by credit rating agencies. “Nowadays, a lot of banks have a higher cost of funding than corporates – that makes it very difficult to be a lender to corporates,” says Mr Riese.

When it comes to blue-chip clients, with easy direct access to capital markets themselves, that may be a problem only for their banks. Loans have traditionally been a loss-leader product, giving the lender a relationship with a customer, and a basis on which to cross-sell more profitable business.

But for small and medium-sized enterprises, banks’ shortage of funding poses a real problem, both politically and economically. SME lending, which attracts higher regulatory capital charges, is especially sensitive in Europe, where most employment is by smaller businesses.

Some reformers believe regulators must keep up the pressure – for instance, limiting banks’ ability to pay dividends to shareholders until they have boosted capital levels further through retained profits. “There will only be long-term prosperity if we underpin the health of our financial system,” says Paul Tucker, deputy governor of the Bank of England. “Had the authorities not pressed the banking system to have more capital, we would probably be in a worse position now.”

The Institute of International Finance, however, which represents the industry globally, estimated this week that complying with new rules will force financial groups to come up with $1,300bn in additional equity. They predict the cumulative effect could push up interest rates on loans by 3.6 percentage points over the next five years and cut global gross domestic product by 3.2 per cent by 2015.

Those who favour a more pragmatic approach to reform have a broader complaint, too – that the process risks creating a whole new set of distortions that could prove just as dangerous as those that preceded the 2008 crash.

Jan Hommen, chief executive of Dutch bank ING, says cracking down on banks will shift risk into “shadow” institutions, from hedge funds to industrial companies branching into lending. “I am nervous that the regulated financial markets – which are basically the oil that greases the economy – are being too tightly regulated,” he says. “Regulators are basically saying: ‘Go there, it’s cheaper.’ But no one’s regulating those new risks.” Rulemakers have promised to study the shadow market but have yet to produce any assessment of the risks.

There are gripes, too, about the side-effects of multiple uncoordinated reforms – at a global level, through the Basel III requirements; in Europe, through the Capital Requirements Directive IV; in the US, through the Dodd-Frank act; in the UK, with next week’s Vickers Commission report; and in the European insurance industry, with the Solvency II rules. “If politicians and regulators are not capable of joining up their thinking, what hope do we have of a sensible outcome?” says Allen & Overy’s Mr Penn.

Taxpayer anger about the 2008 rescues has also limited the options available for dealing with future crises. For example, the Fed cannot direct emergency lending to a single institution.

“I worry that the risk of runs is still very much there,” says Phil Suttle, chief economist at the IIF, referring to the restrictions on the Fed. “If I’m an unsecured shorter-term depositor with the banking system that isn’t clearly insured, I’ve probably got more rather than less worries at this point.”

A still bigger concern is the distorting effect that the clampdown on western banks might have on the few remaining growth markets – most strikingly Asia. “In very macro terms, China clearly has a long way to run in terms of growth. But that doesn’t mean there won’t be bumps along the way,” says a Asia expert at one bank. The continent has steered clear of much of the west’s regulatory reform, so US and European banks are diverting an artificially high volume of investment into the region – from lending to establishing new trading floors – helping to inflate existing bubbles.

But the biggest existential question remains the basic one of lending capacity. And only when the economy’s weak demand for credit finally strengthens, testing the banks’ capacity to lend with their new capital and liquidity constraints, will the world really know whether the future of banking stacks up.
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Asia’s banks: ‘The fish always stinks from the head’

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Liu Mingkang, China’s chief banking regulator, has a folksy way of explaining his work. “The fish always stinks from the head” is a favourite.

This belief that regulation must focus on banks’ head offices can be seen in China’s zeal to enforce the Basel III rules. While there is talk in the US and Europe of easing the liquidity rules, the China Banking Regulatory Commission has been pushing ahead with a set of rules that is stricter in definitions than what has been agreed internationally.

Basel III’s minimum tier one common equity requirement is 4.5 per cent; China has set its bar at 5 per cent. For the leverage ratio, a safety net if risk-weightings fail, Basel III requires at least 3 per cent of total assets; China has opted for 4 per cent.

Even more striking is the pace Beijing has set for implementation. It has ordered its biggest banks to meet the capital requirements by 2013, whereas banks in developed markets have until 2015.

Chinese bankers have been quick to fall in line with the new regulations. The difference with Europe and the US is easy to explain. Top bank executives are appointed by the Communist party and answer to the government.

China’s banking sector had a capital ratio of 12.2 per cent at the end of June, well beyond Basel III standards. Banks around Asia are in a similar position, although the region has treated capital requirements as a mainly western issue.

Japan has stood out, however, as its regulators worked hard to protect their banks from having to move too quickly to increase their capital stocks.

But the absence of complaints from Chinese bankers does not mean that the new regulations will be painless. Wu Xiaoling, a former central bank vice governor, has been unusually candid, warning that banks deemed systemically important could face a large funding gap in the next five years. Concern that they will have to tap equity markets to meet capital rules is one reason for their lacklustre share performance in the past year.

The tough rules are undoubtedly prudent, but they also obscure the main risk for Chinese banks: too much, not too little, government. With all major lenders owned by the state, their commercial decisions are heavily dictated by Beijing.

A case in point was their surge in lending during the global financial crisis, when the government used the banks to fund its stimulus spending. The damage in bad loans is just beginning to emerge and analysts say it will cast a shadow over the Chinese banking sector for years to come.
Simon Rabinovich

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Copyright The Financial Times Limited 2011.