Where to After the Crash?
After every major financial “crash”, governments and regulators impose new regulations to try and prevent a re-occurrence of the crisis. The Glass Steagall Act, taiwanci for instance, which was passed after the stock market crash of 1929, defined the structure of the banking sector in the US for the following seventy years.
Paradoxically, the fragmentation this imposed on the US banking system gave rise to a securitisation business model which stands partially accused of being behind the present crisis. While banks were constrained from operating across county lines, the act imposed no such restrictions on insurance and pension companies. As a result, banks found they were able to be more profitable and to report better growth if they were able to offload assets from their relatively smaller balance sheets to these much larger institutions. Restrictions on banking in the US also played a key role in the globalisation of merchant and investment banks, the growth in the offshore Eurodollar market, and the rise to prominence of the City of London.
This cycle repeated itself in 2002, when regulators in the US promulgated the Sarbanes Oxlet Act following the burst of the dot com bubble. Amongst other provisions, chakrock the act encouraged the accounting profession to adopt stricter financial disclosure rules and fair value accounting, which included the requirement that asset value be based on current market conditions. These “mark to market” accounting rules have also been accused of exacerbating the current crisis.
How then are regulators thinking this time around? Some interesting insights are emerging from various inter-governmental forums, central banks and regulators around the world.
What is coming to light is a list of “complaints” and matching “remedies”. Obviously, not all complaints are of equal merit, and not all remedies will be considered, mytaggys but it is clear that major changes are underway in the banking sector. The question that bears asking in this climate is how some of the proposals under consideration may come to affect banks in the GCC. To answer this, it is important to examine some of the issues more closely.
The culprits & remedies
Macro credit cycle management. There is little doubt that the governments and central banks of the leading OECD nations did not react to the bubble in asset prices early enough. For, as Greenspan famously indicated, it is very difficult to spot bubbles in the making. In the UK, bmblotto however, Greenspan’s counterpart may simply have lacked a convincing mandate to spoil the party while inflation was so subdued.
New instruments that target the credit process itself are therefore now high on the agenda. According to Charlie Bean, Deputy Governor of the Bank of England, “We need a regulatory regime that works against the natural cyclical excesses of the credit cycle”. Precedents for this include, canbioca the Spanish “dynamic provisioning model”, where provisions levels are set by regulation to reflect losses over an entire business cycle, and thus grow rapidly even when in boom times actual losses are limited.
Traded securities markets. One of the hottest topics in the debate about regulation is what the future approach to tradable securities will be. Whereas securitisation is the source of many of the so-called “toxic assets” in the financial system, it should not be forgotten that it has been around for at least forty years, and has both enabled healthy specialisation in financial services and supported increased competition in retail banking, which has benefited consumers greatly.
What has contributed enormously to the current crisis is not only the extent to which the traded securities market expanded before the crash, but the extent to which the securities were kept within the system, ending up on the balance sheets of many banks as part of their trading books. This resulted in a reliance on the tradability of these assets to maintain appropriate levels of liquidity, which could be calculated by means of sophisticated value-at-risk calculations.
The fact that so many of the world’s leading banks, which were presumed to have developed by far the most sophisticated of financial models, failed to get it right will undoubtedly make regulators around the world far less trusting of sophisticated models, and more determined to rely on more traditional liquidity measures and forms of provisioning. So although regulators are not suggesting that banks whose capital adequacy is presently stretched should have a higher capital adequacy in the short term, it is likely that in the medium term capitalisation requirements will be increased, especially against trading positions. These will, in all likelihood, be supplemented by the re-introduction of some core funding ratios to ensure more adequate levels of liquidity.
The parallel financial system. It is clear that one of the many problems which contributed to the current crisis was a change in the nature of financial intermediation. This saw significant growth in the range and complexity of off-balance sheet entities and vehicles that were not adequately regulated, and which were permitted to grow to such a scale that they were able to introduce risk into the financial system.
In the future, regulators will increasingly focus on ensuring that, even if such entities remain outside the ambit of financial regulation, banks carry the appropriate capital for exposures to such entities.
Cross-border banking. One of the most sobering aspects of the current crisis is the extent to which risks have turned up in unexpected places and, as Mervyn King, Governor of the Bank of England has suggested, the way in which “global banks are global in life but national in death”.
Although, in almost all instances, depositors that took bets in jurisdictions where the liabilities of the banking system exceeded the capabilities of the national government to support them have been protected, regulators and depositors will need to think very carefully about delegating responsibilities to lead regulators, who have themselves been found wanting, as well as about investing in banking operations in jurisdictions with limited fiscal resources. Local regulators will undoubtedly be much more concerned about the possibility of a withdrawal of capital from local subsidiaries, and the need for appropriate liquidity ring- fencing.
The impact on banks in the Gulf
Although the financial crisis has affected many banks in the region differently, and there are as many regulators as there are countries, regulatory principles are very quickly shared. In the Gulf there are examples of banks and countries which have been affected by each of the factors, although not necessarily by all of them at once. Once the dust has settled and the appropriate fiscal and monetary relief has been provided, banks are most likely to face a new regulatory regime characterised by requirements for:
- Higher provisions over the economic cycle;
- Higher levels of capital;
- A more conservative approach to liquidity; and
- More rigorous regulation of cross-border activities.
Unfortunately, all of these changes will have a direct negative impact on the bottom line, which will need to be balanced through deep changes in strategy. Most banks will find it impossible to achieve pre-crisis levels of profitability without major improvements in efficiency.
For many, this will be difficult to achieve, and some banks and bank funders will come to recognise that banking is less of a ticket to status or a license to print money than a complex, regulated and low-return activity, which may lead to a wave of mergers amongst smaller institutions. Timing, however, will be critical. Shareholders will need to find a window between appearing to be distressed in the current environment and the time at which valuations become internalised as new realities.
Balance sheet management will achieve a growing importance. Banks that maintain largely passive investments in “liquid instruments” – often offshore – will need to completely re-define their strategies and risk management policies.
As has already been seen, almost all institutions will need to pay much more attention to their liability franchises, but not everyone can win in this race. Investments made in growing a liabilities business have a long lead time.
Calculating the improvements in operating margins required is relatively simple; achieving these improvements will dominate the banking landscape for at least the next five years.
Copyright 2009© Genesis Analytics PTY Ltd
Richard Ketley is a director of Genesis Analytics, and has been head of the banking and access to financial services practices, since 2001. Richard is widely recognised and consulted as a leading expert on banking in Africa. He has worked extensively with banking and financial sector clients throughout Africa and the Middle East.
Richard has lead assignments with banks and financial institutions for over 7 years. These assignments cover the full range of specialist areas covered by Genesis Analytics from working with Boards and management on addressing strategic challenges and bank acquisitions, to advising clients on treasury strategy, to the development of effective retail value propositions that meet client and shareholder expectations. Richard has a particular interest and focus on mobile payments and money transfers and solving the challenges of providing banking services to small businesses. Richard has advised many of the top banks in our geographic area. Richard is an accomplished speaker, and lectures widely on topics in retail banking.