Thursday, 12 July 2012


Five years since the financial crisis broke and a trillions dollars later, you would be forgiven for thinking that enough has been done to restore the financial system and the banks to pristine health. Nothing could be further from that!

Subsequent to the various tax funded bail outs of various financial institutions in almost all the major western economies, one would have thought that the banks would have learnt their lessons. If recent revelations on libor fixing, swap mis-selling, weak money laundering processes or humungous trading losses are anything to go by, obviously not!

Bob Diamond, ex-CEO of Barclays famously said to the Treasury Select Committee in Jan 2011 that the time for remorse was over.  He will be ruing that statement now.

Banks have been handed significant financial penalty in recent weeks but very little of personal accountability is being assigned by the regulator other than moral suasion or by the media outcry.  ING Bank was fined c $600m, Barclays was fined c$500m and it is rumoured that HSBC may be fined a whopping $1bn.  Other banks including BoFA, Citi, Deutsche, JP Morgan etc are under investigation and are most likely to fined as well for their failures over the coming weeks and sadly may not lead to much more than that.  

What this shows is the systematic manner in which corporate greed has eroded the moral fabric of these institutions. The regularity with which we hear of repeated failings in banks, it is obvious that the banks have become ‘too big to manage’.

And if you now thought enough was enough, what are your real choices? Precious little! Competition has been eroded by mega mergers and what we now have is oligopoly. 

So where are we now? The short answer is ‘between a rock and a hard place’! 

How did we land up here?

The ‘light touch’ regulation and the new set of accounting standards for measurement of financial instruments (introduced in 2005) provided a potent playfield to create weapons of mass destruction to fuel the corporate greed.  This combined with the pressure to deliver quarter on quarter earnings growth and the pressure to beat analysts estimates further reinforced the perverse behaviour.

The ability to recognise revenue upfront on long-term products through product structuring was a strong incentive for bankers. Skewed incentive structure resulted in structuring financial products to enable up-front recognition of income facilitated by new accounting standard (IAS39)!

As bankers’ variable compensation is linked to annual performance, early recognition of income leads to a culture of creating more complex structured products. This has lead to mis-selling claims as customers were not offered vanilla products or were lured into structured products by overegging the benefits.

A classic example is the current mis-selling claims of swaps to SME's - bundling of interest rate swap with term loans. A simple term loan product was structured as a floating rate loan with an interest rate swap overlay to facilitate instant revenue recognition by loading the margins on the interest rate swap.  Banks have systematically taken advantage of this accounting asymmetry.  In many instances swaps were offered as a free product on a floating rate loan as a hedge to these unsuspecting and often uninformed customers.  This is not to say that swaps per se are inappropriate as they are a good risk management tool but should be sold where appropriate rather than to unsuspecting and unsophisticated customers. 

Even the CDO market was created on the bank of sub-prime and other mortgage loans with the aim of creating marketable securities to accelerate revenue recognition with devastating effect as the greed took hold and underwriting standards were non-existent. 

Let’s take a look on what has been done by the regulators and how effective it has been thus far and what else is coming…

Recapitalisation of banks

Soon after the financial crisis several financial institutions were recapitalised by Treasury (in most markets) and saved the financial sector from falling abyss.  Banks promptly got back to their old ways, started helping themselves by reestablishing their variable compensation.  Conservation of capital or boosting lending for economic recovery was a secondary objective!

Monetary policy actions have run out of steam…

The monetary policy of the central banks has resulted in a near zero interest environment and significant inflation of the balance sheet of the major central banks.  Neither of these actions has resulted in any perceptible impact on economic growth but it is widely believed that these actions have certainly helped in preventing a deeper recession.

The low interest rate regime has helped with greater disposable income for borrowers but that has not resulted in increased consumer spending.  So far both banks and the customers have been actively deleveraging.  And this could go on for a few years!  At the same time the low interest rates are hurting the savers and the pensioners.  There is a significant wealth shift from savers to borrowers and our pensions are not going to be worth that much.

An avalanche of new regulations…

In order to regulate the banks in a more effective manner, the regulators around the world have been busy developing a raft of regulations that is coming thick and fast! The Basel 3 or CRD IV directive covering new capital and liquidity requirements for banks will mean that banks will need several billions dollars more in capital to meet and more than a trillion dollars of liquidity to meet the new norms. There are several other regulatory initiatives, which take cumulatively would push any hopes of an economic recovery into oblivion. Some of these are:

·                     Volker’s Rule or the Dodd-Frank Act
·                     Vickers Report for UK banks to ring fence retail banks
·                     Crisis management directive – Resolution Plans or Living Wills
·                     Centralised Clearing House for swaps
·                     Significant increase in regulatory reporting requirements
·                     Retail distribution review

And there are some regulations that have much stronger impact than the others.  It’s important for the regulators to prioritise the order in which some of these regulations to take effect to achieve the twin objective of putting the fire out and redesigning the house for the future.

The current penchant for a raft of regulations aimed to minimise risk taking may cumulatively just achieve that, minimal risk taking!  As the Chinese saying goes, be careful what you wish for!

Regulators need to be cautious, lest the medicine may become the ‘poison chalice’.

While it is essential to make the banking system safer to avoid future tax payer funded bail-outs, this can be achieved differently.  Increasing capital requirements now is akin to designing a new fire resistant house while the current one is on fire!  Instead of focusing on putting out the fire first and then rebuilding the house, the regulators are leapfrogging to create a safer banking environment.

Basel 3 is driving banks to conserve capital

The Basel 3 capital requirements raises the core capital requirements to north of 10% (including various buffers) from the current 4% equity and hybrid capital and 8% in total.  In practice the impact is far greater when taken together with the regulatory deductions from capital and increase in risk measurements for trading risk and certain types of risks in the portfolio. The cumulative effect of the above is an increase in capital requirements by about 3 to 5 times from existing levels depending on the institutions asset risk profile.

Banks are in the business of taking risk and do this through both credit extension and maturity transformation. By significantly raising the capital requirements, the credit extension is effectively blunted and by stipulating stringent liquidity norms, the maturity transformation is also severely impaired.

This increased requirement is stifling banks from supporting trade and finance. Banks are actively deleveraging in order to meet the new capital requirements.  Even as  the cost of capital and liquidity have risen resulting in squeezed margins,  the business volumes have significantly shrunk resulting in depressed profitability and limited core equity generation.

Why would anyone provide more capital to an industry stuck in a quagmire of regulations, declining earnings, poor returns on equity, uncertain economic climate and an uncertain future?

….It’s the Capital, Stupid

The Central banks’ are too consumed by monetary aggregates and inflation figures.  They are busy administering increased liquidity measures through their Asset purchases, Long term repo’s (LTRO’s and Operation Twists) and Quantitative Easing hoping that more liquidity will lead to more lending.  Whilst all this is helping liquidity and driving interest rates, it is not providing any impetus to lending.  As lending would result in increased capital requirements at a time when capital is scarce, banks are rightly focused on deleveraging.

So, it is important for regulators to appreciate this and sequence the regulatory changes with the foremost objective of boosting lending to support the economy and even while addressing the safety issues.

It is time the central bankers started focusing on addressing capital requirements of banks.  No amount of increased liquidity is going to encourage the capital starved banks into lending!

…more capital is not a panacea

More capital will only mean that a bank can lose more money before going broke.  Under deployed capital is an equally a bad outcome with cost of credit increasing to ensure adequate returns on capital. 

A set of simple regulations with more effective supervision that aims to instill a strong risk culture that curbs excessive risk taking, significant disincentives for senior management failure will be far more desirable. 

What can be done?

While Quantitative easing has kept the interest rates low, it could have delivered a far greater impact if the Central Banks created a ‘Special Assets Vehicle’ to buy risk assets off the bank.

Special Assets Vehicle

A vehicle funded by the Central Bank can start buying illiquid assets (not necessarily bad assets) from banks at an ‘arms length’ price.  These assets unwind over time as the underlying loans amortise. 

This would alleviate both liquidity and capital in banks, thereby creating capacity for new lending. Ultimately, if banks have to get strong, economy has to fire again and if the economy has to fire again, banks have to start lending!  The situation now is neither is happening and we are in the danger of getting into a downward spiral loop!

….some immediate priorities

Instead of spending endless hours to debate and construct a comprehensive regulatory regime that is leading to more uncertainty stifling new capital for banks, it would be far more beneficial if the immediate focus was on the following:
·             set up a special assets vehicle and buy illiquid assets off banks using quantitative easing (can set strict credit criteria for loans to be bought);
·       enforce a risk culture and ensure Boards of Banks are represented adequately by risk professionals who can set and monitor risk appetite;
·               hold senior management accountable for failure;
·             levy stiffer penalties including criminal prosecution in case of fraud and systematic abuse like money laundering or mis-selling;
·            set prudent guidelines on executive compensation that does not encourage excessive risk taking and has a sufficiently large deferred component that is linked to long term performance;
·                have claw back provisions for failure including docking of pensions;
·               leave the quantum capital at a level of 8% and focus on quality of capital i.e. equity;
·       enforce robust resolution plans including setting sufficient bail-in’able debt to cushion losses;
·             use macro prudential filters to curb excessive risk than stipulating higher capital minimums for all banks… a one size fit all approach is counterproductive.

Having prudent compensation guidelines and strict rules to curb gaming of tax, accounting and regulations alone would have more salutary effect than oodles of regulation! 

And once the dust settles, that would be time to revisit and design a more robust financial framework. The aim should be to have a financial sector that ring fences activities that are raison d’ĂȘtre of banks i.e. of providing payment services, savings and lending products to clients and customers.  And a framework where customers have a choice!  A call for back to simplicity!

The law makers should then take steps to dismantle the ‘too big to manage’ and ‘too big to fail’ institutions that may eventually address the big goal of ‘taming the banks’!

As Gertrude Jekyll, a British horticulturist once said, “There is no spot of ground, however arid, bare or ugly, that cannot be tamed into such a state as may give an impression of beauty and delight.”

She certainly wasn’t thinking of banks!