The successful undertaking of trade and commerce requires institutions that act as conduits through which capital can be exchanged. A sound banking system is essential to society’s wellbeing, as are both savers and borrowers. Without borrowers, a savings culture could not exist because there would be no point in paying interest on deposits. Equally, companies requiring finance could not function without savers. It is the ultimate symbiotic relationship, and essential to continuous social development and progress.
Banks are the cornerstone of this economic relationship. All banks, irrespective of their size or strategy are, ultimately, identical institutions. They deal in the same markets and with each other. That means that the bankruptcy of any one bank, while serious for its customers and creditors, has a bigger impact still on the wider economy because of the knock-on effect on other banks. It is this systemic risk that presented the greatest danger to the UK economy in 2008, after Lehman Brothers collapsed, and which required the injection of billions of pounds of public money to safeguard the banking system.
The challenge for policymakers now is to take steps to ensure that the economy and the taxpayer are no longer hostage to the fortunes of the banking industry. In this article, we examine the factors behind the 2007-08 financial crisis, and use the lessons learned from it to formulate five steps towards a safer financial system.
Moral hazard and the “Too Big To Fail” bank
The systemic risk of large banks has still not been addressed. The “too-big-to-fail” (TBTF) bank, and its guarantee from the central bank lender-of-last-resort (LoLR), creates significant moral hazard for the economy. There is no doubt that the existence of a safety net creates an unconscious reflex in bank senior management to take on more risk. Perhaps not today, because in a post-crisis recessionary environment banks are risk averse; but as the economy recovers, risk appetite will increase. Due to competitive pressures in banking, a higher risk-reward profile becomes a self-fulfilling prophecy, as banks seek to generate more customer business and attract deposits.
In other words, this problem will not go away unless governments proactively address it. Merely raising bank capital requirements is not sufficient; at the time of its bankruptcy Lehman Brothers had an 11% equity capital ratio, which regulators accepted as adequate up to the day of its demise.
Step 1: to tackle the TBTF problem, regulators must demand the following:
Require the trading arms of banking groups to be set up as separate legal entities, independently capitalised, so that they do not endanger the retail arm. This reduces the chance that the LoLR will have to step in to save a failing bank because its trading arm had taken on unmanageable risk exposure. If it was a separately-capitalised subsidiary, it could be unwound without impacting the retail bank;
Set strict rules to manage funding and liquidity risk at banks. This includes requirements to diversify funding sources, and increasing the average maturity of funds. The FSA has already started the process to implement a stricter liquidity regime for banks;
Reduce leverage, and thereby limit asset growth, through the imposition of leverage limits;
Establish a clearing house for the London interbank market, an “International Money Exchange”, that would work similarly to an exchange clearing house. Such a facility would eliminate bilateral counterparty risk and make the money market safer during times of crisis, because it is at these times that banks withdraw lending lines to each other.
These measures will force banks to adopt a more conservative strategy that maintains focus on secure funding and manageable risk taking. This will make them less likely to fail during the next crisis.
The “Shadow Banking” system
The shadow banking system helped create the crisis. Next to the conventional commercial banking circuit, an unregulated parallel banking model had built up over several years. Unlike the classical banking system, it followed an origination and distribution model, moving loans from bank balance sheets to offshore entities such as structured investment vehicles (SIVs). These SIVs needed alternative funding because they did not have the retail deposit base of the banks. However, when the liquidity crisis broke in 2007, their funding evaporated and banks had to take all this risk back onto their balance sheets.
Step 2: Any entity that engages in mismatched or leveraged finance should be supervised by the regulatory authorities. This would allow the regulator to have a more realistic appreciation of aggregate industry risk.
The role of central banks
Central banks inadvertently assisted the build-up to the financial crisis. The aggressive monetary intervention practiced by the US Federal Reserve during the 1990s and after 9/11 created the impression that authorities would always come to the rescue of the banks. Furthermore, continued accommodative low interest rates helped sow the seeds of a price bubble in the housing market that central bankers were too late in identifying.
Step 3: Central banks must target asset prices, as well as inflation, and monitor price developments in equity and housing markets, so that price bubbles can be deflated pre-emptively. This will reduce the social damage that arises when a bubbles bursts.
Improving the regulatory framework
The regulatory framework encourages pro-cyclicality of bank lending. Banks have to hold additional capital against greater anticipated losses as the economic cycle turns downward. This makes an economic recession even deeper when banks are forced to restrict their provision of credit in a contracting environment. Ideally, however, the system would work the other way round, with banks building up capital during a period of growth, so they could take losses and maintain lending in a recession.
Step 4: Regulators must implement “macro-prudential” regulation, requiring banks to operate in less cyclical a manner. This can be enforced by altering bank equity capital and liquidity requirements. At any time when the market is viewed as pursuing ever more risky asset generation, and/or credit is seen as too easily available, the regulator can enforce more stringent requirements.
Bonus culture
The bank bonus culture was only a minor contributor to the financial crash, but attracted the most passionate comment in the media. There is no doubt that the current remuneration structure creates distortions in incentives. The main issue concerns booking profits today for a transaction whose cash flows occur over many years. The solution to this is to modify the remuneration system so that it builds in a long-term view, targets higher quality value-added profits and reduces the “hit-and-run” mentality among bankers.
Step 5: Split the banker’s bonus payment into three parts. The first part would be a standard cash payment. The second part would be paid in stock options that would be held for a minimum time period before they could be realised. The final part of the bonus would be placed in a claw-back account, also monitored for a minimum period. During that period, the bank would have the right to reclaim some or all of this cash if a transaction subsequently created losses.
Conclusion
The events of 2007-08 produced the world’s deepest recession of the post-war period. The banks were key players in this crisis. It is imperative that policymakers learn the right lessons from the crash, so that the taxpayer is less exposed in the future. Until now, governments have not gone far enough in addressing the risks presented by large banks operating worldwide. Further steps are necessary to mitigate this risk, which will benefit both banks and taxpayers in the long term. — Moorad Choudhry
Moorad Choudhry is head of treasury at Europe Arab Bank Plc in London, and author of Bank Asset and Liability Management, published by John Wiley & Sons (Asia) Pte Ltd.
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