Financial Times

Capital needs and structural change: Coming challenges for banks
By Nihal Welikala Former CEO of NDB Bank and Citibank Colombo

Role of banks in an economy
Banks have been described as fulfilling a variety of roles in any economy. Among many other things, they provide payments services, transform liquid short term deposits into illiquid long term loans, and monitor borrowers on behalf of depositors. In short they are a vital element of any economy, and weak performance in the banking sector will inevitably result in wider adverse economic consequences. This was most recently demonstrated by the sub-prime crisis, which originated in the US but whose shockwaves are being felt globally. Emergency infusions of capital at fire sale prices and of liquidity, often at the expense of taxpayers, have had to be made to strengthen the balance sheets of major international banks, in order to limit wider damage to the global economy.

Why is equity capital important for banks?
The amount of shareholder equity in banks is typically very small relative to their borrowings and deposits. Thus, banks are very highly leveraged and operate on a higher level of borrowings in comparison with typical business enterprises. Businesses typically borrow funds roughly equal to their net worth. Banks by contrast, typically have liabilities which exceed 10 times their equity capital, with the bulk of those liabilities representing deposits of relatively small sums received on trust from millions of members of the public. Given the risks inherent in the way banks fund their operations, their systemic importance, and the high economic and social costs of their failure, banks everywhere are expected to operate with a high degree of commercial prudence, and under tight regulation, as a matter of public policy.

In particular, capital regulations require banks to hold a minimum level of equity as a percentage of their loans and other assets. This minimum level of capital is designed to protect the bank against unanticipated losses and to provide confidence to depositors who accept the risk of asymmetric information i.e. depositors are not in a position individually to know whether a bank has taken on risks beyond its capacity to absorb them, and rely on the cushion of equity, as well as close regulatory supervision, independent audits and sound credit ratings to provide a level of comfort. The amount of a bank’s equity therefore defines the limit to which it can attract deposits, which in turn limits the extent to which it can lend.

Capital needs and structural change: Coming challenges for banks

An erosion of the net worth of banks, for example due to large credit or trading losses, reduces funds available for lending if declining bank capital occurs on a systemic and material basis. This occurred recently with sub prime losses, where a vicious global cycle of reduced lending and declining economic growth was set in motion. It has been estimated (Bank of England Quarterly Bulletin, Spring 2004) that the amplification effect of falling bank net worth takes approximately 10 quarters, before output returns to its initial level. Whatever the estimate of the duration of the impact, it is likely that since output was initially produced with capital that was already in place, bank capital erosion affects output with a lag, rather than immediately.

Capital and risk
While there is universal acceptance of the need for banks to maintain adequate capital, what is meant by “adequate” and what is meant by “capital”, evolve over time, in response to changing market and economic conditions both globally and at home, and to the rapidly changing risk profiles of banks. There is little doubt however, that regulators everywhere have made capital adequacy rules increasingly stringent. They are also seeking through the Basle I and II initiatives, to ensure some degree of uniformity of definition across the world. However, since the adequacy of capital depends both on a bank’s risk characteristics and the environment in which it operates, uniformity may be an unattainable goal in a non-uniform world.

Changing risks and recent banking crises
The changing nature of risk, to which regulators are responding inter-alia with calls for additional capital, is illustrated by two recent banking crises, which had significant impacts on national, regional or global economies.

Asian crisis
The Asian economic crisis of 1997 was rooted in a combination of flawed economic policies, and poor governance practices over a long period. A regime of fixed exchange rates led to excessive foreign borrowings to fund domestic operations, to the creation of real estate bubbles, and eventually to unmanageable currency risks, as market forces overwhelmed overvalued exchange rates. At an institutional level, bank performance was impacted by the influence of dominant individual or family owners and by political direction and patronage. Owners eroded the independence of boards and management in making operational decisions. They also pursued their broader visions with depositors’ money, resulting in illiquid quasi-equity assets being booked on balance sheets, heavily disguised as commercial debt or project loans.

The impact of the crisis on the former Tiger economies of East Asia and on their banking systems was contagious and severe, but regionally confined. One positive outcome of the crisis was the consolidation of the banking industry. Small family-owned banks were unable to find the capital needed to make good their losses. The survivors were those who built the scale that was needed to improve operational efficiency and to raise new equity, through mergers and acquisitions. The new consolidated architecture of the banking systems resulting from crisis, was inevitable and beneficial in the long term. However, in the shorter run, it was a painful exercise, which crippled many Asian economies for many years. More than 10 years on, the effects of this Asian financial tsunami are still being felt in a few countries such as Indonesia.

Sub-prime crisis
The present crisis which started stealthily and unexpectedly a decade later in August 2007 at large OECD based banks, is more complex and far reaching in impact. The numbers demonstrate the scale of the problem – US$475 billion in write offs by major banks so far, the forced raising of US$350 billion of highly dilutive new equity, in unfavourable market conditions, and the reduction of $ 1.6 trillion from global market capitalization of banks.

The crisis has caused a severe downturn in housing markets, triggered a global credit squeeze, jeopardized the health of banking systems and pushed the world to the brink of economic recession. It is rooted in the fiscal excesses and lax monetary policies of the last few years in the US and other developed countries, where budget deficits were kept too high, and interest rates too low for too long, in order to stimulate economic growth. To this was added at global banks, a toxic mix of bad lending practices on a massive scale, mainly housing loans to low income, high risks borrowers, and poor liquidity management, with long term loans being funded by short term borrowings. “Ninja loans” to borrowers with no income, no jobs and no assets”, were an extreme example of unreal credit standards in use. Additionally, lack of transparency and accountability, management compensation which was aligned to revenues and not to risks, combined to threaten financial systems and economic stability globally.

A negative feedback loop was created, as banks sold assets and cut lending, in order to improve their capital position. However, these asset sales reduced prices further, which resulted in the need for more assets sales, at even lower prices, and the infusion of more capital to make good the resulting losses. Severe pressure was put on new lending and on capital, by this vicious de-leveraging.

The crisis was also based on the collapse of conventional wisdom in two critical areas. Firstly, the US Federal Reserve was convinced that financial innovation using mathematically sophisticated derivative instruments, had changed the nature of risk by spreading it across the globe. It was assumed that this made the financial system more stable, and permitted banks to cut their capital despite explosive growth in the issuance of debt securities. Secondly, that highly liquid markets, based on lax monetary policies, would persist indefinitely. “Abundant market liquidity led some firms to overestimate the market’s capacity to absorb risk” in the understated words of the Institute of International Finance in Washington.

Disclosure and accounting – the wider impact
Two technical aspects of the problem in the US also deserve mention, as they illustrate the importance and wider economic impact, of disclosure and accounting rules. In the past, when a bank made a loan, it was held on its balance sheet, and it therefore needed to ensure that the borrower was credit worthy and that adequate supporting capital was held. However, the bank needed less capital, and could make more loans, if they were held in special purpose vehicles off its balance sheet, which was permitted under the Fed’s new philosophy and rules.

This process of non transparent disintermediation meant that banks had less need to check credit worthiness. Instead, they were incentivised simply to write more loans, take a fee and sell on the loans. The responsibility for credit worthiness was in effect passed on to a handful of credit rating agencies on the basis of whose unrealistically optimistic ratings, investors across the world scrambled to buy these securities, without much appreciation of the risks they were taking. It has been estimated that off-balance sheet assets of major banks amount to around US$5 trillion. Moves by FASB, the US accounting standards board to bring these assets onto balance sheets have been deferred to 2010, because of fears of the potential impact on the capital of the banking system.

The problem was exacerbated by the fact that US accounting standards were moving quickly to the concept of a “fair value” approach to the computation of profits, as opposed to conventional historic cost and accrual accounting. To oversimplify the issue for the purpose of illustrating the problem, under fair value accounting, financial assets and liabilities are stated in the balance sheet at market value, and any surplus or deficit over cost is credited or charged to profit. The old adage that “cash is fact, everything else is opinion” once more proved its relevance in the crisis, as “fair value” became virtually impossible to determine in increasingly illiquid markets. In shallow or non-existent markets it became impossible for investors to ascertain the true state of finances of a bank, which resulted in the paralysis of inter bank lending based on mutual mistrust, and the need for Central Banks to inject an estimated US$450 billion of liquidity, to prevent systemic collapse.

In good times, fair value accounting can temporarily flatter profits, balance sheets and bonuses, and therefore needs to be underpinned with clear disclosure, and definitions of management responsibility. In bad times, banks have been compelled to write down assets and earnings, by hundreds of billions of dollars, based on artificial estimates of asset prices.

Fair value accounting is pro-cyclical, exaggerating both the peaks and the troughs of the business cycle. Its limitations in terms of the difficulty of determination of asset values in shallow markets, and its impact on profit volatility need to be carefully considered before its principles are adopted in smaller markets like Sri Lanka.

Regulators, regulations and crises
Banking crises develop slowly, but then strike with unexpected speed. Regulators need to have the capacity to identify adverse trends early, and challenge the unholy trinity of complacency, vested interests and conventional wisdom, in a timely manner. Timely action to deal with issues is a lot less expensive, than responding to lines of anxious depositors outside the doors of banks, with calls on the public purse. Providing an implicit government safety net to banks encourages risky behaviour and raises the risk of moral hazard. “Too strong to fail” is better than “too big to fail”.

Recent crises recognized the need to strengthen both the performance and the independence of regulators. Banking has become a complex and technical profession, and regulators need to develop the competencies to keep pace with the industry. Recruitment, remuneration and training policies should reflect this reality. In terms of independence, the IMF has recently highlighted the importance of avoiding “capture” of supervisors, either by political or industry interests. To whom supervisors report, and how they are funded, will largely determine their level of independence and effectiveness.

Lessons to be learned from these crises
Banking crises are not uncommon and have occurred periodically in many countries. They cause wide and severe economic and social damage when they strike. They are rooted in unsound policies and practices, both at macro economic and at institutional levels, which may have become ingrained as conventional wisdom for many years. Unsound policies are connected to unsound banks by a slow burning fuse. The price to be paid for a robust banking system is constant vigilance by independent stakeholders, (boards, management, auditors, rating agencies and regulators) who have the professional judgment and technical capacity to strike the appropriate balance between risk and reward, and economic policies which look not just at goals of economic and employment growth, but at their associated risks and costs.

Problems of banks are amplified by complexity, and in a globalised world, by opportunities for wide product and risk dispersal. However, they are usually based on the breach of the twin fundamentals of banking, namely credit and liquidity risk management

Capital is a first line of defense for any banking system. Banks should not only be well capitalized, but should have the capacity to access new capital during times of stress. This capacity is based on their reputation both for integrity and for high quality management. These qualities give comfort to providers of new equity that sufficient profits will be generated to service their capital. However, no amount of capital or regulations can protect a bank against poor management, conflicts of interest or other unethical conduct.
Consolidation of the banking industry in Asia eventually produced the desired institutional scale and systemic stability in many countries. However, banking sector reform is best undertaken in a proactive rather than a reactive manner, in good times rather than as a response to crisis, to avoid high economic and social cost.

The understandable response of regulators to crisis is to impose more regulations. Much higher level of control mechanisms for banking institutions compared with other commercial organisation is justified, given their fiduciary responsibilities arising from high leverage of public deposits, and the dire consequences of their collapse. However, an appropriate balance must be struck between the need for control, and the need to operate profitably as commercially viable enterprises, accountable for returns to the providers of their capital. Capital and returns are two sides of the same coin. Achieving this balance requires mature judgement, both on the part of those who frame the rules, and those who implement them. Regulators are now also moving to a more proactive role in anticipating rather than reacting to crisis e.g. the recent introduction of stress testing and contingency planning for banks in the US.
It should be recognized that banking regulations, governance rules and accounting standards add to complexity and costs. If they are to be adopted, they must pass the test of relevance for purpose. Rules designed to deal with the issues facing banks in New York or London, but adopted on a “one size fits all” basis in smaller markets can in fact be counterproductive, if they divert management and regulators into time consuming technical complexities, and away from recognizing and managing the real risks which may be at ones own doorstep or add to costs without producing commensurate benefits. It’s all about balance.

Opinion is developing now that we may have seen the worst of this particular crisis, although relief may not come soon enough for many investors and banks. “Markets can stay irrational, longer than you can stay solvent” -- J M Keynes. However, as the global economy slows, and consumer defaults start to increase, the questions of whether a second tsunami wave is due, and whether banks have sufficient capital to protect themselves against it, are now being raised.

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