COVER STORY: BANKING
Bankers and regulators are beginning to lay out the future structure of the global financial industry. In the short term, it is set to be a deeply confusing place.
By Nick Kochan
It must never happen again! That is the cry of the bank regulators, who have stared global financial meltdown in the eye and recoiled in horror. The fear of something so painful in human and employment terms, so costly in investment terms and ultimately perhaps most embarrassing in regulatory and political terms has prompted a spate of proposals for changes to the system of banking controls over the past two years.
The proposals from regulators, politicians and bankers have flowed as freely as did the bonuses in the earlier, pre-crisis world. They have taken three basic routes. The first covers issues of capital allocation. The second deals with bank structures. The third tackles perhaps the thorniest problem: that of over-mighty bonuses.
Increasing the requirement on banks to put capital aside is probably the most frequently touted solution. It also has considerable merit as it hits at bankers’ tendency to lend more than their assets can justify. Banks are currently required to set aside capital based on their assessment of the risk of their portfolios. Principles for assessing risk are contained in the Basel II regulations. But Philipp Hildebrand, vice chairman of the governing board of the Swiss National Bank, says the latitude allowed to banks for determining risk is much too wide. He also says the Basel criteria fail to account for the most unlikely events, sometimes called “black swans.”
The solutions may be tough for bankers, but they are not very complex, Hildebrand says. “There needs to be a lower limit set for the capital-to-assets ratio of banks,” he asserts. “The present system has blatantly failed. At the moment, listed non-financial firms have capital-to-asset ratios of 30% to 40%. Unbelievably, before the onset of the current crisis, all of the world’s top 50 banking institutions held, on average, only 4% of capital. None of them held more than 8%,” he adds.
Banks are not exactly enamored of such suggestions, though. George Magnus, the chief economic adviser to Swiss bank UBS, says the requirement to increase the capital base, and hence minimize the risk, could limit banks’ capacity to innovate. This has given rise to a regulatory drive to find a “counter-cyclical” system to manage the pain of capital allocation. “Capital needs to be set aside during the good times, so that it is available when a problem occurs,” says Magnus. “That will ensure the safety net is there when the crisis hits, and there is less need for a mad scramble for funds to rescue the bank at the very point when they are hardest to find.”
Bank structures, as well as financial requirements, need to be assessed in the context of extreme risk, says Stephen Lewis, the chief economist at Monument Securities. “Banks need to review their global structures and ask themselves what would happen if the apocalypse occurs,” he says. “They need to be able to build a business that is not so interconnected that the whole structure fails if one part fails.”
The concept of the so-called “living will,” currently just a fragment of regulatory jargon, is designed to prepare a bank for meltdown even when it is solvent, explains Lewis. Preparing for a potential financial meltdown “may mean dismantling over-complex taxation structures and pulling out of some of the less core banking areas,” he adds.
The point of the discussion where governments have up to now become most involved is the assault on bonuses. In the United Kingdom in particular, the blunt instrument of a windfall tax has provided some useful revenue for government to mitigate the worst effect of the crisis but has done little—if anything at all—to deal with the demand for a restructuring to ensure bonuses better reflect performance. Banks appear to accept that they need to do something on this score. At the same time as many bankers have denied themselves bonuses in an attempt to defuse the political assault, they are making efforts to deal with the charge that bankers have earned their bonuses too quickly and easily.
Jehangir Masud, a banker with private investment bank PMD International, says bonuses need to be tied more closely to the long-term performance of a deal or of an institution. “Bonuses should be drip-fed over the period of a loan or mortgage,” he suggests. “This ensures that it is a just reward for a deal well done. We are through with a disastrous period when people were able to walk away with their bonus even if the deal promptly collapsed, leaving institutions weak and poor performers wealthy. Institutions are helped by having people who not only create deals but also manage them over their duration. We need to see a return to an ethos of long-termism in banks.”
Volcker’s Ascendance Shocks Banks
Bankers hoping that they could set the terms for the debate over future ways to minimize bank risk received a rude shock at the end of last year when Paul Volcker, the former chairman of the Federal Reserve, and his patron, US president Barack Obama, waded into the argument. Worse yet, for the bankers, Volcker and Obama were championing proposals that bankers had hoped would remain in the realm of theoretical academia. These came within a whisker of a return to Glass-Steagall legislation, which had outlawed banks combining investment and commercial banking under one roof.
In from the cold: Volcker’s return to prominence caught banks by surprise
Volcker put his thoughts succinctly in September 2009 to the House of Representatives banking and financial services committee: “As a general matter, I would exclude from commercial banking institutions, which are potential beneficiaries of official (i.e., taxpayer) financial support, certain risky activities entirely suitable for our capital markets. Ownership or sponsorship of hedge funds and private equity funds should be among those prohibited activities. There are deep-seated, almost unmanageable, conflicts of interest with normal banking relationships.”
The cries of pain in the banking community still resound. “With the Volcker proposals, politics is trumping economics,” Magnus says. But while bankers squirm, academics hail the “Volcker rule” as a necessary move in banking system reform. “The debate about solutions to the problems facing the world’s sick banks has moved out of the recesses of the regulators and the technicians,” says Peter Hahn, an adviser to the UK’s lead financial regulator, the Financial Services Authority, and an academic at London’s Cass Business School. “This is no longer a technocratic exercise. By proposing legislation, the American authorities and government are taking an axe to everything that has gone before. The discussion about the future look of global banking has been brought out of the closet,” Hahn adds.
Opponents to the Volcker-championed reforms tend to argue either that they will be too draconian and cause unnecessary damage to banks and clients or that they are unworkable and therefore less effective than the politicians hope. Magnus falls into the first camp, arguing that the Volcker rule will wreak excessive and unpredictable damage. “Obama’s law might make it punitively expensive for banks to run operations or balance sheets beyond a certain size,” he asserts. “That would force institutions to slim down. In the long term, that would probably not make any difference to the banks. In the short term, if the banks had to basically shed billions or trillions of dollars’ worth of assets on top of the deleveraging that they’re doing at the moment, it could be highly destabilizing.”
The Volcker rules risk being unworkable, adds Hahn, as they might severely constrain many aspects of the uncontroversial commercial banking business. “When a bank recommends that an investor buy into a hedge fund, they will typically say, ‘We have this investment, and so should you. If you lose, we will also lose.’ If the bank cannot invest even its own capital in a fund, then that option is closed,” Hahn explains. “Some people would argue that banks holding the deposits of retail customers should not also be offering to invest private wealth as private wealth management can be a high-risk business. At that point the Obama reforms start to unravel a bit,” he adds.
Regulations May Hurt Profitability
The measures will fulfill political demands for lower bonuses but at a cost to profitability, warns Magnus. “Competition in the market will grow, and that will bear down on prices and profits. This in turn will lead to a restraint on banking bonuses. We will get a smaller banking sector, not a concentrated banking sector,” he claims. “We need to make sure that activities are spread around more institutions. The more competitive the banking sector is, the better it is for customers but also the less likely it is that the super-normal profits will be earned. It’s the super-normal profits that make big bonuses.”
Magnus picks up on a common theme among opponents of reform, arguing that Volcker, far from assisting the system, could actually add to the risk. “You will push a lot of that activity into another part of the financial market, which is less well regulated, or which will become less well regulated—for example, directly into other independent hedge funds,” says Magnus.
Volcker’s rules are irrelevant to a banking system that thrives or fails by assuming risk, says Patrice Muller, managing partner at London Economics, an economics consultancy. “The financial system is like a waterbed, where the risk moves around with the pressure,” says Muller. “Risk that leaves one part of the system will find its way to another part.” Terry Smith, the chief executive of Tullett Prebon, a money broker, urges regulators to resist a knee-jerk reaction to a crisis whose roots are deep and structural. “Regulations are an inevitable response to crises, but they do not necessarily solve them,” argues Smith. “Japan’s banking meltdown in the early 1990s produced a welter of regulation and structural change, but its impact has been negligible.”
The worst outcome from the Volcker rule would be if it led to a financial system that was more rigid and less creative in delivering its intended purpose—namely to intermediate credit—than it is today. But Smith says Volcker could end up doing just that. “You could stifle the financial sector and end up with a permanently dysfunctional financial industry. Japan is obviously not in a financial crisis anymore, as it was in the 1990s, but the financial system in Japan is still not intermediating a lot of credit. You can have structural reform that works, and you can have structural reform that basically just keeps things, relatively speaking, dysfunctional.”
The alternative to a system that is too highly regulated and rigid is one where regulators lose the plot and allow risks to run out of control, warns Hildebrand. “If we increase our dependence on risk models, we are at risk of picking the wrong models,” he says. “What if the data used to calibrate these models turns out to be of poor quality? What if the models were correct in the past, but the future is different? What if certain tail events simply cannot be modeled?” he asks. “These are all important considerations that we have to keep in mind when we interpret the risk figures from complex models. As it turns out, to view the model outputs as a true representation of reality has proven to be a grave mistake.”
Complexity Hampers Internal Control
Hildebrand believes the banks’ increased reliance on their internal models has rendered the job of supervisors extraordinarily difficult. “First, supervisors have to examine banks’ exposures. Second, they have to evaluate highly complex models. Third, they have to gauge the quality of the data that goes into the computation of these models. To put it diplomatically, this constitutes a formidable task for outsiders with limited resources,” he asserts.
The system needs deeper dramatic change than even Volcker projects, says Luc Keuleneer, a partner in KPMG in Brussels. “Reporting standards and even Glass-Steagall are all based on the belief in efficient markets. Yet markets are not always efficient,” he points out. “So you have a problem. If you just change Basel II a little bit, or change reporting standards a little, you are not changing the fundamentals that always come back to you if something is going wrong.” Keuleneer says the solution is to completely rewrite the rules for equity levels in banking and to restructure financial reporting standards. “Regulators think that individuals are rational,” he says. “But most are, in fact, irrational. We need to adjust the link between regulation and bankers’ ability to fool people that they can make them rich.”
While responses to Volcker from the banking community have been largely critical, some have seen opportunities in the proposals. For example, Mike Mayo, a leading banking analyst at Calyon Securities in New York, sees little downside in the proposals to break up the banks. Indeed, he thinks there might be opportunities arising from it. “Companies may be able to offload hedge funds and private equity activities into third-party funds and generate fees on this extra asset management-type service, as well as free up capital for other uses,” he writes. Mayo says the risk reduction comes from swapping direct capital exposure by the financial institution for a relationship where the institution manages the assets for another party and gets fees for this service. “By raising third-party funds and selling their investments into the asset management unit, Goldman [for example] could free up roughly $7 billion in capital,” Mayo claims. The actual numbers, he adds, depend on “how much, if at all, the company is allowed or required to co-invest and keep some ‘skin in the game.’”
Ultimately, the Volcker rule may resolve many of the most pressing issues in the global financial system, but in the short term it has brought fresh uncertainty to an already uncertain world of banking risk, of capital structures and of remuneration principles. Unfortunately, that increased uncertainty is practically unavoidable. The crisis has brought to the top of the banking agenda the challenge of understanding and mitigating regulatory risks, and the new rules sound the death knell on an era where making a profit was really the only goal. Now restraint will trump risk, and caution will override creativity. Welcome to a new, more stable—but more boring—banking world.