Make it better
29 Jun 09
Pouring public funds into banks has stablised the financial system – but the economy is not out of the woods yet by any means, says Robert Outram
by Robert Outram
Getting the world’s banking system to work again is, quite literally, a matter of life and death. The impact of the banking crisis on the world’s economy, for many people, threatens lives as well as livelihoods.
As John Hegarty, head of the Centre for Financial Reporting Reform at the World Bank, points out: “There is $700bn less in private capital flowing into developing countries this year; 60m people have been kicked back into absolute poverty; and there are a billion people suffering severe hunger. It is very difficult to talk to these people about ‘green shoots’.”
In the UK, the Government has taken action on a grand scale. It has put billions of public money into worst-hit banks and it has also set up an insurance solution, the Asset Protection Scheme, to help protect against losses on so-called “toxic assets”.
The Bank of England is also putting billions of pounds in (borrowed) public money into the financial system through “quantitative easing”.
So far, this unprecedented outpouring of public funds appears to have stabilised the system. Concerns continue, however. Credit is still very restricted for individuals and businesses. The banks have been recapitalised, but are they fully functioning?
Frank Blin, senior partner, Scotland with PricewaterhouseCoopers, says: “Banks are undoubtedly strengthening their balance sheets, and there is a greater sense of stability, but we are not out of the woods yet.
“Managing the tension between lending, and strengthening bank assets, is a delicate balance.”
Blin refers to the banks’ core dilemma. If stability is the top priority, then they must focus on strengthening balance sheets. On the other hand, the economy needs banks to be lending, especially to businesses.
John Hegarty says the sums now being poured into the system are necessary: “In previous financial crises, the cost of the downturn in the economy has been greater than the cost of bailing out financial institutions.”
He adds: “The issue now for banks is not so much liquidity as their capital base, and whether they have the nerve to continue lending.”
In a speech at the Association of British Insurers last month, Paul Tucker, deputy governor of the Bank of England, warned that banks should not be tempted to deleverage simply by cutting back on the availability of credit, adding, “not lending would be a counterproductive business and financial strategy.”
One senior director in the UK banking sector told CA Magazine: “There is a conflict between the need to ensure the public’s money is safe in UK financial institutions and the need to ensure banks are fulfilling their purpose of money transmission and lending to individuals and businesses.
“The essence of safety is the banking system generating its own capital – in other words, profit. So it’s not about Government or anyone else injecting capital into the system. To get asset values back up and liquidity back into the system, banks have to start lending profitably again.”
It’s also clear that banking regulation is set to change. The indications so far at UK and European level, and from the discussions of the world governments represented at the G20, are:
• regulation is likely to focus more on risks to the whole financial system, as opposed to processes within individual institutions
• crossborder regulation will be better co-ordinated
• regulators are more likely to challenge the strategy of banks’ senior management
• remuneration and bonuses for senior directors and trading staff are likely to come under scrutiny, but probably less so than the press and backbench politicians would like to see.
Marcus Sephton, head of regulatory services at KPMG in the UK, says: “A successful regulatory regime will need to balance both macro financial supervision with national policies and economic priorities and will have the long-term objective of financial stability.
“Overall, we expect regulation to become more intrusive and challenging, with larger supervisory teams. Boards are going to need to be able to demonstrate how they are dealing with the risks their firms are running and to explain clearly any weaknesses in the business models and plans to address them.”
Sephton adds: “In the UK, the most dramatic shift we’ve seen is the FSA’s commitment to making judgements on the judgements of senior management… senior management should now expect to be seriously challenged on fundamental issues like management competence, business models, strategy and the interaction of conduct and prudential issues.”
Pamela Muir, director, corporate with law firm McGrigors, says: “It would seem inevitable, following the failure of the tripartite model [in which responsibility for banking supervision and crisis management was shared between the Bank of England, the FSA and Government ministers], that a stronger regulatory framework will be implemented. I expect this will involve increasing oversight by the Bank of England on both capital adequacy and liquidity.”
Muir adds: “I expect that the popular topics of ‘bonus culture’ and ‘risk management’ will be heavily focussed upon to restore public faith in the sector. A balance will have to be struck between regulation and enterprise though, or we risk delaying or preventing the return of adequate liquidity.”
The Confederation of British Industry, representing the UK’s leading employers, is not surprisingly looking for both liquidity and stability. According to Matthew Fell, the CBI’s director of company affairs, the regulatory response should seek to achieve:
• better capitalised banks, able to be more resilient to liquidity shocks throughout the business cycle
• a regulatory framework, particularly on capital adequacy and accounting rules, that doesn’t amplify the business cycle
• a much better understanding of where risk lies and how to manage it better; this includes better supervisory arrangements for cross-border FS groups and robust corporate governance within individual firms.
But, Fell believes, we should also be wary of:
• the UK acting in isolation
• pursuing a “one-size fits all” regulatory response – which could do harm to insurers and others in the diverse financial sector
• a prescriptive approach where the regulator dictates business models and seeks to make everything “100 per cent safe”, stifling responsible innovation.
PWC’s Frank Blin says: “Regulators are moving more from focusing on systems and controls to assessing the competence of management and board governance, looking at whether boards have the right qualifications – which does not mean that they all have to be bankers.
“The system of rewards has also come under scrutiny – we could see deferred bonuses rather than paying bonuses out of unrealised profits.”
The crisis itself did not respect borders. The impact of issues such as sub-prime lending in the US on European banks, and the difficulty of organising crossborder rescue packages – for example, Fortis, which involved three completely separate deals with the governments of Belgium, the Netherlands and Luxembourg – means greater crossborder co-ordination is imperative.
At the European level, it has been agreed in principle to set up a European Systemic Risk Council (ESRC) and European System of Financial Supervisors (ESFS). The former will oversee macro-economic risks while the latter will oversee individual institutions.
The European proposals do not go as far as creating a single regulator, but they create a more robust framework in which national regulators can share information and work together.
KPMG’s Marcus Sephton says the proposals for the ESRC should create “a good early warning system” and also welcomes, with caveats, the ESFS. He adds, however: “No matter what regulatory regime is decided upon, all aspects of national macroeconomic policy – down to the specifics of national deposit protection insurance schemes, currency management and bank rescue regimes – must be considered and, ideally, should be able to be accommodated by the global framework. It is also critically important that any European initiatives align with G20 proposals, to avoid undue complexity for global financial institutions.”
Crossborder regulation could run into problems when national regulators have different priorities. As one senior banker points out: “While people can agree in principle that systemic stability is important, putting the brakes on the economy because of one person’s opinion would be a hard decision to take. National regulators are responsible for their domestic markets and they will not want to be told what they can or can’t do.”
Over-burdensome regulation of the mainstream banking system might also cause even more deals to go through the less heavily regulated parts of the financial sector, such as fund managers and hedge funds. Some have called for a root and branch restructuring of the banking system, separating out the riskier elements of the business – for example, through forcing mainstream banks to demerge from their investment banking arms. This would be a reversion to the “Glass-Steagall” regime, which applied in the US before the era of deregulation in banking.
Alternatively, as the CBI’s Matthew Fell suggests: “A better approach would be to identify activities that pose a systemic risk – such as payments systems – and make sure that these operations can continue in the event of failure, rather than trying to say, ‘this is a systemically important institution that can’t fail’.”
One part of the sector that has fared somewhat better than most is Islamic finance. As Omar Shaikh, a CA and board member of the Islamic Finance Council, explains: “Islamic banks are not allowed to get involved in interest-based transactions and they do not deal in exotic financial instruments or sub-prime mortgages.”
He adds: “What’s happened [with the financial crisis] has been completely unacceptable for many people and it begs the question, could we have an alternative form of banking?
Shaikh suggests that governments explore the concept of a “narrow bank”, that is, one that exists solely for money transmission. As the bank does not lend money out, it would be entirely safe. Shaikh says: “Over the past 12 months, if such institutions existed people would have put billions into them.”
It’s an innovation that would require a radical rethink in banking and banking regulation, although it is not necessarily tied to the idea of Islamic banking. Shaikh argues: “Scotland, more than anywhere, has a proud history of ethical finance. Scotland has a strong, stable and transparent financial system and it is in the best position to be a global innovator.”
It’s not surprising that institutions founded on the concept of sustainability are also seeing increased interest from savers.
Triodos Bank operates in the UK, the Netherlands, Belgium, Spain and Germany. In 2008, the bank had £1,312m in funds under management, and income of £70.2m with 169,517 accounts. Many of the sectors Triodos lends to, such as renewable energy, are still buoyant, and the bank was named as Sustainable Bank of the Year at the Financial Times’ Sustainable Banking Awards last month.
David Cousland, regional manager, Scotland with the bank, says: “Triodos has grown 25 per cent a year over the past five years and there has been even more interest in the bank during the credit crunch. We’ve got a simple model: people save with us and we lend those savings out.
“We saw a 13 per cent increase in savings deposited with Triodos last year. The bank is still comparatively small, but growing. There is a climate of opportunity for sustainable banking.”
As the world continues to feel the effects of the banking crisis, it’s clear that change is coming for the way the sector is run and regulated. Whether that means simply a more tightly regulated version of today’s banking sector, or whether there is room for more radical alternatives, remains to be seen.