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
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
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
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
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
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.