Discourses on Finance & Economics
THE FUTURE OF BANKING
INTRODUCTION
This write up is based on the recent events in the subprime mortgage crisis and discusses the possible future development of banking as a result of that crisis.
Banks as a whole have lost a substantial amount of public trust as result and will have to work harder to regain their previous levels of customer trust. It will no longer be the case of nice print outs, good customer service, positive charts and figures.
Some banks may return to more conservative business models where their exposure is limited and their business much more easily regulated. It could also be a possibility that banks may decide it is wiser to diversify their branches under a group (i.e. virgin group) to reduce liabilities to the entire system. If the investment banking arm does not do well, it will not affect the performance of the other branches as a whole.
If the industry of banking declines, every other industry will deteriorate proportionately as well because they are essential in matching capital to labour and creating growth in the economy through the proper issuing of credit to capable borrowers.
SECURITIZATION
Securitization is useful in creating liquidity, but the issue in the current crisis lies in its poor application and lack of information and not in the concept itself. Many mortgage brokers and originators concentrated on writing as many loans as possible and relying on the banks to repackage them into securities and the banks, worked hard to sell the securities to the investors.
There were poor regulations on who the originators could loan to and this resulted in a drop in loaning standards. Another factor which contributed greatly to the decrease in loaning standards was the fact that the loan was securitized and the risk was offloaded from the originator to the banks and from the banks to the investors which reduced their stakes in the matter and diminished their sense of responsibility.
In the traditional mortgage business where the borrower goes direct to the bank to obtain a loan rather than a complex system of securitization, it becomes the best interest of both parties to be able to maintain a healthy relationship. The bank will review the profile more thoroughly as they are directly at risk and would limit the amount of risk the borrower can take.
As the distance between the borrower and the investor increased through securitization, the quality of information provided degrades as multiple profiles of borrowers are mixed and repackaged into securities. It is difficult to determine if borrowers under the purchased securities actually have any financial capability of repaying the loans.
As the defaults occur due to increase in interest rates and the apparent financial incapability of the borrowers show up, the demand for these securities froze and market value dropped severely as supply overshoots demand.
These points (of a non-exhaustive list of errors) reflect a great laxity in management and regulation of risks. Banks are therefore, forced to improve their system and focus on improving the management skills of their executives as well as selecting a management with strong backgrounds in core operations to prevent these lapses from re-occurring as well as to better manage the crisis.
REGULATION & TRANSPARENCY
Following up from the previous topic on securitization, tougher regulations would definitely be put in place to target the irresponsible issuing of credit and to implement a sensible system of risk management which will be covered more in-depth in the next section.
Not only must the system of regulation be made more stringent, it may also be necessary for the banks to increase transparency on its operations to regain the customer’s trust.
Other regulations could include changes in the requirement of the bank’s ratio of capital to asset, similar to the Spanish regulations with their banks. Interestingly because of the stringent require of Spanish banks to possess a high capital to asset ratio, they were not involved in the securitized mortgages and was largely unaffected by the crisis.
Enforcing strict regulations (one of the examples listed above) will definitely create “safe” banks, it significantly hinders the primary operations of the banks as a financing institution. While the easily-excitable public may take a knee-jerk reaction to this crisis, governing bodies should exercise caution in implementing regulations.
After all, some of the principal culprits were poorly regulated issuing of credit and lack of transparency in the bank’s operations. Transparency should be given to a reasonable extent such that the investors are able to make a well informed decision without the banks losing their competitive edge.
PROPER RISK MANAGEMENT
There is a strong need to understand the spirit of the law (or regulations) and not the letter of the law. The fraudulent regulations dodging as compared to sound investing concepts was the collapse of the securitization bubble.
It can be simply stated that the subprime mortgage crisis was a standard credit bubble and the banks failed to see all the associated risks. Securitization may have painted a pretty picture, but the underlying matter is the same: over-eager lending, careless investing and a widespread failure of risk management.
The segregation of risk management in banks gave rooms for errors. The banking industry needs to take a “big picture approach” as opposed to specializing in managing only market risks(sudden price movements), credit risk (defaults on payment) or operational risk (rogue traders, break down in operational equipment like IT, communications etc.).
Take a hypothetical example of how these risks can be interlinked.
A credit desk wants to make a $500m loan a gas firm but has a lending limit of only $400m. To make the loan, the credit desk buys a $100m credit default swap from a trader within the same bank which will pay out if the firm defaults. The trader hedges himself against the risk of paying out on the firm by buying protection on another oil firm, assuming that its paths are aligned with those of the first.
The end-result? A simple loan has turned into a complex mixture of market and credit risk.
These should go hand in hand with the method of assessment of risk. Currently, banks assume a static environment: that positions can quickly be closed out, that closing large positions does not itself move market prices; and that the cost of hedging remains stable.
In practice, none of those assumptions has proved correct because other institutions think in a similar manner. The result is a reversed of the intended effect with multiple institutions attempting to close their positions, creating instability and increasing systemic risk.
A holistic approach by evaluating all these interlinked factors carefully can contain the effects of crisis and reduced its duration. Key issues such as illiquidity of the market (from investors and funds attempting to sell), defaults on payment (due to changes in interest rates or other factors) and the lack of a contingency plan could have been easily addressed and avoided.
ADDITIONAL NOTES
Other points in contention could be the pay of the bankers and the risk they take. The system of compensation gives them an incentive to take excessive risks because the short-term upside is far greater than the long-term downside. Good performance (even if short lived) is rewarded with bonuses where as poor performance results in only the loss of the job.
Proposals suggest paying the bankers in shares to give the bankers an interest in the well being of the entire operation. However, decisions that really count are made at the top of the organization and people would not want to be subjected to factors over which they have no control such as poor performance in other departments.
On the other hand better pay attracts better people. Even Warren Buffett, the world's most revered investor, could not stop an outflow of people from Salomon Brothers in the 1990s when he backed plans to cut bonuses.
Hence reform will need to be gradual and a practical stance need to be taken if paying in shares was to be used. The segregation of branches by forming them into different entities under a group (as mentioned earlier) could very well remove the problem of “uncontrollable factors”.
IN CONCLUSION
Securitization will be shunned for a period of time until a point when the market feels that sufficient regulation and transparency has been put in place and that it is “safe” to invest again in such financial products.
However, this is not to say that securitization is flawed on its own. Some European banks are buying back securities at below-par prices because the underlying credit is good.
A gradual but inevitable shift to better risk management (such as seeing the “big picture”, change in compensation schemes etc.) and focus on all rounded management is not far on the horizon. While some may claim a gloomy outlook, I find that the prospects of banking are brighter than before as change allows new ideas and concept to come forth and flourish, though they may not always be perfect.
THE FUTURE OF BANKING
INTRODUCTION
This write up is based on the recent events in the subprime mortgage crisis and discusses the possible future development of banking as a result of that crisis.
Banks as a whole have lost a substantial amount of public trust as result and will have to work harder to regain their previous levels of customer trust. It will no longer be the case of nice print outs, good customer service, positive charts and figures.
Some banks may return to more conservative business models where their exposure is limited and their business much more easily regulated. It could also be a possibility that banks may decide it is wiser to diversify their branches under a group (i.e. virgin group) to reduce liabilities to the entire system. If the investment banking arm does not do well, it will not affect the performance of the other branches as a whole.
If the industry of banking declines, every other industry will deteriorate proportionately as well because they are essential in matching capital to labour and creating growth in the economy through the proper issuing of credit to capable borrowers.
SECURITIZATION
Securitization is useful in creating liquidity, but the issue in the current crisis lies in its poor application and lack of information and not in the concept itself. Many mortgage brokers and originators concentrated on writing as many loans as possible and relying on the banks to repackage them into securities and the banks, worked hard to sell the securities to the investors.
There were poor regulations on who the originators could loan to and this resulted in a drop in loaning standards. Another factor which contributed greatly to the decrease in loaning standards was the fact that the loan was securitized and the risk was offloaded from the originator to the banks and from the banks to the investors which reduced their stakes in the matter and diminished their sense of responsibility.
In the traditional mortgage business where the borrower goes direct to the bank to obtain a loan rather than a complex system of securitization, it becomes the best interest of both parties to be able to maintain a healthy relationship. The bank will review the profile more thoroughly as they are directly at risk and would limit the amount of risk the borrower can take.
As the distance between the borrower and the investor increased through securitization, the quality of information provided degrades as multiple profiles of borrowers are mixed and repackaged into securities. It is difficult to determine if borrowers under the purchased securities actually have any financial capability of repaying the loans.
As the defaults occur due to increase in interest rates and the apparent financial incapability of the borrowers show up, the demand for these securities froze and market value dropped severely as supply overshoots demand.
These points (of a non-exhaustive list of errors) reflect a great laxity in management and regulation of risks. Banks are therefore, forced to improve their system and focus on improving the management skills of their executives as well as selecting a management with strong backgrounds in core operations to prevent these lapses from re-occurring as well as to better manage the crisis.
REGULATION & TRANSPARENCY
Following up from the previous topic on securitization, tougher regulations would definitely be put in place to target the irresponsible issuing of credit and to implement a sensible system of risk management which will be covered more in-depth in the next section.
Not only must the system of regulation be made more stringent, it may also be necessary for the banks to increase transparency on its operations to regain the customer’s trust.
Other regulations could include changes in the requirement of the bank’s ratio of capital to asset, similar to the Spanish regulations with their banks. Interestingly because of the stringent require of Spanish banks to possess a high capital to asset ratio, they were not involved in the securitized mortgages and was largely unaffected by the crisis.
Enforcing strict regulations (one of the examples listed above) will definitely create “safe” banks, it significantly hinders the primary operations of the banks as a financing institution. While the easily-excitable public may take a knee-jerk reaction to this crisis, governing bodies should exercise caution in implementing regulations.
After all, some of the principal culprits were poorly regulated issuing of credit and lack of transparency in the bank’s operations. Transparency should be given to a reasonable extent such that the investors are able to make a well informed decision without the banks losing their competitive edge.
PROPER RISK MANAGEMENT
There is a strong need to understand the spirit of the law (or regulations) and not the letter of the law. The fraudulent regulations dodging as compared to sound investing concepts was the collapse of the securitization bubble.
It can be simply stated that the subprime mortgage crisis was a standard credit bubble and the banks failed to see all the associated risks. Securitization may have painted a pretty picture, but the underlying matter is the same: over-eager lending, careless investing and a widespread failure of risk management.
The segregation of risk management in banks gave rooms for errors. The banking industry needs to take a “big picture approach” as opposed to specializing in managing only market risks(sudden price movements), credit risk (defaults on payment) or operational risk (rogue traders, break down in operational equipment like IT, communications etc.).
Take a hypothetical example of how these risks can be interlinked.
A credit desk wants to make a $500m loan a gas firm but has a lending limit of only $400m. To make the loan, the credit desk buys a $100m credit default swap from a trader within the same bank which will pay out if the firm defaults. The trader hedges himself against the risk of paying out on the firm by buying protection on another oil firm, assuming that its paths are aligned with those of the first.
The end-result? A simple loan has turned into a complex mixture of market and credit risk.
These should go hand in hand with the method of assessment of risk. Currently, banks assume a static environment: that positions can quickly be closed out, that closing large positions does not itself move market prices; and that the cost of hedging remains stable.
In practice, none of those assumptions has proved correct because other institutions think in a similar manner. The result is a reversed of the intended effect with multiple institutions attempting to close their positions, creating instability and increasing systemic risk.
A holistic approach by evaluating all these interlinked factors carefully can contain the effects of crisis and reduced its duration. Key issues such as illiquidity of the market (from investors and funds attempting to sell), defaults on payment (due to changes in interest rates or other factors) and the lack of a contingency plan could have been easily addressed and avoided.
ADDITIONAL NOTES
Other points in contention could be the pay of the bankers and the risk they take. The system of compensation gives them an incentive to take excessive risks because the short-term upside is far greater than the long-term downside. Good performance (even if short lived) is rewarded with bonuses where as poor performance results in only the loss of the job.
Proposals suggest paying the bankers in shares to give the bankers an interest in the well being of the entire operation. However, decisions that really count are made at the top of the organization and people would not want to be subjected to factors over which they have no control such as poor performance in other departments.
On the other hand better pay attracts better people. Even Warren Buffett, the world's most revered investor, could not stop an outflow of people from Salomon Brothers in the 1990s when he backed plans to cut bonuses.
Hence reform will need to be gradual and a practical stance need to be taken if paying in shares was to be used. The segregation of branches by forming them into different entities under a group (as mentioned earlier) could very well remove the problem of “uncontrollable factors”.
IN CONCLUSION
Securitization will be shunned for a period of time until a point when the market feels that sufficient regulation and transparency has been put in place and that it is “safe” to invest again in such financial products.
However, this is not to say that securitization is flawed on its own. Some European banks are buying back securities at below-par prices because the underlying credit is good.
A gradual but inevitable shift to better risk management (such as seeing the “big picture”, change in compensation schemes etc.) and focus on all rounded management is not far on the horizon. While some may claim a gloomy outlook, I find that the prospects of banking are brighter than before as change allows new ideas and concept to come forth and flourish, though they may not always be perfect.
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