model for global banking

8/6/2019 Model for Global Banking

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Learning from the crisis: Is there a

model for global banking?


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Introduction

Crisis not restricted to the mortgageperiphery of the financial system or to WallStreet. Afflicts Banking as well.

Two contradictory reasons why this was notexpected: Banks more regulated then other segments of the

financial system

Deregulation resulted in credit-risk transferpractices, reducing exposure of banks toimpaired or worthless assets.


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What explains bank exposure?

Banks were carrying an inventory of suchassets that were yet to be marketed

They wanted to partake of the high returnsearlier associated with those assets

Had also set up special purpose vehicles forcreating and distributing such assets

Had lent to institutions that had leveragedsmall volumes of equity to make hugeinvestments in these kinds of assets.


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Consequences

Banks too are afflicted by losses onderivatives of various kinds, resulting in write-downs that are wiping out their base capital

Large infusion of capital by the government torecapitalise these banks seems unavoidable

Open or covert, back-door nationalization of

leading banks in different countriesnecessary: Citigroup, Bank of America, RoyalBank of Scotland and Lloyds Group.


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Failure Cannot be permitted

Banks are at the centre of the payments andsettlements system in a modern economy, orthe institutions, instruments and proceduresthat facilitate and ease transactions withoutlarge scale circulation and movement ofcurrencies.

Banks are the principal depository institutionsand risk-carriers in an economy.


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Resulting global trend

After having failed to salvage the crisis-afflicted banking system by:

guaranteeing deposits,

providing refinance against toxic assets, and

pumping in preference capital

Governments in the UK, US, Ireland and

elsewhere are being forced to nationalizetheir leading banks by opting to hold amajority of ordinary equity shares.


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Lesson from the crisis

Despite the proclaimed sophistication of thecurrent A-S model, its transparency, itsaccounting standards and its financialinnovations that ostensibly reduce risk, itleads to failure with systemic implications

Not surprising since the creation of the

current financial structure was predicated ondismantling a regulatory structure expresslydesigned to deal with fragility.


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Early evidence of fragility

During 1955-81, failures of US banksaveraged 5.3 per year. During 1982-90failures averaged 131.4 per year or 25 timesas many as 1955-81. Four years ending 1990failures averaged 187.3 per year.

The most spectacular was the S&L crisis,

precipitated by financial liberalisation. Long Term Capital Management collapse

flagged dangers of leveraged speculation.


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Implications

Questions the form that banking structures,banking strategy and banking regulation tookin the US and UK. Need for rebalancingstate-private sector relationship

The kind of post-1970s financial liberalizationand reform in developing countries geared to

homogenizing financial systems toapproximate the A-S model unacceptable.


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Glass-Steagall as insurance against failure

Under that framework, deposit insurance,interest rate regulation, and entry barriers limitedcompetition and rendered any bank as good asany other.

Restrictions were imposed on investments thatbanks or their affiliates could make, limiting theiractivities to provision of loans and purchases ofgovernment securities.

Solvency regulation involved periodicexamination of bank financial records andinformal guidelines relating to the ratio ofshareholder capital to total assets.


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Implications of the structure

Even though this regulatory framework was directed at andimposed principally on the banking sector, it implicitlyregulated the non-bank financial sector as well by limitingdirect and indirect involvement of banks.

Even by the 1950s, banking activity constituted 80-90 percent of that in the financial sector.

At the end of the 1950, savings accumulated in pensionand mutual funds were small

Trading on the New York Stock Exchange involved a dailyaverage of three million shares at its peak as compared

with 160 million shares per day during the second half ofthe 1980s, when leverage became possible.


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Implications of the structure

Banks would earn a relatively small rate ofreturn defined largely by the net interestmargin. In 1986 in the US, the reported return

on assets for all commercial banks withassets of $500 million or more averagedabout 0.7 per cent, with the figure for high-

performance banks at 1.4 per cent.


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Inner contradiction leading to

Deregulation This outcome of the regulatory structure was,

however, in conflict with the fact that thesebanks were privately owned.

Because banks important for capitalism theyhad to be regulated in a manner that madethem less profitable than other institutions in

the financial sector and private institutionsoutside the financial sector. This amounted toa deep inner contradiction in the system.


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The transition since the 1970s

Inflation since the mid-1960s and theresponse to it highlighted this contradiction

Deregulation proved unavoidable

Involved the dismantling of all structuralregulation the controlled the activitiesconducted by and rates charged by banks

Fundamental transformation of banking


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Deregulation leads to crisis

Shift from buy-and-hold to originate-to-distribute increases risk in the system. Thismodel migrates out of the banking system

leveraged by bank finance

Risk discounted because of transfer andinsurance practices that socialise risk and

reduce risk cognition of individual agents Real economy benefits from credit-financed

activity enhanced by easy money


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Misperception of the nature of the crisis

Not a problem of banks

Problem of banks but one of liquidity

Just fear of toxic assets that can be resolvedby absorbing bad assets

Solvency problem that needs capital infusionthat is temporary and non-invasive

Finally, nationalisation unavoidable even ifdisliked because of the need forrecapitalisation with common equity.


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The problem at the banks

In its update to the Global Financial StabilityReport for 2008 issued on January 28, 2009,the IMF had estimated the losses incurred by

US and European banks from bad assets thatoriginated in the US at $2.2 trillion. Barely 2months earlier it had placed the figure at $1.4

trillion. Equity base of most banks is relatively small

even when they follow Basel norms.


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The need for recapitalisation

IMF: global banks that have already obtainedmuch support from governments would needfurther new capital infusions of around half a

trillion to stay solvent.

Alternative suggestion: split the system intogood and bad banks. Bad banks set up

with public money acquire the bad assets ofthe banks, repairing the balance sheets of thelatter.


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Infeasible alternative

Did not take account of the price at which thebad assets were to be acquired. If acquired atpar, it amount to misusing taxpayers money

If some scheme such as a reverse auction isused to acquire the bad assets, then the saleprices of these assets would be extremely

low and the so-called good banks would haveincurred huge losses which they would haveto write down leading to insolvency


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Is nationalization inevitable

Injecting capital need not implynationalization, if it takes the form of loans tobanks or investments in preferred stock with

no voting rights or limited voting rights.

Adequacy of these forms of financingdepends on the volume of losses and write

offs and the resulting capital infusionrequired. If these are large, preferred stock,for example, is not good enough.


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Common equity

Such stock or even loans are senior in thecapital structure and are not the immediatemeans of covering losses. They often involve

mandatory pay-outs.

Only holders of common equity immediatelyabsorb losses when incurred and need to be

provided for. So it is the common equity basethat gets eroded first and it is capital of thiskind that guarantees solvency.


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The lessons

Regulation with private bank ownershipresults in inadequate profits and pressure toderegulate

On the other hand deregulation leads to crisisand nationalisation

A combination of public ownership and

structural regulation of banking needed forcapitalism


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Lessons for developing countries

They should stall and reverse the movementto private from public ownership or opt forpublic ownership if banking is fully private in

order to save the banking system.

Serves a larger purpose. Intervention toshape financial structures is needed for

another reason, viz. to use the financialsector as an instrumentality for broad-basedand equitable growth with stability.


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Principal benefits

Allows the government to use the bankingindustry as a lever to advance thedevelopment effort and achieve broad-based

growth.

Subordinates the profit motive to socialobjectives, and allows the system to exploit

the potential for cross subsidization and todirect credit, despite higher costs, to targetedsectors and disadvantaged sections

model for global banking

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