Friday, November 21, 2008

Financial crisis and the future of banking news


It is obvious that the banking industry will see the most dramatic changes after this financial crisis. Should the big global banks stick to their universal banking model or should they become boutique firms? Also, can we afford to have banks that are just too big to fail? By Vivek Sharma

The other day a friend called me to ask if he should close his bank deposits and take out the cash. Most of his money was in a small cooperative bank, which offered better interest rates, and someone had told him that the smaller banks in India were definitely unsafe when huge American and European banking giants were going bankrupt.

It seems surreal to most that so many of these banks can be in trouble all at the same time. Even the best capitalised banks with absolutely no exposure to asset-backed securities and other derivates, like many banks in India, have seen a huge erosion in their market value.

Are the current business models of banks fundamentally flawed? If so, how will they change after this crisis?

In their glory days, the big banks were much more than regular banks. Apart from their traditional business of raising deposits and lending to individuals and businesses, most banks expanded into a whole range of new businesses over the last few decades. They set up separate divisions or subsidiaries to handle fund management, advisory services for corporate and wealthy individuals and even broking services.

When restrictions that separated commercial banking from investment banking were lifted in the US in the late '90s, almost all the big banks jumped right in and started competing directly with the Wall Street investment banks.

There is a lot of merit in allowing banks to offer a wide array of services to their customers, or to become one-stop financial superstores. As long as there is healthy competition, the economies of scale bring down intermediation and other service costs that benefit the customers. Diversified business models, both geographically and across product lines, are less risky for shareholders as weakness in some segments is counterbalanced by growth in other segments.

But, the insatiable appetite for better returns on capital and fatter bonuses encouraged bankers to move into more complex and risky businesses. Proprietary trading, where a bank made trading bets using its own money, called global markets division by many banks, contributed more to the bottom line of many banks. When the business of asset securitisation exploded, it opened up lucrative opportunities in origination and trading of derivatives.

Unfortunately though, the regulatory structures that are in place and the risk management models currently followed by banks are not designed to accommodate the more recent, and riskier, diversifications. Regulators always take time to understand market innovations and hence regulations always come after a lag. But, on hindsight, it is incredible that the risk management models followed by banks failed to evolve and capture the potential downside.

There is a reason. The systems didn't evolve because the new businesses were too complex and hence risks were underestimated. One of the perceived attractions of financial securitisation was that risks were evenly spread across a large number of investors who held derivative instruments, unlike the pre-securitisation era when lenders shouldered the entire risk of default. Also, the more complex derivatives allowed investors to pick investments according to their desired risk profile. Some derivatives were even thought to be as secure as sovereign bonds, but with better yields. Then there were credit insurers who offered further protection to make the investments even more secure. It seemed like a perfect world, where risks are low and returns are high, and where business was always expanding which allowed the banks to continue growing.

When the system started crashing, most banks were undercapitalised and ill-prepared. Instead of reducing risks, derivatives became a source of risk as most banks had loaded up on them. By the time they realised that too much of a good thing can indeed cause harm, it was too late and the world was caught in the worst crisis in nearly a century.

Should the universal banking model be scrapped?

When the dust settles and the world recovers from this crisis, even if much of the global economy remain the same, banks will see major changes. Many of them will be forced, either by their precarious financial position or by regulators, to redraw their current business models. Are there better models?

It is fashionable to talk about freshly minted Nobel laureates and their theories. So let me bring this year's economics Nobel winner Paul Krugman's trade theory into the frame. It may appear odd, trying to stretch a theory on global trade to analyse a specific industry. It is not so.

Krugman expanded on David Ricardo's theory of comparative advantage which essentially said countries benefit when they specialise in what they are best at producing and then importing other goods and services. This did not explain why some countries traded in the same set of product, for example both exporting and importing cars. Krugman said this is because of differentiations within the same product group and countries specialise in segments within a product group rather than the entire product group. So, Germany specialised in high-end cars while Japan focussed more on efficient small cars.

Stretching Krugman's theory to the banking industry, will banks be better off specialising in some products and services rather than trying to be everything to every customer? It will indeed be advantageous for many banks to focus only on select businesses. Even now, within the broader banking and financial services industry, there are large firms focussed only on select segments.

The large Wall Street investment banks were obvious examples until their demise. There are a large number of fund management firms that are not directly tied to any global bank. Then there are boutique banks, like the many privately-owned Swiss banks which focus on advisory and wealth management services to select clients. Reports indicate that Goldman Sachs, which converted itself into a regular commercial bank, wants to take this route and focus only on the upper-end of the retail banking market rather than have a large network of branches across the world.

It is very likely that more and more banks will gravitate towards more focused business models. Even if the managements are not prepared, shareholders and governments which now hold big stakes in banks may force them to do so. This is already happening. Royal Bank of Scotland or RBS, which received a generous capital infusion from the British government, has already shut down its proprietary trading desk.

Nevertheless, attractions of the 'universal bank' business model still remain. Most customers, both retail and businesses, and especially in the low-end of the market, want a wide range of financial services. And they want the services to be cheap. Only a universal bank business model, like a supermarket, can satisfy this market and not the specialised, boutique firms, which obviously would charge more for their services. Then there are the benefits of big global brands and extensive networks for customer interface, both regular bank branches and online stores for financial products.

So, both models will continue to exist. The focussed, boutique business model will become more popular, but the era of big universal banks are definitely not over. In fact, if the recent consolidation moves are any indication, big banks like JP Morgan and Citigroup are likely to become even bigger after acquiring their smaller rivals which are struggling to survive.

Too big to fail? Why should they be?

As it is evident in this financial crisis, there is a huge risk in allowing banks to grow beyond a certain size. They become 'too big to fail' and will pose risks, not only to the individual firms but to the entire financial system. As The Wall Street Journal columnist Daniel Henninger asked recently, 'if something is too big to fail, isn't it …… too big?'

But, regulators are actively encouraging the big banks to acquire the smaller ones and grow even bigger. Even if such shotgun marriages are arranged to protect the depositors of smaller banks which are failing, aren't the regulators creating even bigger monsters? Won't such monsters become unmanageable in the next crisis and force governments to roll out more expensive bailouts?

While the universal banking model is beneficial, beyond a point, the huge systemic risks far outweigh the benefits of economies of scale. Regulators should look for ways to discourage banks from becoming too big to fail. Else, regulators should ensure that banks which are too big have the ability to take care of themselves in a crisis and not run to the government for support.

One of the options that regulators may consider is prescribing progressively higher capital and reserve requirements as banks grow in size. In other words, the bigger the bank, the higher should be its capital and reserves as a percentage of liabilities. Setting aside funds to meet reserve requirements involves a cost for banks. So, unless the incremental gains from growing in size do not offset the costs of higher reserve requirements, banks will prefer not to grow beyond a point. If a bank still finds it worthwhile to continue growing, it will have more capital and reserves than other banks and will be in a better position to face a crisis.

Also, regulators may ask for better risk management practices for larger banks. The risk committee of Spanish bank Banco Santander's board meets twice a week and that bank is one of the least affected in Europe by the crisis. Regulators should prescribe such practices for all big banks and can even think of nominating their own independent representatives to the risk management committees.

The banking industry should not repeat the same mistakes all over again and it is the job of regulators to ensure that they don't.

The world cannot afford another financial crisis... at least for a few decades.

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