Governments will wreck their currencies to save banking system

Payback Time:
Banks Have Battle Ahead
to Restore Financial Standing

By Peter Thal Larsen
Financial Times, London
Sunday, January 6, 2008

http://www.ft.com/cms/s/0/6185d5c6-bc69-11dc-bcf9-0000779fd2ac.html?ncli...

Early in the new millennium, as they surveyed the wreckage of the global technology boom and the burst stock market bubble that it had produced, the world's leading financiers marvelled at the resilience of the 21st-century financial system.

Despite heavy losses in telecommunications and the collapse of large companies such as Enron and Parmalat in other sectors, no big financial institution had run into serious difficulty. This, bankers and regulators argued, was because banks had embraced techniques such as securitisation and the use of derivatives to pass on risks that they would previously have held in their entirety.

This approach, dubbed the "originate and distribute" model, was widely hailed as having transformed the banking industry into a less risky -- and more profitable -- business.

Today those claims have been shown to be hollow boasts. The crisis in the US mortgage industry, far from being smoothly absorbed by the global financial system, has proved contagious, prompting a paralysis among professional investors and a crisis of confidence in the banking system.

But for many bankers the most shattering revelation from the turmoil of the past six months is the extent to which risks that had supposedly been transferred to other investors have come flooding back on to banks' balance sheets. Far from dispersing the risks they had underwritten, banks are being shown to have stashed loans in complex structures that ultimately required their support.

The result is that a banking industry that a year ago looked robust and well-capitalised has turned out to be supporting a much larger asset base than most investors had thought. To make matters worse, the previously hidden assets are often those whose value is the most suspect. The subsequent correction is likely to have far-reaching consequences for how much capital banks need, how they are regulated and how they make money in the future.

"The financial system has become leveraged to a greater extent than one could have guessed from looking at the balance sheets of regulated banking institutions alone," Malcolm Knight, general manager of the Basel-based Bank for International Settlements, the central banks' bank, said in a recent speech. "The deleveraging process that is now taking place in the system is, to put it mildly, unlikely to be totally smooth."

So what will banking groups now do?

For many large Western banks, the first priority is to shore up their capital. Banks that in recent years have been returning capital to shareholders in the form of share buy-backs and higher dividends are expected to start raising capital. That will help address their exposure to obligations such as the bank-sponsored off-balance sheet vehicles known as conduits, which had expanded to more than $1,000 billion (L505 billion, E676 billion) in assets when the crisis struck.

The same applies to structured investment vehicles, the entities that were among the most enthusiastic buyers of complex, highly-rated debt securities created by the banks. These SIVs were supposed to be independent of the banks that created and managed them. But when the crisis hit, large banks such as Citigroup and HSBC found they had little choice but to take responsibility for the assets.

More recently, banks have also felt obliged to bail out investors in money market funds -- supposedly safe, liquid investments -- that were at risk of reporting losses. A dozen or so large US banks have so far injected more than $4 billion into these funds, even though they have no formal legal obligation to do so. Regulators are likely to pay closer attention to these kinds of commitment in future.

"There is going to have to be more capital injected into the system, to support the greater level of obligations, whether they are contingent or actual," says the chairman of one of the world's largest banks. Quite how much capital the banks will need is, however, a subject of intense debate. The amount will depend partly on the size of their losses related to subprime mortgages and on the extent to which the current squeeze triggers a broader economic slowdown, leading to higher defaults on other types of loans.

These factors will vary in different parts of the world. For example, the European banking industry has been less directly affected by the subprime meltdown than their American counterparts. But on some measures European banks have been operating with less capital than those in the US, where regulators enforce rules that provide a floor to the amount of capital banks must hold.

Analysts at Citigroup estimate that European banks will be forced to absorb risk-weighted assets worth around E450 billion ($666 billion, L336 billion) on to their balance sheets as a result of the turmoil in the industry. Depending on which measure is used, they calculate that European banking is labouring under a capital deficit equivalent to 5-20 per cent of the banks' market value.

Amid all this uncertainty comes another upheaval for banking: a new approach for measuring banks' capital, known as Basel II. The framework, which came into force in Europe this month and is due to be adopted by larger US banks next year, is designed to improve the allocation of capital by encouraging banks to take a more sophisticated approach to measuring risk. But the Basel II approach is largely based on the use of complex risk models that have been thoroughly discredited by the recent crisis.

Indeed, the crisis has been a sobering experience for financial regulators, who had spent much of the past five years fretting about the hidden risks in hedge funds and other unregulated entities, while failing to spot the risks building up in the institutions that they were supposed to be supervising. As a result, regulators are likely to use their powers under Basel II to force banks to hold more capital.

"The crisis has shown that regulators have been asleep at the wheel, not just in terms of what they have allowed to be included in capital but also what they have allowed to be excluded from the balance sheet," says Simon Samuels, European banking analyst at Citigroup.

Notably, the stock market is already helping to enforce this discipline. The banks that have suffered the heaviest share price falls in recent months have been those perceived by shareholders to have the smallest capital cushions. This has forced some drastic steps. In the past few weeks, Citigroup, Merrill Lynch, Morgan Stanley, and UBS -- those banks that had suffered the heaviest losses on subprime-related bets -- have accepted almost $30 billion in new capital from sovereign wealth funds in the Middle East, Singapore, and China.

Even banks that have avoided large losses are likely to find they will need more capital. They are expected to sell assets, cut dividends and/or issue fresh equity in order to rebuild their capital bases. Smaller lenders may decide the best way to solve their problems is by selling out to rivals. Fresh capital will, however, be required not just to support existing obligations but also to fund growth.

The credit crisis has choked off many of the markets that banks in recent years relied on to take assets off their balance sheets. Issuance of mortgage-backed securities has dropped sharply, while demand for more complex instruments such as collateralised debt obligations -- packages of loans that have been sliced to create new securities -- has dried up completely. Many bankers think it will be months, if not years, before they can start issuing these securities again. If and when they do, investors are bound to demand higher returns than before and are likely to require banks to demonstrate confidence in the securities by keeping a greater proportion themselves.

In short, this means that banks will be forced to fund more of their future loans from their own balance sheet resources. The shift has prompted some leading bankers to declare the prevailing business model obsolete. "Previously we had the idea of moving towards a model of origination and distribution," Alessandro Profumo, chairman of Unicredit, one of Europe's largest banks, told the Financial Times late last year. "This model is not there any more."

Others are less gloomy, arguing that despite the speculative excesses of the past few years, the mechanisms for dispersing risk through the financial system will still work. "In an environment where interest rates are higher, there will be greater differentiation between different classes of risk," says one leading banking executive. "I don't think that calls into question the fundamental technology."

Even so, it seems likely that the banking sector is facing a prolonged squeeze. Higher levels of capital will depress returns, while any increase in bad debts among corporations or consumers would eat into profits. The credit squeeze has already increased the cost of borrowing for consumers, particularly in the mortgage market. Although companies' balance sheets are reasonably robust, an economic slowdown would hit their prospects.

Banks face higher funding costs both in the wholesale markets and in their retail business, where competition for deposits is increasingly fierce. Institutions with large investment banking arms will also be hit by a general slowdown in activity.

Meanwhile, the authorities are expected to examine the case for exerting a tighter grip on the banking system. Chastened by the near-collapse of institutions such as Northern Rock, the UK mortgage lender, regulators will initially concentrate on overhauling rules governing banks' management of liquidity risk. But a wider rethink of banking regulation cannot be ruled out. Ever since the 1930s, when the aftermath of the stock market crash prompted US legislators to separate commercial from investment banking by passing the Glass-Steagall Act, financial crises have triggered a legislative response. US politicians have already proposed reforms of the mortgage broking industry. In Europe, regulators are training their sights on credit ratings agencies.

Yet regulators are also aware that any aggressive moves to rein in the banking industry could risk exacerbating the crisis. Through their ability to create credit, banks play a pivotal role in the economy.

In the past few years, the banks' apparent ability to pass on much of their risk meant the scope for creating new credit was almost limitless. The changes already taking place in the industry have led to tighter credit conditions, prompting central banks into a co-ordinated intervention to supply cheap liquidity to the banks. "A forced aggressive deleveraging of the banking system would convert a banking crisis into an economic crisis," says Citigroup's Mr Samuels.

Even if economic decline is avoided, banks are likely to find that their growth rate begins to return to levels that were widely seen as the norm before the industry began its breakneck expansion just over a decade ago. The only bright spot for banks is the continued rapid growth in Asia and the Middle East. But it seems unlikely that those economies will be able to shrug off a recession in the US.

"Opportunities in the banking industry will be more limited for the period ahead, even after the current severe stress eases out, and the market will be faced with -- and will have to accept -- the new 'dull' reality of structurally slower profit growth," says Sam Theodore, managing director and head of European financial institutions at DBRS, the rating agency.

The next 12 months will be crucial in determining whether the banking industry comes back to earth with a painful bump or whether it can engineer a smoother landing. Either way, it will be a long time before any banker dares to claim that his industry is less risky than it was before.

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