New York Stock Exchange Trading Floor
This rise in the level of defaults has had profound knock-on consequences: 1) Huge loan losses and provisions by banks in many countries, 2) Drying up of inter-bank lending, 3) Cessation of wholesale capital markets fund raising, 4) Falling share prices, 5) Rating downgrades. The coincidence of all these factors has led to the extreme state of volatility and illiquidity across almost all financial markets.
Some commentators have suggested that the blame for this “bursting” of the property asset bubble can be fairly laid at the door of central banks in general and the Federal Reserve in particular - notably under Alan Greenspan’s watch. The Greenspan approach was that central banks should not try and spot asset bubbles but rather stand ready to sort out the mess when they burst.
This approach, I believe history will show, has been a profound error of judgement. We are currently confronted with an extraordinary effort to save the financial system of not only the
In April 2005, Greenspan said: “Where once more marginal applicants would have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in sub-prime lending.” He was certainly correct about the rapid growth in sub-prime lending.
There is, however, another aspect somewhat overlooked in this unfolding crisis: if sober and sensible management had prevailed at many of the financial institutions that have either failed or been rescued, we would very likely not be in the mess we are in today.
Responsibility for executing low risk strategies for growth lies on the shoulders of management and boards
Consumer demand to “live the American Dream” is of course unquenchable at the source, but that is no excuse for the aggressive pursuit by banks and other institutions of “ill-judged” financial strategies involving significantly higher risks. Placing undue reliance on regulation to have prevented the current crisis also misses the point. Responsibility for executing low risk strategies for growth lies squarely on the shoulders of management and boards and investors/shareholders, not on regulators. There is also the aspect of individual responsibility in not taking on too much debt – this has also been overlooked by many commentators.
Perhaps a few examples of “ill-judged” financial strategies will illustrate the point:
2) The over-high dependency of many banks and institutions on wholesale funding through the Repo market, Interbank Lending, Securitisations and other capital market issues meant there was no back-up plan when these sources of finance started to diminish or disappear due to concern about values of assets and solvency. The loan to deposit ratio of HBOS, for example, had reached 177% when it was rescued by Lloyds TSB last week. It was facing the near impossibility of renewing its wholesale funding sources of renewing some GBP 198 billion of funding obligations.
3) Lax underwriting and risk management practices including over–reliance on sophisticated financial models and off-balance sheet vehicles (and the urge to use these to get round regulatory capital requirements) by many institutions have contributed to the disappearance of wholesale funding. For example granting 100 per cent, 120 per cent or
“exploding” mortgages (an initial low teaser interest rate which then escalated significantly) on ever higher income multiples, and on the basis of self-certified statements of income and dubious collateral valuation, eventually undermines the credibility of those lending institutions that indulged in such practices – and which no amount of financial modelling, parking in off balance sheet vehicles, or use of credit insurance can ever mitigate.
4) Quite what possessed AIG Financial Products to write US$440 billion of credit default swaps to banks on a variety of Mortgage Backed Securities and Collateralised Loan Obligations will make a good book one day as this enormous exposure effectively led to the demise of the company. It found itself unable to post cash-collateral in the required amount as the securities fell in value. Hence, the $ 85 billion rescue by the Federal Reserve.
The point from these four examples is that all were deliberate management decisions which ultimately led to the rescue or failure of their institutions. Such strategies were foolhardy and thus avoidable. There will undoubtedly be repercussions from the poor decisions made by many banks and institutions.
Banks are always potentially “fragile” creatures by virtue of being typically geared on their capital at levels of 10 to 1. This level of gearing carries with it a high degree of responsibility towards depositors, customers and counterparties as well as shareholders and in my view imposes on executive management and boards of banks a strong duty of care when setting out strategies for growth.
The importance of having robust checks and balances, i.e. good governance cannot be emphasized strongly enough as regards decision making.
We will be seeing the consolidation of the banking market as a result of the mergers and acquisitions of a number of banks. The highly leveraged independent investment banking business model has probably had its day. Wholesale funding dependencies will be significantly reduced as banks return to lending based predominantly on customer deposits. Significant de-leveraging can be expected as the banking industry shrinks assets and trading volumes.
The international bond and capital markets are likely to remain virtually closed, and certainly very expensive to access for the banking community for some time until bank balance sheets are repaired and trust is restored. Longer term capital market funding will therefore remain a very scarce and costly resource.
Greater transparency in financial reporting and more regulation will become a part of the landscape. Regulation will likely become much more intrusive as regulators look to examine in ever greater detail asset quality, liabilities and capital structures as well as revenues and profitability. The cavalry invariably arrives late however and it would seem that the less foolhardy will, in future, be regulated to the standards that should have applied to the more foolhardy that had to be rescued or went bust.
Uncertainty will remain in the
By Antony Withers
Chief Executive Officer, Mauritius Commercial Bank and President of the Mauritius Bankers Association.