Five steps to safer banking

It is imperative that policymakers learn the right lessons from the crash, so that the taxpayer is less exposed in the future. Until now, governments have not gone far enough in addressing the risks presented by large banks operating worldwide

The successful undertaking of trade and commerce requires institutions that act as conduits through which capital can be exchanged. A sound banking system is essential to society’s wellbeing, as are both savers and borrowers. Without borrowers, a savings culture could not exist because there would be no point in paying interest on deposits. Equally, companies requiring finance could not function without savers. It is the ultimate symbiotic relationship, and essential to continuous social development and progress.

Banks are the cornerstone of this economic relationship. All banks, irrespective of their size or strategy are, ultimately, identical institutions. They deal in the same markets and with each other. That means that the bankruptcy of any one bank, while serious for its customers and creditors, has a bigger impact still on the wider economy because of the knock-on effect on other banks. It is this systemic risk that presented the greatest danger to the UK economy in 2008, after Lehman Brothers collapsed, and which required the injection of billions of pounds of public money to safeguard the banking system.

The challenge for policymakers now is to take steps to ensure that the economy and the taxpayer are no longer hostage to the fortunes of the banking industry. In this article, we examine the factors behind the 2007-08 financial crisis, and use the lessons learned from it to formulate five steps towards a safer financial system.

Moral hazard and the “Too Big To Fail” bank

The systemic risk of large banks has still not been addressed. The “too-big-to-fail” (TBTF) bank, and its guarantee from the central bank lender-of-last-resort (LoLR), creates significant moral hazard for the economy. There is no doubt that the existence of a safety net creates an unconscious reflex in bank senior management to take on more risk. Perhaps not today, because in a post-crisis recessionary environment banks are risk averse; but as the economy recovers, risk appetite will increase. Due to competitive pressures in banking, a higher risk-reward profile becomes a self-fulfilling prophecy, as banks seek to generate more customer business and attract deposits.

In other words, this problem will not go away unless governments proactively address it. Merely raising bank capital requirements is not sufficient; at the time of its bankruptcy Lehman Brothers had an 11% equity capital ratio, which regulators accepted as adequate up to the day of its demise.

Step 1: to tackle the TBTF problem, regulators must demand the following:

Require the trading arms of banking groups to be set up as separate legal entities, independently capitalised, so that they do not endanger the retail arm. This reduces the chance that the LoLR will have to step in to save a failing bank because its trading arm had taken on unmanageable risk exposure. If it was a separately-capitalised subsidiary, it could be unwound without impacting the retail bank;

Set strict rules to manage funding and liquidity risk at banks. This includes requirements to diversify funding sources, and increasing the average maturity of funds. The FSA has already started the process to implement a stricter liquidity regime for banks;

Reduce leverage, and thereby limit asset growth, through the imposition of leverage limits;

Establish a clearing house for the London interbank market, an “International Money Exchange”, that would work similarly to an exchange clearing house. Such a facility would eliminate bilateral counterparty risk and make the money market safer during times of crisis, because it is at these times that banks withdraw lending lines to each other.

These measures will force banks to adopt a more conservative strategy that maintains focus on secure funding and manageable risk taking. This will make them less likely to fail during the next crisis. {break}

The “Shadow Banking” system

The shadow banking system helped create the crisis. Next to the conventional commercial banking circuit, an unregulated parallel banking model had built up over several years. Unlike the classical banking system, it followed an origination and distribution model, moving loans from bank balance sheets to offshore entities such as structured investment vehicles (SIVs). These SIVs needed alternative funding because they did not have the retail deposit base of the banks. However, when the liquidity crisis broke in 2007, their funding evaporated and banks had to take all this risk back onto their balance sheets.

Step 2: Any entity that engages in mismatched or leveraged finance should be supervised by the regulatory authorities. This would allow the regulator to have a more realistic appreciation of aggregate industry risk. 

The role of central banks

Central banks inadvertently assisted the build-up to the financial crisis. The aggressive monetary intervention practiced by the US Federal Reserve during the 1990s and after 9/11 created the impression that authorities would always come to the rescue of the banks. Furthermore, continued accommodative low interest rates helped sow the seeds of a price bubble in the housing market that central bankers were too late in identifying.

Step 3: Central banks must target asset prices, as well as inflation, and monitor price developments in equity and housing markets, so that price bubbles can be deflated pre-emptively. This will reduce the social damage that arises when a bubbles bursts. 

Improving the regulatory framework

The regulatory framework encourages pro-cyclicality of bank lending. Banks have to hold additional capital against greater anticipated losses as the economic cycle turns downward. This makes an economic recession even deeper when banks are forced to restrict their provision of credit in a contracting environment. Ideally, however, the system would work the other way round, with banks building up capital during a period of growth, so they could take losses and maintain lending in a recession.

Step 4: Regulators must implement “macro-prudential” regulation, requiring banks to operate in less cyclical a manner. This can be enforced by altering bank equity capital and liquidity requirements. At any time when the market is viewed as pursuing ever more risky asset generation, and/or credit is seen as too easily available, the regulator can enforce more stringent requirements.

Bonus culture
The bank bonus culture was only a minor contributor to the financial crash, but attracted the most passionate comment in the media. There is no doubt that the current remuneration structure creates distortions in incentives. The main issue concerns booking profits today for a transaction whose cash flows occur over many years. The solution to this is to modify the remuneration system so that it builds in a long-term view, targets higher quality value-added profits and reduces the “hit-and-run” mentality among bankers.

Step 5: Split the banker’s bonus payment into three parts. The first part would be a standard cash payment. The second part would be paid in stock options that would be held for a minimum time period before they could be realised. The final part of the bonus would be placed in a claw-back account, also monitored for a minimum period. During that period, the bank would have the right to reclaim some or all of this cash if a transaction subsequently created losses.


The events of 2007-08 produced the world’s deepest recession of the post-war period. The banks were key players in this crisis. It is imperative that policymakers learn the right lessons from the crash, so that the taxpayer is less exposed in the future. Until now, governments have not gone far enough in addressing the risks presented by large banks operating worldwide. Further steps are necessary to mitigate this risk, which will benefit both banks and taxpayers in the long term.

Moorad Choudhry is head of treasury at Europe Arab Bank Plc in London, and author of Bank Asset and Liability Management, published by John Wiley & Sons (Asia) Pte Ltd. 

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    Corporate rivals against Dadri power project, ADAG tells SC

    ADAG has alleged in the Supreme Court that their corporate rivals were behind the petitions filed by farmers against the land acquisition for the company's proposed 8,000MW Dadri power project in Uttar Pradesh

    Anil Dhirubhai Ambani Group (ADAG) on Monday alleged in the Supreme Court that their corporate rivals were behind the petitions filed by farmers against the land acquisition for the company's proposed 8,000MW Dadri power project in Uttar Pradesh, reports PTI.

    "The petitions were motivated. This was a case of corporate rivalry. The rivalry seen in the gas dispute here (before the apex court)," senior advocate Mukul Rohatgi, appearing for Anil Ambani-led Reliance Power Ltd (RPL), said before a Bench headed by Chief Justice KG Balakrishnan.

    RPL's submission came during the hearing of its petition challenging the decision of the Allahabad High Court quashing the Uttar Pradesh government's notification to acquire land for the project.

    The Bench, also comprising Justices RV Raveendran and Deepak Verma, posted the matter for hearing on 29th January after advocate ML Sharma, appearing for some farmers, said a caveat has already been filed in the matter and no order should be passed without hearing the opposite side.

    "We are also not planning for any stay now," the Bench said, while accepting the plea of the farmers that they should be given an opportunity to be heard.

    Mr Rohatgi said he had no objection and accepted the suggestion that a copy of RPL's petition be given to the farmers who have filed the caveat.

    However, he alleged that at the behest of ADAG's corporate rivals, petitions were filed in the High Court by the farmers against the allocation of land for the project for which the gas was to be supplied from the KG Basin.

    RPL assailed the High Court decision saying that it was entertained four years after the allocation of land was made and in many cases farmers have already withdrawn the compensation amount.

    Mr Rohatgi said that around 5,827 farmers had consented for the acquisition of their land by the Uttar Pradesh government. “Under such circumstances, how can the High Court pass such an order?” he asked.

    "Once you have given consent, you are stopped from filing objections for land acquisition," he said, adding that out of (over) 5,000 persons, only 432 farmers filed the petition in the High Court, so the benefit of the High Court order will go to them only.

    The Allahabad High Court had said that the state government had side-stepped a provision inviting objections from land-owners while coming out with the notification for using emergency powers to acquire land for the company.

    In its appeal, RPL had contended that the High Court should not have entertained the petitions of the farmers on grounds of delay in filing them.

    It said that the company had complied with the provisions of the Land Acquisition Law and the project was in the public interest.

    About 2,500 acres of land were acquired by the state government from the farmers for the project.

    The High Court judgement had come on several petitions filed by farmers challenging acquisition of the land in 2004, when the Samajwadi Party was in power in the state.

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    Markets expected to remain firm

    Indian markets shrugged off weak global trends, closing the day on a positive note

    During the day, Indian markets opened in positive territory on fresh buying, but shed momentum later due to weak global cues. The Sensex was up 87 points from Friday’s (15 January 2010) close, ending the day at 17,641, while the Nifty closed at 5,275, up 23 points.

    At 10 hrs IST, the Sensex was trading up 75 points from the previous day’s close at 17,628 while the Nifty was trading at 5,268, up 15 points.

    At 14 hrs IST, the Sensex was trading at 17,671, up 116 points, whereas the Nifty was trading up 30 points at 5,282.

    Jaiprakash Associates plunged 1% after its net profit declined 38.9% to Rs103.02 crore in the December 2009 quarter against the December 2008 quarter. The company said that the latest quarter’s profit was after a one-time expense of Rs212 crore towards employee compensation.

    Hindustan Composites jumped 8% after the board approved selling the company’s property at Ghatkopar, a Mumbai suburb, for Rs571 crore to Raghuleela Lessors and Developers.

    ORG Informatics shot up 8%, after the company secured an order worth Rs14.05 crore.

    CMI FPE was locked at the 5% upper limit at Rs950.05, after the company bagged a contract for a wide-width cold rolling complex from Asian Colour Coated Ispat for an undisclosed sum.

    Engineers India zoomed 9%, extending gains and making a new high after the government (on Thursday, 14 January 2010), approved sale of 10% stake in the state-run company.

    During the day, Asia’s key benchmark indices in Hong Kong, Indonesia, Japan, and Taiwan fell by between 0.23%-1.16% while indices in China, South Korea and Singapore rose by between 0.17%-0.59%.

    On Friday, 15 January 2010, the Dow Jones Industrial Average plunged 101 points whereas the S&P 500 and the Nasdaq Composite were down 12 points and 29 points respectively. US markets remain closed on Monday, 18 January 2010 for Martin Luther King Jr Day.

    We expect Indian bourses to open higher tomorrow and remain firm.

    As per reports, agriculture minister Sharad Pawar said today that wholesale sugar prices in India have dropped in the past two to three days, while retail rates are expected to fall in 10-15 days.

    D Subbarao, governor, Reserve Bank of India, said that the timing and sequence of exit from an easy policy is still a challenge, said reports. He also said that the challenge was to support growth without compromising price stability.

    Meanwhile, the finance ministry is reportedly likely to keep the corporate tax rate unchanged at 30% in the coming budget, as it faces stiff resistance from companies to the draft direct tax code proposal to cut the rate to 25% and remove all exemptions. The Central Board of Direct Taxes is not willing to cut rates, as any reduction in statutory rate will further reduce the effective rate and dent the government’s revenues. The government is already struggling with a 16-year high fiscal deficit, equivalent to 6.8% of the gross domestic product for the fiscal year 2009-10.

    Sunil Mitra, disinvestment secretary, said in a television interview that the government was likely to mop up more than Rs24,000 crore in fiscal 2010. He further added that the government plans to list 60 unlisted public sector units, and may even ask for dividend before divesting cash-rich companies.

    Stock market regulator the Securities and Exchange Board of India (SEBI) reportedly wants the government to scrap tax benefits for corporate investing in mutual funds. If the proposal is accepted by the government, it could be a body blow to local asset management companies and other firms.

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