“Just look out of your window and you can see a banking crisis,” David Llewellyn, banking professor of Loughborough University, recently told an audience of financiers in Bangkok. Banks have once again been as surprised as everyone else to find themselves in the thick of a financial crisis, this time in south-east Asia. Have they abandoned customary restraints and become chronically risk-addicted?
Banks that have lent heavily to Asia are being blamed for bad credit decisions and for threatening the very fabric of the financial system. But they are forced by fierce competition to produce attractive returns on capital in ever tighter markets and are likely to argue that they must take risks to safeguard margins.
The days of dependable banking collecting deposits and keeping traditional customers happily in-pocket are a thing of the past. Commercial banks in the US and Europe have been forced to cut costs and branches while diversifying into such businesses as pensions, insurance, asset management and investment banking. For many banks this has caused an identity crisis.
Competition has meant that margins are getting squeezed and that as banks search for more income, risk parameters have broadened. What’s more, markets can now be created with tools as simple as a phone, a computer, and the internet.
As technology has made it it easier to imitate a bank, more non-banks have piled into the business supermarkets, insurance companies, phone banking services and building societies. In the UK, supermarkets are offering interest rates on cheque account deposits four to five percentage points higher than banks. This is putting pressure on banks to reconsider their own rates. Sainsbury’s, one of the UK’s top-four supermarket chains, recently topped £1 billion ($1.6 billion) in deposits with a team of just 24 “banking” professionals.
All of this has left the so-called real banks wondering just what they, in turn, should aim to be. In the US, many banks now call themselves financial services companies and don’t even bother referring to themselves as banks in their annual reports.
In the UK, big banks such as NatWest and Barclays decided they should become combination retail-investment banks in order to wage battle with US competitors. But after their investment banking businesses turned in miserly single-digit rates of return, compared with the fatter double-digit returns from their retail businesses, they’ve now pulled back.
Even Germany’s Deutsche Bank, which has committed vast sums to building up its London investment banking arm, Deustche Morgan Grenfell, has now decided to integrate that business with its commercial banking operations. Some observers suggest there’s bound to be a culture clash conventional wisdom has it that it’s best to keep commercial and investment bankers in separate rooms. The move is, in any event, an illustration of how commercial banks are being forced to reinvent themselves not once, but many times.
“What’s a bank? The notion of what a bank is these days is very fuzzy,” says Lowell Bryan, senior partner at consultants McKinsey in New York. Bryan, who wrote a book entitled Breaking up the bank 10 years ago. He argues that banks have been disaggregating while non-banks take on a bigger role in financial markets. “The notion of what a bank is, is changing as economic markets integrate. This provides opportunities for diversification,” he says.
Opportunities perhaps but banks have had to forage for those opportunities as traditional income streams shrink. Fifteen to 20 years ago, most western banks generated 90% of revenue from interest income. It’s now 60%, 40% or lower, says Ed Furash, a banking consultant at Furash & Company in Washington, DC.
Banks have been making up for that loss with other forms of income: derivatives and fee-based income from investment services. Furash says investment management is today a $14 trillion global business with a 14% annual growth rate that should continue through 2010 an opportunity margin-conscious banks don’t want to miss. He also reckons derivatives-based earnings for the larger commercial banks now make up 15% to 20% of their earnings. The downside is that volatility can work against you something that makes shareholders shudder.
There have already been costly mistakes. In November 1997, Chase Manhattan lost as much as $200 million trading emerging-market debt. Part of the problem reportedly sprang from complex derivative exposure to emerging markets. Then there was NatWest’s old investment banking arm, NatWest Markets. The entire group unravelled after losses of £77 million caused by mispricing of derivatives in its investment banking arm, most of which has since been sold to Bankers Trust. More recently, there have been rumours that Union Bank of Switzerland made unquantified derivatives losses last year, and that this may have contributed to driving it into the arms of rival Swiss Bank Corp.
“Capital markets have been playing a bigger role, and one of the questions arising is: have these changes made banks riskier, and is the required result different kinds of regulation?” says Charles Goodhart, a banking specialist at the London School of Economics. Certainly, commercial bank credit ratings aren’t what they used to be. Gone are the days of the AAA banks, with a few exceptions such as Deutsche Bank and Rabobank, thanks to third world debt crises and property market debacles.
Goodhart says bank credit ratings have fallen relative to non-bank financials and even to large corporations the banks’ old customers. He says: “What’s the point to pay for their [banks’] intermediation when you can just go to the capital markets?” The fact that many clients have done just that has squeezed banks harder. “The profit margins of banks have tended to fall and the banks partly in consequence have tended to go into riskier businesses. Many have made losses,” Goodhart says.
George Soros, the global investor who has made billions working the risk gamut of the world markets, recently suggested in an open letter to the Financial Times that the prevailing system of international lending “is fundamentally flawed”, that the financial system is suffering systemic breakdown as evidenced in east Asia, and that a safety net is needed. He has called for the founding of an International Credit Insurance Corporation that would guarantee international loans for a small fee.
Roger Alford, senior research associate and emeritus reader at the London School of Economics, disagrees with Soros, arguing that banks have time and again demonstrated that they need restraints rather than incentives when it comes to assuming risk. International lending insurance would, in Alford’s view, encourage them to be more reckless.
“This creates a moral hazard,” Alford says. “The trouble with Soros’s scheme is that it is simply looking at the symptoms, not the causes.” He adds: “Risk should not become risk by dint of being insured. This [insurance] is removing the incentive that makes banks risk-vigilant.” Alford argues that banks have for too long relied on the state to pick up the tab for bad lending decisions, because governments are fearful of political and economic fallout and so traditionally are loath to let bigger banks fail. So banks gamble more than they otherwise would.
Alford argues that history shows that banks need to be made more accountable for their mistakes: “I think there should be penalties for bad banking. If an airline pilot makes a mistake and causes a lot of damage, he’s held responsible. Bankers have a special responsibility because their mistakes can lead to systemic problems.” He takes the radical view that banks should hold 100% capital against risky assets. Under the Basle capital adequacy agreement, which took effect in 1992, international banks are supposed to hold capital equal to at least 8% of their risk-weighted assets. They must also have tier-one capital, mostly equity, equal to at least 4% of risk-weighted assets.
In Breaking up the bank, Bryan suggested a more complicated solution for insulating banks and depositors from the hazards of loan-loss crises like the Latin American debt crisis and the $150 billion US savings-and-loan debacle in the 1980s. He advocated breaking apart the lending and deposit-taking functions of banks and called for banks to rely much more on credit securitization for generating reasonable returns, limiting risk in the process. Credit securitization involves products such as mortgages, credit-card receivables and auto loans being repackaged into pooled securities that then get a safe-stamp credit rating from Standard & Poor’s or Moody’s. These are then sold off in different types of vehicles to investors.
“I argued that the whole industry should be moving toward securitization,” Bryan says. “Banks should hold safe securitized assets and everything should be funded by non-deposited money. Since that time [1988], the whole industry has moved in that direction.” Now, at least in the US, where debt markets are much more developed than in Europe, he says: “More classes are being securitized, and banks are shedding assets to investors who don’t need to hold book capital. It’s on the verge of taking off in Europe too.”
If monetary union stays on course for 1999, some observers estimate Europe’s fixed-income market will grow to roughly 75% the size of the US’s. A larger, more liquid debt market would mean companies having greater access to cheaper capital market alternatives, forcing banks to be more creative.
There has been some securitization involving mortgage portfolios in Europe mostly in the UK but the idea has yet to gain popular appeal. That’s partly because banks have feared displeasing customers who dislike the thought of strangers owning their debt. There are signs, though, that corporate borrowers may be forced in time to yield ground.
Last year, a group of US and European commercial banks banded together to form the Loan Market Association to encourage the development of a corporate secondary-debt market. In return for letting lenders sell underwritten loan obligations to other banks outside the core syndications group, borrowers can save on pricing. That’s what UK company Imperial Chemical Industries discovered when it was faced last year with the need to raise $8.5 billion to buy the speciality chemicals businesses of Unilever. Bankers say ICI saved as much as 15 basis points by giving lenders a sell-down right. Banks, meanwhile, have the chance to earn extra fees and free up capital in the process. It also helps diversify risk.
Or does it? Furash thinks otherwise. “If there is a potential systemic problem in banking,” he says, “it’s the syndication of loans, the way people think they have laid off risk by selling loans. This is just socializing risk.” He thinks banks are increasingly compromising credit quality as they fight for new customers. “The old parameters on how risk was measured are no longer being used. What used to be a single A credit isn’t the same as it was 30 years ago. As margins have been squeezed, risk has been broadening out. Companies that couldn’t get credit now can. We’re in the middle of risk warfare.” That risk warfare will likely persist for some time. Most agree that the US and Europe, in particular, are still heavily overbanked and that competition is going to get a lot tougher as more non-banks pile in.
“It’s quite likely hundreds of banks will disappear,” predicts Ian Woodhouse, a director with consultants Price Waterhouse. “There will be an interesting combination of banks and non-banks. There’s probably going to be a different ranking of banks than there is now.”
This is cold comfort for those commercial banks still struggling to define just who and what they want to be. “The banks are much like in wartime, in an open city. They can be shot at from any direction,” says Michael Lipper, president of Lipper Analytical in New York. Some that have ventured far afield and have been battered in the competition crossfire may decide that being an old-fashioned retail bank isn’t such a bad idea after all. Barclays seems to have decided this with the recent sale of its equity investment banking business to Credit Suisse First Boston, and its plans to put retail banking back at the forefront of its operations. Lloyds TSB, which never deviated from the retail banking path, can smugly say it knew this was the best idea all along. But others may still find the thought of going back to plain-vanilla banking anything but exciting.
“Retail banking has probably had a very low profile. Nobody wants to go into retail banking, even though it’s more profitable,” says Sheila Heffernan, banking professor at London’s City University Business School. Investment banking is still the home of the big bonus and that ineffable sense of risk and glamour.
That said, Lipper suggests there will always be a place for the plain-and-simple commercial bank. It may never be the most fashionable on the financial markets catwalk but it will continue to have its place. Lipper reflects: “I think some banks will go back to their roots. There’s a place in this world for good commercial banks, just like good specialty stores.”
