Banks at Risk

Global Best Practices in an Age of Turbulence

Peter Hoflich

• Publisher: Wiley
• Year: 2012
• Print ISBN: 9780470827192
• eBook ISBN: 9780470827222
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Ideas on how to reform the financial services industry, from experts on the inside

In the wake of the financial crisis of 2008 the practices of the entire global financial services industry have been called into question. From the government, to the media, to the general public, everyone is re-thinking the way forward for the financial sector, but the stakes are high. Should negative trends in the industry continue and financial innovations allow fallout from the next crisis to grow exponentially, the endgame could be the sort of mutually assured destruction that topples entire economies. Charting the way forward for financial services reform requires a fundamental reappraisal of how things are done in order to avert disaster in the near future, and Banks at Risk: Global Best Practices in an Age of Turbulence explores what the future holds, by talking to experts in the know.

Compiling the insights of ten key figures in the financial services industry—regulators, commercial bankers, risk managers, and infrastructure specialists—who look at both strategic and operational issues in their assessments of how to clean up the industry and move towards a system of properly-managed risk, the book explores exactly what we need to do to prevent another crisis.

Sharing their thoughts for the first time are Liu Mingkang, the Chairman of the China Banking Regulatory Commission; Eric Rosengren, President of the Federal Reserve Bank of Boston; Joel Werkama, Assistant Vice President of the Federal Reserve Bank of Boston; Jane Diplock, former chairperson of the International Organization of Securities Commissions and the former head of New Zealand's securities commission; Jose Maria Roldan, head of the banking supervision at the Bank of Spain; Jesus Saurina, Director of the Financial Stability Department at the Bank of Spain; Dick Kovacevich, former chairman and CEO of Wells Fargo Bank; Mike Smith, CEO of ANZ Group and former head of HSBC's Asia Pacific operations; Shan Weijian, Chairman and CEO of Pacific Alliance Group and former senior partner of TPG Capital; Rob Close, former CEO of CLS Group; Tham Ming Soong, Chief Risk Officer at the United Overseas Bank in Singapore; and Tsuyoshi Oyama, former head of the risk assessment division in the international affairs division of the Bank of Japan.

• Takes a unique look at the problems with the financial services industry and what can be done to fix them
• Brings together ideas for reform from numerous internationally respected figures working in the industry, many of them writing about their solutions for the first time
• Offers a remarkable insight into how to build a more sustainable future

Eminently thought provoking, Banks at Risk presents real solutions to reforming the financial services industry, from the men and women who know it best.

Part One

The Regulators

Chapter 1

Effective Supervision of Systemically Important Banks

Liu Mingkang

Chairman, China Banking Regulatory Commission

The too big to fail (TBTF) problem stems from the excessive risks taken by some large banks. If not curbed, these risks enable large banks to externalize their costs, thereby effectively coercing governments to bail out failing lenders. Although many good suggestions have been made concerning the TBTF issue, and capital is surely an important tool in addressing it, regulators should give priority to factors that give rise to excessive risk-taking of large banks in order to tackle the problem satisfactorily. And regulators should adopt preemptive measures—before risks mature—with more engaged and more intense supervision of high-risk large banks. To a large degree, effective solutions to the TBTF problem are those that are already in the hands of regulators.

The current global financial crisis is in large part a crisis rooted in large banks.³ The failures of some large banks resulting from excessive risk-taking threatened the stability of the entire global financial system and dragged the real economy into recession. Governments in many countries were forced to bail out troubled banks with taxpayers’ money. It is unsurprising that the public in those economies was angry and disappointed about the behavior of the troubled banks. If the problem of dealing with TBTF banks is not addressed properly, in the post-crisis era, the moral hazard risk in national and international banking systems will become even more severe, and banking systems will be in danger of higher risk. G-20 leaders and the Financial Stability Board (FSB) have proposed a series of comprehensive measures to promote financial stability, and supervisory authorities that monitor many of the world’s economies are also working on various ways to address this issue. All of these efforts have the purpose of building a more resilient financial system in which the balance between efficiency and stability can be neatly regained and maintained. From a Chinese banking regulator’s perspective, the moral hazard facing large banks and why it is necessary to address the issue of TBTF banks now can be seen. There is also a need to introduce and comment on various measures that have been proposed so far. I feel that at the core of the TBTF problem is the excessive risk posed by the very existence of TBTF banks; the risk is the source of negative externality and actually, the bigger the risk, the higher the probability of an eventual government bailout. Preemptive measures targeting the risks facing large banks are the key solution for the TBTF problem.

THE MORAL HAZARD FACING LARGE BANKS

Because it operates on leverage, a modern banking system has inherent volatility and is subject to periodical asset bubbles and credit cycles. An insurance scheme is needed for a banking system but it creates the dilemma of moral hazard in the system. While this problem has existed for a long time, it has been further complicated by the massive development of financial systems in the past few decades, making the current banking system more volatile in quite a few aspects. First, with the facilitation of information technology, financial liberalization, and globalization of the world’s economy, the size of individual banks has increased tremendously to allow them to pursue the benefits of economy of scale and scope and as a result, concentration of the world’s financial systems has increased tremendously. From 1995 to 2008, the size of the 50 largest banks in the world increased more than three times, reaching combined assets of US$70 trillion. Of the $1.1 trillion losses already exposed in the crisis, one-third was concentrated in five banks.^4,5 In several countries, such as Switzerland and Iceland, the cost of saving banks was even larger than the annual gross domestic product (GDP) of the country, far beyond the capability of the governments, thus making their banks too big to save! Second, in the past 30 years, the banking system has shifted from a credit culture to an equity culture—the income of banks has shifted from simply providing loans to securitizing them, and the funding of banks has changed from drawing deposits to capital markets, an over-reliance on which results in a large amount of embedded leverage. More important, although the overall risk of large banks has increased greatly, capital requirements under the Basel II framework do not really reflect these changes. Low exposures assigned to securitization and off-balance-sheet items have further reduced the capital requirements of large banks. Highly embedded leverage and low capital together increase the vulnerability of financial systems. Third, current financial systems have become increasingly interconnected, with differences between banks and non-bank financial institutions blurred by the rapid development of off-balance-sheet activities, credit derivatives, and various non-bank financial intermediaries such as guarantees, monoline insurance, and hedge funds.

Under the system described above, once a large bank is on the verge of collapse, the whole system would be hurt by the spillover effects and negative externality, triggering a systemic crisis. Shocks can be transmitted through at least three channels. The first is the balance sheet channel. Considering that in most cases, large banks are the major counterparty of a large number of financial institutions and hubs of financial networks, their failure would either bring about direct losses for a large number of smaller financial institutions or, by way of guarantee or insurance, induce indirect losses to these institutions. Payment contagion will ensue. The second channel is the credit channel. Once a large bank fails and no other bank comes to replace the troubled bank to continue providing credit, the aggregate amount of credit available for business will shrink, resulting in adverse effects on the wider economy, which also puts serious pressure on employment and production. Increased default will then cause second-round impact on banks. The third channel is the market price channel. When a troubled large bank is forced to liquidate in a fire sale its assets with a haircut, the asset prices will spiral down, forcing more banks to get rid of their assets under fire sale conditions as well. Under such circumstances, what started as an external shock could be internalized by way of changing banks’ behavior, accelerating the collapse of market prices, and de-leveraging. In the real world, the financial system is much more complex and interconnected, making the channel of contagion much more complicated than described above. Information uncertainty further increases the severity of the crisis.

Considering the significance of banks in maintaining financial stability and supporting the real economy, and although governments usually claim that they would not bail out large banks as they did in the crisis, once these banks are at the brink of failure their governments in almost all cases are obliged to take action to save them. During this last crisis, governments and central banks provided an unprecedented scale of capital injection, liquidity support, and asset buybacks, as well as loans and guarantees.

The credibility of several national governments was greatly impaired in this crisis. If the moral hazard behavior of dealing with TBTF banks is not fully addressed, the financial system after the crisis will face greater risk.⁶ As such, strengthening the supervision of large banks has been brought to the forefront of financial regulation reform.

SUGGESTED MEASURES

Since the outbreak of the crisis, the FSB has been pursuing a package of comprehensive measures to cope with the TBTF issue. One of these measures is to reduce the probability and impact of failures of systemically important banks (SIBs).⁷ Policy measures under active consideration are several and include increasing the capital or liquidity surcharge (or both) calibrated to a measure of systemic externality, introducing a leverage ratio as a backstop to risk-based capital requirements; enhancing on-site examination and off-site surveillance of SIBs; improving consolidated supervision; establishing sound corporate governance and compensation regimes; and strengthening cross-border supervision. The second comprehensive measure is improving the banking resolution regime to ensure banks can be wound down in an orderly manner without precipitating disruptions to the provision of financial services to the economy. Policy measures include the establishment of legally binding resolution plans (or living wills) for SIBs. And banks may need to simplify their structures, enabling the impaired parts to be easily separated from others. The third comprehensive measure is enhancing financial infrastructures and markets, increasing transparency, and reducing contagion risks upon individual bank failures. The FSB suggests that on top of all these measures, if regulators find it necessary they should be bestowed with the power to limit the scale and activities of banks. National authorities are debating heatedly on the feasibility of this latter measure, with the United Kingdom and the United States taking the lead in the debate. The U.K. Financial Services Authority (FSA) tends to favor establishing a continuous function of capital requirements based on assessment of the systemic importance of individual banks, while the U.S. Treasury favors tiering banks and building bucketed requirements for different tiers of banks.⁸ The FSA supports limiting, via capital requirements, the extent to which commercial banks are involved in proprietary trading,⁹ while the chairman of the U.S. Economic Recovery Board, Paul Volcker, has proposed structural reform by prohibiting commercial banks from conducting proprietary trading, thus inhibiting them from engaging in highly risky activities. Despite the various opinions and discussions, a broad consensus exists that the TBTF problem is a very complex issue and no single measure can be used to tackle it satisfactorily. A combination of measures is therefore necessary.

I share most of the views of these constructive discussions. We are witnessing the largest financial overhaul since the 1930s, and the various proposals on the table to date clearly show the willingness of academics and policymakers to carefully debate the pros and cons to best strike a balance between setting up a healthy competitive environment and continuing to support genuine competition. In this regard, I have some observations to add to the discussions underway.

First, there are some contradictions between the identification of SIBs and capital requirements in the proposal of the Macroprudential Group (MPG) of the Basel Committee on Banking Supervision (BCBS). The MPG proposes the use of an indicator-based approach for the identification of SIBs, and then the establishment of a continuous function between capital requirements and the identified systemic importance of the SIBs. Although the intention of such an effort is good, it may turn out to be paradoxical in implementation, as to identify an SIB first and then impose higher capital requirements accordingly may actually signal that the governments will bail out the bank once it is in trouble, as otherwise there is no reason to charge higher capital on the identified banks. It is also in this regard that the systemic levy on identified banks in an ex ante manner does not seem to be justified, although another form of levy—a financial crisis responsibility fee charged on banks that received government support in this crisis to pay back taxpayers’ money—is quite reasonable. In my opinion, quite contrary to the intention, the result of charging higher capital on identified SIBs would actually further encourage banks to engage in excessively risky activities. Although the internal cost for large banks to take excessively risky activities is very high, as long as banks have been identified as SIBs and charged a fee with the implication that they are assured of a government bailout, they would have an incentive to externalize the cost of high-risk activities. The constraint ability of capital requirement for inhibiting banks from undertaking excessive risk activities would actually be seriously weakened. I argue that a capital charge should not be applied on the identified SIBs, but instead on identified risks; I will go into detail about this later.

Second, an indicator-based approach is good in principle but is difficult to apply in practice. As the MPG pointed out, due to the fact that indicators to measure interconnectedness and substitutability are difficult to quantify, in the end, the estimation of the interconnectedness and substitutability of the SIBs has to a large degree overlapped with the estimation of size. In light of this, an indicator-based approach, although it seems more accurate, in effect may prove to be more arbitrary, with a high possibility of killing large but prudent banks and causing unfair competition. Perhaps we need to recognize that one important problem in today’s regulation is that regulators increasingly off-load their responsibilities for deep analysis and evaluation of the risks of banks, which is what they are paid to do, on to a series of indicators and models. To a great degree, the problem revealed by the crisis is not the lack of new tools and instruments but the regulators’ negligence of their assigned responsibilities, the so-called regulatory capture. If the philosophy of regulatory capture is still guiding our direction of reform, we are in danger. We should be aware that in most cases, risks are not quantifiable, and moreover, the interactions among various risks are not linear, but exponential—beyond the capture of indicators and models. The challenge of better quantifying risks has long existed in today’s science, not to mention its application in finance. The imperative of struggling out of a crisis situation does not change very much the likelihood that we can find satisfactory solutions all of a sudden. A more practical and effective solution is instead to emphasize regulators’ deep knowledge about banks and conduct a more expertise based assessment of their risks. This certainly is not to say that indicators or models are unimportant. What we need is to place regulators’ analysis and judgment about risks into the principal place. Under this precondition, indicators and models can play an important role in assisting judgment. If we overlook the primacy of personal analysis above indicators, we risk putting the cart before the horse.

Third, capital surcharge is surely a very important tool, and higher quality capital does provide a buffer to allow supervisors more time to seek a better resolution of a troubled institution, but capital is not the answer in and of itself. It is difficult for capital to prevent risks in a preemptive manner because regulators cannot charge higher capital on banks before the latter take excessive risks. To charge higher capital after banks have already taken excessive risks will result in becoming trapped in the dilemma I described above. Moreover, although it is feasible in theory for capital to increase a bank’s cost of taking excessive risks, studies have shown that in the real world banks can always find ways to circumvent the rules and transfer the increased costs to depositors and investors—by charging higher fees, changing asset portfolios, or otherwise moving the risky activities to the loosely regulated shadow banking system. Therefore, the tools necessary to solve the TBTF problem are much broader than just capital. Capital can be effective only when applied in combination with other risk-prevention measures to enhance the resilience of the financial system. The function of capital should not be interpreted as a levy or a tax on externality posed by SIBs; rather, it should be used to increase the ability of banks to absorb loss.

SOME THOUGHTS ON THE SOLUTION TO THE TBTF BANK PROBLEM

Some of the current proposals on bank reform further complicate the issue of TBTF banks, and it seems that we are still not firm in our stance on some fundamental issues surrounding the TBTF problem. Perhaps we need to think about the issue of TBTF banks from another perspective, and then it will be revealed that at the core of the problem is the excessive risk-taking of some large banks. As Adair Turner has pointed out,¹⁰ there is a rule of diminishing marginal returns. Once we exceed the optimal point, marginal returns decrease and diseconomy follows. If we agree on this, it should come as no surprise that the efficiency of a banking system cannot be pursued indefinitely: while the benefit of financial efficiency will surely continue to increase, the potential cost of bank failure also increases in this process. The reason some large banks continue expanding and pursuing financial efficiency indefinitely is simply that there are opportunities for them to externalize the increased costs arising from conducting excessively risky activities. In effect, the higher the risks and external costs, the greater the likelihood that governments will be forced to bail them out, and once again the problem of TBTF banks grows. A link exists between high-risk activities and the likelihood of government bailout. The essence of the TBTF problem therefore lies in that some large banks seek to pursue excessively risky activities, thus forcing governments to bail them out by externalizing the costs. Under the short-term incentives schemes, the benefit of higher risks goes to the senior management of banks, while the cost of bank failure has to be borne by taxpayers. Moreover, due to the public’s belief that governments simply cannot afford to let these banks fail, depositors and investors tend to put their money in TBTF banks and markets tend to ascribe a higher rating to such banks.¹¹ This perception gives these banks the advantage of borrowing at preferential rates, thereby winning an unfair competitive edge by reducing their financing costs, weakening market discipline, and reducing the efficiency of resource allocation at the macro level.

In light of this, to effectively tackle the TBTF problem, measures should focus on excessive risks taken by large banks. By doing this, we can avoid the problem facing the identification of SIBs with an indicator-based approach, because risk will be the criterion to categorize large banks into prudent ones and aggressive ones. It should be admitted that due to the inherent nature of volatility in a banking system, large banks with low risk still have the possibility of encountering abrupt external shocks, and systemic impact could follow. Under such a circumstance, it is inevitable for governments to bail out these banks to prevent systemic spillover. This kind of government cost is justified and should not be paid by the banks. However, for those banks that kidnap the government by taking excessive risks, regulators should adopt intense and intrusive supervision in a preemptive manner, and they should have the authority to take action against these banks. Together with stricter capital requirements and a credible, strong resolution regime, these measures would contribute to eliminating the day-to-day effects of people’s expectations about TBTF banks. In sum, no bank should be TBTF in future banking systems.

My suggestions on addressing the TBTF issue are as follows.

1. For the identification of large banks that need more intense supervision, risk profile should be the key criterion. In this regard, factors contributing to higher risks of large banks and their interaction in today’s financial systems should all be considered and assessed by regulators in a dynamic background and on a case-by-case basis. Interconnectedness and substitutability in an indicator-based approach are surely factors to be considered, among others. Moreover, factors such as the complexity of bank structures and business models, leverage, funding sources, and risk concentration should also be considered in the process of assessment. The implementation of living wills would help iden...

Table of contents

• Cover
• Contents
• Title page
• Copyright page
• Dedication
• Acknowledgments
• Introduction
• Part One: The Regulators
• Part Two: The Practitioners
• Part Three: The Risk Managers
• INDEX