Banking beyond the Financial Crisis

This unprecedented global financial crisis we are going through has made continuity an issue for many large, world-class banks, forcing some to go bankrupt, get bought and merged, accept government bailouts or even be nationalized. The firm I work for is part of the PricewaterhouseCoopers (PwC) global network, whose member firms undertake long-term engagements in many countries to perform consulting work for bank regulators and private companies. Over the past few months, PwC has found that great changes are taking place in the operating environments banks find themselves in around the world. This article will single out for in-depth discussion four of the main findings that have particular resonance for the Asian banking industry. These four findings concern the following:

• Money vacuum: Capital, lending and liquidity face unprecedented shortages;
• Renaissance: The traditional bank business model will make a comeback;
• Past must not be repeated: Bank regulators will strive to avoid a return to recent excesses;
• Natural selection: Winning banks will seize chances to build competitive strength.

The following discussion examines these trends in more depth, beginning with the “monetary vacuum”, and includes our recommendations and advice to banks.

The money vacuum: The current financial turmoil has made it a lot clearer to banks that the thing most likely to result in a bank’s sudden bankruptcy is not so much insufficient capital as it is a liquidity crisis. Moreover, the problem has continued to evolve: Not knowing how long the turmoil would last, the first impulse was to keep a tight grip on all available funds and begin actively “de-leveraging”. As a result of this aggressive de-leveraging, businesses and the public suddenly found it difficult to obtain loans from banks and started vigilantly practicing their own de-leveraging. This vicious circle of tightening credit retards economic recovery, and it also undercuts to efficacy of expanded fiscal spending by governments around the world.

In times of de-leveraging and monetary vacuum, we believe banks must pay particular attention to the following points:

• Apply differentiated customer management and avoid across-the-board credit tightening: When you tighten credit to customers in a weak economy, it is especially easy to harm customer relations and your bank’s reputation, so the thing banks should avoid most is applying indiscriminate credit tightening. Instead, they should carefully apply customer management policies based on appropriate differentiation between classes of customers so as to maintain long-term relationships with loyal customers.
•  Work in concert with government expansionary policy to alleviate the impact of de-leveraging: The economic downturn has impacted virtually every industry, and governments have adopted expansionary fiscal policies to rescue their economies. However, the negative effects of bank credit tightening can offset the positive effects of government economic stimulus packages. Hence, to the extent that the banking sector as a whole can act in harmony with government expansionary policy, limiting the impact of de-leveraging on corporates and individuals, it can slow the pace of economic decline and, in the end, benefit overall operations in the banking industry.
• Increase autonomy and diversification of funding sources: De-leveraging on the part of banks has caused a large-scale contraction in the inter-bank lending market, so that many banks have had to change their funding structure – raising the proportion in core deposits and boosting the diversity and autonomy of funding sources – in order to lessen their reliance on the inter-bank lending market and decrease uncertainty over the supply of funds.
• Concentrate on core markets and areas of expertise: With the capital and lending markets being squeezed hard, banks find it difficult to support involvement in businesses and markets that eat up capital and in which they are not competitive, and for this reason they must refocus on the core areas of their business. They must carefully consider which fields they can really compete in and win, then resolutely exit fields in which that they cannot become one of the market leaders within 3-5 years, and concentrate resources on the markets they are truly strong in.

Renaissance: The traditional bank business model is staging a comeback.

In recent years, so-called financial innovation and financial engineering generated a number of problems:

1. Banks became very complex and difficult to analyze;
2. Financial markets became increasingly divorced from the real economy as the global derivatives market grew from three times GDP in 2001 to nine times GDP in 2008.
3. For banks, business engagement activity became separated from risk bearers (due to the proliferation of securitized products).
4. Complexity grew beyond people’s control.

The innovations exposed bank employees to moral hazard and led to excessive leverage, finally resulting in massive destruction of wealth. We can foresee that oversight agencies in many countries will strive to simplify the scope of business they allow banks to engage in, and lower banks’ risks (and rewards) for the sake of financial stability. This also implies that traditional bank business models will receive renewed emphasis.

In addition, the financial “tsunami” has made it abundantly clear that there are many areas in need of examining when it comes to how banks have priced and managed risk and encouraged risk-taking behavior. Discipline in regard to risk was not strictly followed in day-to-day business decision-making, and the role of risk control often went little further than superficial controls and capital allocation. The result was that banks were unable to bring risk factors into proper consideration, either in product pricing or employee compensation systems, making it difficult to raise decision-making quality.

Based on the above, we believe that banks must respond as follows:

• Simplify products and organization: Choose simple and clear product lines and organizational structures, thereby cutting expenditures needed to manage complex business models.
• Focus on core business areas: Choose which fields to exit and which ones should be concentrated on. Although current prices for assets disposed upon exiting a business field are far from ideal, the advantages of completing a core adjustment early on outweigh the disadvantages.
• Emphasize risk management: Business engagement and risk bearing concepts must be taken up anew; business models that rely on high degrees of leverage, complexity and non-transparency must be changed, and banks must accept lower rates of return and more oversight. Superficially, at least, bank profit numbers may fall, but risk-adjusted rates of return will not necessarily suffer.
• Link hedging strategy more closely to systemic risk: Make more frequent use of scenario analysis and stress testing to assess risks, and conduct additional analysis of the complex systemic relationships between one’s own bank and other market participants. The latter step will give a bank an understanding of its full exposure when systemic risk arises, and this knowledge can be incorporated in its hedging strategy so that sufficient reserves will be on hand well ahead of time.
• Adjust the incentive system: If simple and transparent traditional bank business models are to become mainstream again, incentive systems must be adjusted correspondingly, with heightened attention to bank risk management and greater involvement by finance and HR departments. Possible adjustments include
  1. Performance bonus calculations must consider the underlying degree of risk and length of risk exposure pertaining to different pieces of business
  2. Performance bonuses should not be paid until all costs and risks are met.
  3. Bonuses should awarded out of realized profit should be reasonably deferred, at least in part.
  4. A considerable portion of an individual’s remuneration should come from department-level bonuses.
  5. The incentive system should be designed to mesh with the corporate culture that the bank hopes to build over the long term.

The past must not be repeated: Bank regulators will strive to prevent a return to recent excesses.

Banks have come to be viewed as the perpetrators behind the recent financial crisis, and the general public now has a clearer understanding of the impact financial market turmoil can have on the real economy. On the part of governments and regulators, there is also a new interpretation of the “too big to fail” problem: Given that large banks can not easily be allowed to fail, this also means that banks must accept greater supervision and bear more social responsibility. overnments and regulators around the world will therefore strengthen oversight to ensure that a similar crisis does not occur again. It can be expected that any bank behavior which might impact financial stability will receive intense scrutiny, and that direct supervision of bank liquidity will be strengthened. Statutory capital will be defined more strictly, and minimum capital requirements will also rise.

In recent years, financial supervision mechanisms in major countries have evolved in response to the changing environment, but it must be admitted that the speed at which financial markets diversified and grew more complex overwhelmed the monitoring and control capacities of those mechanisms. If bank operations are to be assertively monitored, cooperation from banks and support from the public are needed, but a major challenge for governments now is making sure oversight agencies themselves have enough financial oversight talent and capability.

The financial meltdown has clearly highlighted the importance of interaction between elements of the international banking system , and it has shown the inadequacy of past financial oversight models centered solely on individual countries. Although there are practical difficulties to establishing a global oversight body, national supervisory agencies have already demonstrated their willingness to work together toward goals they cannot achieve individually, and the hope is that they can bring into being transnational, cooperative oversight mechanisms to strengthen supervision of transnational financial activity.

Also, now that governments in Europe and the U.S. have become major shareholders of many large banks, their influence over the banking industry is bound to increase greatly, with their oversight role broadened to cover such operational matters as bank development strategy and incentive systems.

In view of the foregoing, we advise banks to adopt the following measures in order to respond appropriately to the new banking oversight environment:

• Welcome the new supervision mechanisms with a positive attitude: It is best to take a positive approach – even to excessive oversight that governments may impose in the initial stages of this transformative period – and assist the supervisory agency to establish suitable oversight policies in the search for a new equilibrium.
• Take the initiative to engage the government in dialogue: Governments can be expected to propose a host of policy measures in the midst of financial turmoil, so banks should communicate proactively with their governments, taking the initiative to propose analysis and suggestions that are in the interest of the overall banking market and society in general. This can help enhance the quality of government policies and improve banks’ own competitive conditions.
• Take social responsibility for banking system stability: As for government emergency policies to solve the crisis, banks should respond favorably and cooperate, and they should pay closer attention to the stability of the banking system in order to fulfill the social responsibility role that banks, as public entities, are obliged to play.

Natural Selection: Winning banks will seize chances to build competitive strength.

When being rocked by financial storms, banks may have no choice but to concentrate on surviving and adapting to changes in their external environment. We all know, however, that storms dissipate sooner or later, and most banks will survive them; and the middle of a crisis, moreover, is when a reshuffling of the competitive hierarchy is most likely to occur, the reason being that bank executives are prone to overreact in the pursuit of survival at all costs, weakening their long-term competitive strength.

One of the things revealed by the recent financial turmoil is that most banks supposed the future would be pretty much the same as the past, which led them to under-prepare for decidedly different circumstances when they arose. It was assumed, for example, that:

1. Housing prices would continue to rise;
2. Default rates on subprime mortgages going forward would be similar to past rates;
3. Sufficient liquidity could be obtained from the inter-bank lending market; and
4. Developed country economic growth would stay at 2~4%.

In the end, these biased assumptions resulted in serious losses for shareholders. Moreover, the behavior of some banks throughout this period of financial distress has lost them the trust of much of the public, which universally condemns them for their high salaries, unethical marketing of financial products, and role in creating the financial turmoil, among other things. As a result, one can expect that banks will have to face more inquiries and scrutiny from different stakeholders (including shareholders, transaction counterparties, supervisory agencies and the general public). Also, given the freedom and speed of global money flows, banks must place special emphasis on the crisis of confidence among investors and transaction counterparties, because now that they are paying particularly close attention to bank risks, banks can be pushed to the brink in a matter of days after showing the slightest signs of trouble.

Based on the above, we believe that the ultimate winners after the financial turbulence passes will be banks that, while calmly dealing with their business continuity issues, also focus on the following key points:

• Reformulation of long-term development strategy based on the new financial environment, and detailed re-evaluation of the business model to adopt for that new environment;
• Regular demands by upper management for organization-wide evaluation of different scenarios, with formulation of appropriate response plans. In addition, longer-term historical data should be used to assess risks, along with an expanded scope of assumptions for stress tests and scenario analyses, making good use of assistance from outside consultants, and frequently examining the reasonableness of the assumptions. Based on the results of the analysis, one can design a capital structure and business model that is better able withstand fluctuations;
• Adroitly seizing acquisition opportunities produced by the financial turmoil in order to realize the aforementioned development strategy and business model;
• Rebuild and regain the trust of different stakeholders. Study how to manage operations so as to take into consideration different expectations among stakeholders, especially expectations coming from government and the society;
• Continued attention to the effects of natural resource scarcities and changes in the Earth’s climate. Admittedly, these are not the most important issues banks face, but in the long term they will create opportunities for banks, while at the same time bringing challenges. Examples include financing and investment for building a low-carbon economy, green energy construction and social sustainability.

This article was published in Taiwan in the Commercial Times newspaper between February 2 and March 24, 2009.