Bankers rate their risks

For the first time ever, bankers have rated ìpolitical interferenceî as their greatest fear. We look at the reasons behind their anxieties

 

When governments and their regulators said that banks must reappraise the key risks that face them after bailing the sector out to the tune of billions of taxpayers’ money, they probably did not think that financial institutions would rate their saviours as their worst nightmare.

Bankers are complaining that political interference is now the biggest risk facing the banking industry. The “politicisation” of banks as a result of bailouts and takeovers now poses a “major threat” to their financial health, according to some 450 senior figures who contributed to the annual Banking Banana Skins report from professional services firm PricewaterhouseCoopers (PwC) and the Centre for Financial Innovation, a think-tank.

It is the first time in 15 years of the study that the risk has even featured as a significant risk, let alone coming top. “Bankers saw politics distorting their lending. Non-bankers said rescues had damaged banks by encouraging reckless attitudes. Regulators worried that governments would withdraw their support from banks before they had time to rebuild their financial strength,” PwC said.

Political risk was top of the agenda for respondents from North America, Europe and industrial countries. In the Asia Pacific region it was rated in fourth place after regulation, macro-economic trends and credit risk. In emerging economies political interference was rated in seventh place.

Government intrusion in to the banking system through bail outs and official support heads the list of risks in North America, notably in the US. Canadian banks are more concerned about the threat of regulatory over-reaction. The immediate concerns in both countries are very much with crisis fall-out: credit and liquidity risk, and the shaky prospects for economic recovery. Europe is also deeply concerned about the consequences of government involvement with banks, notably in the UK where has been a lot of it and where many respondents to the survey were located. Linked to this is a fear of a regulatory over-reaction, particularly by Brussels.

The survey’s authors say that political risk is closely related to the third – “too much regulation” – and the concern that banks will be further damaged by an over-reaction to the crisis. Other dangers on the list include credit risk (at number two) and the economy (at number four). A lack of liquidity fell to number five from last year’s top spot, while the availability of capital was a new entrant at number six. Derivatives fell from four to eight, with the final three made up of risk-management quality, credit spreads and the performance of equities.

Several bankers have publicly complained about political interference – notably the Royal Bank of Scotland’s chief executive Stephen Hester, who argued that the politicisation of RBS was hampering its recovery and would harm the taxpayer by making it more difficult for the government to make a return on its investment. However, he did later say that he regretted his words – which are firmly of the minority view.

The sector’s critics have argued that politicians have not gone far enough in reining in a sector which sought to return to business as usual by paying huge bonuses just months after taxpayers across the developed world were forced to inject billions to keep it afloat. The culture of excess has led to the Chancellor, Alistair Darling, imposing a one-off 50 percent supertax on banks’ bonus pools. A similar measure has also been proposed in France, while US President Barack Obama wants to introduce a levy on banks to recoup US taxpayers’ funds and is proposing to ban deposit-takers from the most risky activities of “casino capitalism”.

There is a certain irony in the bankers’ complaints, admits David Lascelles, the editor of PwC’s survey. “It is ironic that politics should emerge as a risk when the banks had to be rescued in the first place,” he said. “But there is clearly a crisis in the relationship between banks and society, and it will take years to rebuild trust. Until it is, banks will operate under a financial handicap.” John Hitchins, PwC’s UK banking leader, added: “With political interference as the top risk and too much regulation at number three, the concern is that the financial crisis has taken the bank industry’s future out of its own hands.”

Bankers’ concerns with regards to political interference fall into three areas. One is the moral hazard created by bank rescues. The managing director of risk at a large US bank said that it had already begun to breed complacent attitudes and a belief that “we’ll always be bailed out”. Ros Altmann, a policy adviser at the London School of Economics, said that banks now assumed that they cannot fail “which distorts their operational decisions and permits different behaviour than would otherwise be the case. They also know that governments need bank share prices to stay strong in order to offload taxpayer stakes in future which, again, gives them the one-way option of reaping the rewards of risk-taking, but not suffering the penalties of failure”.

The second is the politicisation of lending. Having bailed the banks out, governments are pushing them to keep lending through the recession, against their better judgment. A director at a large UK bank said that “political meddling in the financial sector is almost universally contradictory and negative. One can’t lend more to support the economy and build up capital bases at the same time”. A credit analyst at a large Japanese bank said that “political interference in both banking and regulation is likely to lead to a mis-allocation of resources, which will probably increase, not decrease, the risk profile of the system”.

The third concern is how governments will withdraw their support without upsetting the banking system and jeopardising the recovery. A respondent from Ireland, where the government is deeply involved, said: “Currently, the system is extensively supported by individual states. The ability of individual banks, and the system in general, to extricate itself from such support and raise capital on a standalone basis is an issue”. The chief risk officer of a large South African bank said: “The main immediate concerns have been alleviated through government intervention. The remaining concern is mostly around the disengagement process of governments from their intervention, and whether this would occur in an orderly way”.

The future of government intervention is also a crucial question for regulators, one of whom said that “premature withdrawal of government support could leave weaker banks unable to finance their assets on a sustainable basis given their high leverage”. Several respondents raised the additional worry that there was no money left to bail banks out of a new round of failures. A senior risk officer at a large US bank said that “should the ‘green shoots’ prove false, and these countries have exhausted their resources, no company will be ‘too big to fail’ – which could create a crisis deeper than any of us have seen”.

Below are some of the key risks that bankers have identified, as well as some of the reasons that might have shaped their opinions.

Credit risk
Banks need credit to operate but they managed to collectively wipe over a trillion dollars off the face of the Earth. As a result, for the past few years, banks have been resistant to lending money to consumers – or each other through inter-bank lending arrangements. Governments had to bail the sector out to kick-start it again, and linked to the main risk of political interference, no bank wants to be without credit again.

However, some banks perhaps remember the crunch a bit differently from the rest of us. At the beginning of March Vikram Pandit, chief executive of Citigroup, blamed short selling (whereby sellers borrow stock in a company, sell it and hope to buy it back at a lower price) rather than any self-inflicted weakness for the bank’s near-collapse in 2008 and thanked taxpayers for its government bail-out. Christopher Whalen, managing director of Institutional Risk Analytics, took issue with Pandit. “His bank has got the highest [credit] loss rate of any of the big four,” he said. “The shorts were just responding – the emperor had no clothes.”

Pandit said Citi had repaid $20bn in bail-out funds, paid $3bn in dividends to the government and $5.3bn in premiums on the asset guarantee programme. The US holds a 27 percent stake in the bank. “Citi owes a large debt of gratitude to American taxpayers,” Pandit said. But the US government would rather have its money back – and promptly. Herb Allison, assistant Treasury secretary, said: “We wish to dispose of those shares in the public market as soon as circumstances permit.’’ However, while Citi’s stock has been trading above the $3.25 price at which the government acquired its stake, it is at too small a premium for the Treasury to be confident of making a profit if it tried to sell its whole stake in the near future.

Derivatives
One of the criticisms that has been levied at banks and their boards is that they did not fully understand the financial instruments they were using to generate profits and could not, therefore, appreciate the risks that were inherent in them. Derivatives – the multi-billion over-the-counter market where investment banks trade millions of contracts which are not recorded on any public exchange – have been a case in point, perhaps especially so since even financial regulators did not even have enough information about how they worked.

Such mistakes are hopefully about to change. At the beginning of March derivatives dealers agreed in a letter to the Federal Reserve Bank of New York to give regulators more information about over-the-counter (OTC) derivatives trades in the credit, interest rate and equity markets and will continue shifting more trades towards central clearing. Even as banks raised their target of clearing credit derivatives that can be cleared to 85 percent from 80 percent – a key measure that regulators are calling for to reduce the risks of a systemic collapse of the financial system in the event of a default by a dealer – derivatives investors have so far failed to sign up for similar specific clearing targets.

Extending clearing to large dealers as well as big investors is widely regarded as an important step towards reducing derivatives risks, but in practice it is complex to implement. “Remaining impediments to the expansion of buy-side access to clearing include legal and regulatory, risk management and operational issues,” the letter to the Fed said. They said “a meaningful amount of open interest in buy-side transactions will be cleared”.

With continued concerns about transparency in markets such as credit default swaps, which have come to the fore amid the pressures on Greece and its creditworthiness, the industry is planning to analyse existing sources of data in OTC markets, with the first report due at the end of March. Bankers involved in the plans said this could include information such as screens used on Bloomberg or other data providers with price levels. Work is also expected with trade repositories such as the Depository Trust & Clearing Corporation where data about credit derivatives trades is lodged, in analysing trading and volume patterns. However, as central clearing is extended from its traditional role in exchange-traded instruments to OTC products, there is debate about the shape of clearing houses and what rules should govern then.

Hedge funds
Not all financial institutions were battered by the credit crunch. For some financial services firms, the banking crisis was just that – limited to the banking sector. Hedge funds, for example, were criticised for betting against the banks, and making a fortune in the process.

Opinion is still divided on the industry. In February the UK’s FSA said that hedge funds do not pose a real systemic risk to the financial system, despite the criticism they have received for their perceived role in the global credit crunch. London funds surveyed by the FSA, which have about $50bn of assets under management, or 20 percent of the industry, barely control one percent of the entire European equity market – a sign that if the industry were to collapse, a sale of their assets would not pose a risk big enough to destabilise the system, the report says. Also, contrary to market perception, the average “leverage” or debt used by hedge funds to invest, is about twice their assets – compared to about 30 times used at large retail banks.

In fact, says the FSA, the largest investment bank’s exposure to a single hedge fund is no bigger than $500m, a sum that would not sink a large institution. “While these are large numbers, they are manageable in the context of the overall credit risks and capital requirements of the surveyed banks,” the report says.

But not everyone is convinced – particularly those people who are based outside of London, the world’s hedge fund capital. Michel Barnier, the new European commissioner for the internal market, is on course for a bruising showdown with hedge funds and private equity firms after signalling an unwillingness to compromise over plans to regulate hedge funds and private equity more aggressively, despite their threats to leave Britain.

Barnier, who has also launched an EU probe of short selling and the credit default swaps market, has come under pressure from the private equity and hedge fund industry to amend an EU draft directive on alternative investment fund managers (AIFM). Many funds are managed in the UK but the money is domiciled in havens such as the Cayman Islands or Jersey. The Commission is proposing that territories such as these would be required to demonstrate “equivalent” regulatory regimes, and be transparent – something that they are unlikely to agree to.

“Requiring high standards of supervision and transparency from the European industry but not from third country funds and managers active in Europe would be short-sighted,” said Barnier. “It would impede effective monitoring of risk in Europe and create an unlevel playing field and opportunities for regulatory arbitrage”.

Simon Walker, chief executive of the British Private Equity Association, said the situation was “extraordinarily serious”, particularly since 60 percent of the private equity and 80 percent of hedge fund activity in the EU is in London.

Barnier will also now investigate short selling of the euro – at a 10-month low against the dollar – and so-called “naked credit default swaps trades”, which critics say have been used by speculators to destabilise the euro and the market for Greek and other sovereign debts.

Barnier said: “We’re working on the fundamentals of derivatives, to understand who does what, and in credit default swaps we’re looking at the aspect that relates to states.” However, the commission’s approach has been heavily criticised. Michael Hampden-Turner of Citigroup Securities said: “You can’t blame the mirror for your ugly face.”

Credit default swaps are a type of insurance taken out when an investor is concerned about risk of default. At the moment, for example, the premium to insure Ä10m of Greek government securities is Ä428,000. “Naked” shorting via the credit default swap market takes place where the trader does not own the underlying security, likened to taking out life insurance on other people, with similar homicidal intent. The Greek and Spanish prime ministers have publicly blamed “speculators” for undermining the single currency.

Liquidity
Controlling and monitoring bank liquidity is vital if banks are to keep check on their assets and cash, and the easier that they can get hold of their liquid assets, the safer they – and the economy – will be. Regulators have been considering ways to ensure that there is enough liquidity in the market to prevent another crisis, but attempts to introduce new rules on the issue have been thwarted in some quarters.

For example, the UK Financial Services Authority (FSA) has delayed implementation of tough new liquidity standards it published in October because of the economy’s continuing weakness, thereby giving UK banks a period of grace. Reflecting concerns expressed by lenders, the regulator conceded that it would be “premature to increase liquidity requirements across the industry at the current time”. When it announced the revised standards last October, the FSA said it would “not tighten before economic recovery is assured”.

The rules are now not expected to be introduced before 2011 after the regulator said its next announcement would be in the final three months of this year. The new liquidity regime is an attempt to ensure that a lender’s treasury assets are readily convertible into cash in a crisis so it can pay out to customers without resorting to state help if there is a run as was the case with Northern Rock.

Banks such as HBOS were using their treasury portfolios, which are meant to be super safe, to generate income by buying sub-prime mortgages. Under the new rules, banks will be barred from holding anything except gilts and customer deposits which are easy to sell. According to the FSA, banks had just £280bn of qualifying assets last October. They will need to raise £110bn more by replacing corporate bonds and asset backed securities with gilts. Under such a scenario, the regulator said the lost potential income would be £2.2bn a year compared with “the average return in December 2007”.

Under its extreme scenario, the FSA said, banks would need to raise £620bn at a cost of £9.2bn a year. The FSA has pressed ahead with liquidity reform unilaterally to get on top of the problem early. However, banks have warned that the cost of tougher liquidity rules and tighter capital requirements will limit the availability of credit for business, potentially threatening growth. In its release yesterday, the FSA acknowledged the concerns.

Less than a week earlier at the beginning of March, Lord Adair Turner, FSA chairman, gave evidence to the Treasury select committee as part of its “Financial institutions – too important to fail?” inquiry urging MPs to impose tighter controls on Britain’s biggest banks. Turner, who last year dismissed the City as “socially useless”, told the committee how the banking sector should be shaken up to avoid a repeat of the economic crisis.

Turner said that regulators such as the FSA should force new, higher, capital and liquidity ratios on the world’s largest banks, especially those with large exposure to risky “casino banking” activities. Last October he argued that this would help avoid a repeat of the events of 2008, when Lehman Brothers collapsed and nearly took the rest of the sector with it.

In February Turner questioned whether the growth of “sophisticated” financial products had really benefited the wider economy. “There does not appear to be any compelling proof that increased financial innovation over the last 30 years in the developed world has had a beneficial effect on output growth,” he said in a speech in Mumbai.

The Treasury select committee has already taken evidence from many of the other key players in the UK banking sector. Mervyn King, governor of the Bank of England, said in late January that the UK government needed to take a more radical approach. King also backed President Obama’s own efforts to shake up the world of banking and prevent retail banks from also running hedge funds or private trading arms.

In February the Bank of England Governor Mervyn King said that the mortgage special liquidity scheme will not be extended. During the Bank of England’s Inflation Report briefing, King confirmed that the Special Liquidity Scheme which has helped lenders fund mortgages during the crisis would end in January 2011 as scheduled. This has triggered fears that mortgages will dry up and rates will rise sharply towards the end of the year because lenders will struggle to borrow from wholesale markets to fund deals.

Mortgage brokers said that the good progress made in improving mortgage availability over the past year will be undone. Ray Boulger at John Charcol, the mortgage broker, said: “There could be a big problem if the scheme is not extended. The mortgage market has improved in recent months but if the Bank of England does not compromise, then the deals will dry up and become more expensive.

He added: “Lenders who need to repay money they have borrowed from the scheme will not be able to lend. Those that were not involved in the scheme will raise rates on mortgage deals, not only because they can because of lack of competition, but because they will not want to be swamped by applications if it a deal is too good to miss.”

At the beginning of February the UK’s Council of Mortgage Lenders (CML) warned that a £300bn funding gap – the difference between what property buyers wanted to borrow and the funds available to lenders – would open up when existing government support schemes expired if there was not an extension of the scheme. The CML said: “The collapse of wholesale funding markets has left a £300bn gap in mortgage funding. Unless there is a policy approach intended to encourage the development of wholesale funding, we are likely to see a long-term decline in choice for UK mortgage customers.”

Regulatory risk
If there’s one thing that financial services firms do not like, it’s more regulation. But beggars can’t be choosers as national enforcement agencies and regulators all around the world gear up to make the banks knuckle down. The world’s two leading financial markets – the US and the UK – have already been making recommendations, though none are yet fully in force.

The Volcker Rule (also known as the Volcker Plan), first publicly endorsed by President Obama on 21 January 2010, is a proposal by American economist and former Federal Reserve Chairman Paul Volcker to restrict banks from making certain speculative kinds of investments if they are not on behalf of their customers. Volcker has argued that such speculative activity played a key role in the financial crisis of 2007–2010. His plan also prohibits banks from owning or investing in a hedge fund or private equity fund, as well as limiting the liabilities that the largest banks can hold, which fits in with  President Obama’s intention to end the mentality of financial institutions being “too big to fail”. Volcker was earlier appointed by Obama as the chair of President Obama’s Economic Recovery Advisory Board created on 6 February 2009.

The plan has some high level support. In a letter to The Wall Street Journal published on 22 February 2010, five former Secretaries of the Treasury endorsed the proposals. But the plan needs more support in Congress, and at the time of this issue going to press, it did not seem likely that President Obama was going to get it, with Democrats and Republicans querying why the president saw fit to drop in the proposal late in the regulatory overhaul. Congress is in favour of a weaker bill which will allow federal regulators to restrict proprietary trading and hedge fund ownership by banks, but not prohibiting these activities altogether.

The plan (as it currently stands) also has its critics from outside the US. UK business secretary Lord Mandelson says that Volcker’s plan is “too difficult” to implement. The business secretary’s strong public criticism of the proposals reflects widespread frustrations among ministers at a “sweeping” overhaul that was conceived and announced without consultation with the UK. Stressing that the UK preferred co-ordinated action on banking supervision, Lord Mandelson said: “President Obama’s proposals on banking regulation, I have to say, came as a bit of a surprise to people working on the G20 agenda and it’s important that we keep the multinational agenda firmly on track.”

“Trying to apply sweeping rules about the structure, content and range of activities of banking entities is too difficult to do,” Lord Mandelson said. “Whatever their size, whatever their range of activities, you need good regulation. It’s the principle and practice of regulation you have to focus on, not the size of banks,” he added.

In comments that echo those of Lord Mandelson, Charles Dallara, managing director of the Institute of International Finance, which represents the largest global banks, called on countries to work together to avoid “fragmenting” a regulatory reform process begun at the Group of 20. “Either the G20 leaders believe that the G20 framework is the way to go or they don’t,” he said. Michel Barnier, European Union internal market commissioner, has also warned that the Volcker plan could not be imported in the same form to Europe.

The UK has also recommended substantial changes to the way banks manage risk. At the end of November Sir David Walker published his final recommendations on UK banks’ corporate governance, pay policies, and approaches to risk management. His key recommendations included strengthening the role of non-executive directors so that they can provide an effective challenge in the boardroom, disclosing pay policies including deferring two-thirds of cash bonuses and favouring long-term investment reward schemes (though not capping executive remuneration), and having non-executives chair risk committees which will have the power to scrutinise and, if necessary, block big transactions.

Banking banana skins 2010 (2008 ranking in brackets)
1     Political interference (-)
2    Credit risk (2)
3    Too much regulation (8)
4    Macro-economic trends (5)
5    Liquidity (1)
6    Capital availability (-)
7    Derivatives (4)
8    Risk management quality (6)
9    Credit spreads (3)
10    Equities (7)
11    Currencies (13)
12    Corporate governance (16)
13    Commodities (12)
14    Interest rates (9)
15    Fraud (11)
16    Management incentives (17)
17    Emerging markets (18)
18    High dependence on technology (15)
19    Hedge funds (10)
20    Rogue trader (14)
21    Business continuation (23)
22    Retail sales practices (20)
23    Conflicts of interest (21)
24    Back office (19)
25    Environmental risk (25)
26    Payment systems (27)
27    Money laundering (24)
28    Merger mania (28)
29    Too little regulation (29)
30    Competition from new entrants (30)