Sunday, 19 September 2010

Neglecting What Saved Us

The Malta Independent on Sunday 19.09.2010

Neglecting what saved us

Often we hear boasts from different quarters claiming credit for the fact that our banking sector has remained rock solid even during a financial crisis that shook the best and the rest.   Credit is certainly due.

What is questionable is to whom.

Primarily it is due to our forefathers who have imbued into us a strong culture of thrift.   Thrift ensured that funds necessary for macro and micro investments were found internally without resorting to foreign borrowing in any meaningful manner.   Thrift empowered our domestic banks to fund all their loan books through retail deposit with liquidity to spare.   When the 2008 liquidity crunch hit, our banks were not at the mercy of wholesale lenders withdrawing credit lines simultaneously.

Northern Rock, Bear Stearns, Lehman Brothers, Royal Bank of Scotland, Citibank, Lloyds Bank, Fortis, Hypo Real Estate and many others remain horror stories we read about but thankfully distant
from local realities.

Credit is due to local bankers who stuck to what modern finance whizz kids would consider boring utility banking of taking deposits and converting them into loans to other sectors of the economy, basically the traditional intermediation role of banks between savers and investors.
Prudent banking policies ensured that loan books remained in relatively good performing condition.
Loans were never hived off from our banks’ balance sheet through securitisation.   The need for banks to know their customer who was to remain an asset on their balance for a very long time, ensured that the credit approval process remained robust and capable of withstanding economic downturns.

As success has many fathers, credit has been claimed also by the political class and the regulators.
Probably a measure of credit is due to this class as well but recent events seem to suggest that this credit is mostly due by accident rather than by design.   Otherwise our regulators would not be allowing the stark erosion of competitive advantages that have saved us in times of troubles.

It is strange but true that this is happening whilst financial regulators worldwide are carefully designing stricter regulations and tightening supervision over financial markets to avoid a relapse similar to the 2007 -2009 crisis.

This by no means implies that regulators are allowing or condoning breach of the written rule book.
Effective regulation, however, goes well beyond the rule book.  Effective regulation depends on the wink and the nod much more than it depends on the rule book. It is this wink and the nod which seems to be disappearing from our system of financial regulation.

Let me be as specific as prudence permits me to be.    Local banks that operate across the whole service universe are a great asset to the economy.     HSBC and Bank of Valletta dominate but smaller banks like APS and Lombard offer competition relative to their size.    Recently these were joined by a Banif, a Portuguese owned bank that added spice to the competition much to the benefit of consumers, be they savers or borrowers.

Some competition also comes from foreign owned banks operating mostly to book international business, but once here, they adopt a rather laid back approach to attracting local deposits and do some local lending.

The spectrum was until recently complete with a specialised bank like FimBank, a niche bank with internationally recognised competence for specialised trade finance that competes prudently for fund raising whilst adding value to the local economy through offering trade finance to both local enterprises as well foreign units owned by local entrepreneurs.

All these banks are credit licensed institutions authorised to participate in the privilege to raise deposits in this liquid economy and benefit from the Deposit Protection Insurance set up by the regulator.

 In essence this insurance is a contingent liability that exposes the taxpayer to substantial liability if such liability were to change from contingent to real ( as happened in UK with the failure of
Icelandic banks operating under the home deposit protection scheme which was clearly insufficient and the burden spilled over to the UK taxpayer).

The system has a cloak of fairness around it, a sort of unwritten social contract among the banks, the depositors and the taxpayers represented by the government and the regulator.   The taxpayer offers the depositors an explicitly limited and implicitly unlimited guarantee on their deposits and the banks in return intermediate such deposit by transforming them into maturity mismatched loans to permit the economy to grow through private sector investments in factories, hotels, real estate, homes and to a limited extent consumption borrowing.

This unwritten social contract was breached when a foreign owned bank, using a name, corporate colours and logo which attempt to draw brand power from the former Mid-Med Bank, was licensed
to compete aggressively in the deposit market purely and explicitly to operate as a long only highly leveraged hedge fund investing in high rated foreign fixed income securities.
A thorough analysis of their financials, which show a bare gearing of some 27 times gross assets to equity and consequent unweighted  capital ratio of less than 4% which magically converts to a comfortable 37% through regulatory risk weighting of the assets, shows this is clearly a hedge fund licensed to raise deposits which are used to fund margin for borrowing huge sums on wholesale inter-bank  market to invest in high rated papers currently accepted for repo by the European Central Bank (ECB).

The promoters of the new bank are clever to exploit a rare opportunity created by the artificial scenario caused by the ECB’s rescue effort to stabilise the banking system, where banks can borrow
short term at near zero rate from the ECB, and consequently on interbank markets on a secured basis, and invest same in high rated paper generating a margin of 3% (300 basis points) or more.

 Nothing wrong in banks doing this to restore their balance sheets after the knock they received in 2008/2009, and so be able to start functioning properly again in their crucial intermediation function.

However there is something gravely wrong in allowing private equity investors to dress their hedge fund with a Maltese credit institution licence and ride free on the Maltese taxpayers’ explicit and implicit guarantee to raise deposits which are immediately leaked out of our economy and used to provide margin calls for huge wholesale funding.
Such margins funding is normally done by hedge fund investors with their own money without any taxpayer protection.

Hopefully we will not have another banking crisis in my lifetime and this lowering of our regulatory standards, especially the unwritten wink and nod type, will not send any bill to our taxpayers.  Hopefully I will sound like a Cassandra.    But this does not mean that we should take the risks we are taking.  No way can anyone be satisfied that we are really out of the woods in the financial crisis.

Barclays promoting Bob Diamond to the CEO role says it plainly that the big banks just don’t get it and insist on running casino banking alongside taxpayer protected utility banking. This is like lighting a bonfire next to a fireworks factory.    Barclays received two great strokes of luck that saved it from casino bets that Bob Diamond wanted it to make. It was saved from disaster of overpaying for ABN AMRO just before the crisis hit in 2007, purely because there was a bigger fool who over paid even more. The bigger fool was a tandem formed by RBS and Fortis who both had to be saved at great taxpayers’ expense.

Barclays was saved a second time by the British Government by refusing to authorise its blind purchase of Lehman Brothers which would have wiped out Barclays through the acquisition of overpriced toxic assets.   As it happened following Lehman bankruptcy, Barclays acquired the pieces of Lehman it really needed basically for free and without any risk. It was not Bob Diamond’s skill that kept Barclays on the straight and narrow; it was pure lady luck.

Yet Diamond gets promoted to CEO, secures atrocious remuneration deals and bullies the UK regulator that if they pursue with plans to break up Barclays to separate casino banking from utility banking he will move the bank to a new jurisdiction.

Secondly we should not assume blindly that the ECB will be there forever. The sustainability of the Euro system is being increasingly questioned. Whilst the political will to save the Euro remains strong, ultimately if the price of saving it gets too big, no one should assume a blank cheque from anyone.

And if the ECB is not there to offer repo’s to banks that need instant liquidity would the burden fall on our own Central Bank, and if so would it have the appetite and the capacity to offer such repo’s?

  Are we oblivion to such hidden risks or are we truly willing to neglect what saved us?  

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