Credit Crunch Revisited

My last article on the subject was published as far back as 2009, but I was surprised to learn that I’m still getting more than 10 hits a week and it has made me think what a critical subject it remains.

As I reflect on the past five years I cannot help but wonder whether the banking world has learnt much from the lessons of the credit crunch.

Let’s examine the evidence.

Predatory Practices in Retail Lending

One of the key causes of the crisis was the willingness of banks to promote retail mortgage products to customers who could ill-afford them.

In the United Kingdom, the new Mortgage Conduct of Business Code substantially tightens lending criteria by introducing an affordability test that considers higher interest rates and the absence of repayment vehicles. Furthermore the Financial Policy Committee appears to be on the verge of taking the steam out of the London mortgage market by instructing the PRA to impose mortgage limitations on the industry.

In the United States, sub-prime mortgages have been replaced by “another chance mortgages” but this time with much tighter criteria.

It would appear therefore that interventionist regulation has certainly dealt with the root cause of this issue.

Flawed Statistical Lending Models

The flawed lending models that existed back in 2009 remain in place, but thankfully reliance on them is reduced.

Pillar 2 capital levels have been used by regulators to deal with model risk.

The most encouraging development is the use of the leverage ratio. It is interesting to see the PRA taking an aggressive stance on a metric that relates capital levels to nominal assets (before the models create the impression that certain credit risks are actually riskless!).

Basel 3 does not force the international imposition of the leverage ratio for a few years to come. Indeed, it is curious to note that some major countries (Hong Kong, Japan) have yet to publish their thoughts on this mechanism.

So this I fear remains work in progress, some five years on.

Reliance on Credit Rating Agencies

The jury is still out for me on this one.

The financial services sector had become hooked on credit ratings. They were being used for statistical modelling purposes and by regulators. The possibility that an AAA rating could be wrong was inconceivable.

Clearly the sub-prime debacle and reliance on the opinion of rating agencies in this respect has led to massive soul-searching.

Whilst the rating agency business model remains in place, a number of measures have been taken which include:-

• The need for agencies to register with regulators;
• New independence rules have been formulated;
• The US SEC and European ESMA have conducted and published the results of inspections with some areas requiring remediation.

My work with major institutions still reveals an un-healthy reliance on these ratings, if for no other reason than banks are loath to in-source the expertise that has been outsourced to these firms.

More work required here I think.

Lack of Senior Management Understanding

We are witnessing a massive increase in regulators’ due diligence on the technical expertise of senior management teams. This is especially the case in the US and the UK, although the situation in Asia remains patchy.

We recently saw the PRA push back publicly against the proposed appointment of a new FD for an insurance company on the grounds this gentleman had not worked in the sector. Unthinkable a number of years ago.

However, I believe this focus on senior management competence is concentrated on the larger players. I have doubts that the regulators have the resource to properly examine the management teams of middle tier institutions. To my mind, this is not a problem if such medium sized firms do not suddenly become a threat to financial stability.

Liquidity Risk Mis-Management

Most jurisdictions have anticipated Basel 3 and introduced more rigorous limitations on the relationship between liquid assets and funding profiles.

That said, such initiatives have been implemented on a country by country basis, with the UK leading the way.

A global agreement on minimum liquidity levels, a requirement of the Basel 3 initiative, remains to be finalised creating a “balkanisation” of regulatory oversight.

The jury is still out on this theme.

IFRS – Accounting Policies on Reserves

Existing international accounting standards make it difficult for banks to recognise bad news on the credit front until tangible evidence of impairment has actually occurred.

As a result financial statements have tended to delay the recognition of bad news already contained in banks’ internal statistical expected loss models.

The good news is that IFRS 9 will allow banks to use these models for provisioning purposes, a positive step I believe.

Use of Products That Service No Wider Societal Purpose

The CDO cubed was perhaps the best example of a product that was just a plaything for investment bankers and did little for the rest of us.

The higher capital requirements that have been put in place (Basel 2.5) have been almost universally implemented, now making it very difficult for banks to continue to play at the casino using these types of product.

A number of other structural initiatives aimed at reducing “casino banking” should go a long way to preventing bankers from using these instruments. These initiatives include:-

• Volcker in the US;
• Vickers in the UK;
• Liikanen in the EU.

Unfortunately political lobbying may dilute these new regulations in the long term.

Playing “Pass the Parcel” – Using Securitisation

New regulations now make it more difficult for risk to be created without proper due diligence and then passed on to unsuspecting investors.

These rules have:-

• Increased capital requirements on equity tranches;
• Increased capital on holdings of securitised debt
• Encouraged regulators to use Pillar 2 to aggressively penalise banks that are over-reliant on securitisation to fund themselves.

The world is in a better (and safer) place because of this.

Stress Testing & Scenario Analysis

Banks had previously failed to properly engage with stress testing and scenario analysis as a forward-looking mechanism.

However, regulatory-imposed stress testing and scenario analysis is now the norm.

The Fed conducts an annual test of its major banks. Indeed, Citigroup experienced the consequences of a flawed framework earlier on this year as it was forced to defer its strategic plans.

The ECB and the EBA are in the process of rolling out their own mega stress testing initiative.

My only fear is the fact that banks may rely too heavily on regulators to impose stress testing parameters, rather than using their own imagination to build scenarios of their own.

There is still a way to go on this in my opinion.

Incentives

If one believes that incentives to take short term risk were a major root cause of the credit crunch then the jury is still out.

The G20 politicians agreed that:-

• Variable play should be limited in relation to fixed pay;
• Variable pay should be calculated in relation to risk taken;
• Awards should be paid by means other than just cash;
• Employees should be incentivised to consider the long term perspective;
• Bonuses should be clawed back if mal-practice or losses are discovered.

The European Union has sought to implement these principles in a rules-based and highly prescriptive manner. However, UK banks are all seeking to find a way around some of these limitations using fixed (but flexible!) allowances.

The US retains a principles-based view, which allows the US banks to aggressively poach staff from their EU-oppressed competitors.

Asia sits on the fence.

Much still to be aggrieved about, if you believe that pay was one of the root causes of the crisis.

I believe that pay was a factor, but that organisational culture was a bigger factor.

Culture

Much has been said about lack of risk and control culture in banks contributing to the credit crunch.

I would argue that the real issue was the failure of banks to maintain an appropriate cultural balance. In particular, organisations failed to manage those with an entrepreneurial outlook in relation to the people with a risk and control focus.

We are currently pretending that we are capable of making bankers become totally focused on risk and control. I have grave doubts that this is either achievable or necessary.

The world will always need creative entrepreneurial people to build new things and sell them.

It’s the balance that matters.

The Regulators

With hindsight I am sure that some regulators would admit to being “asleep at the wheel”.

The world of financial services has now been transformed into an environment where the regulator is pre-eminent. I believe the following points support my view:-

• Regulatory risk is now seen as the largest financial value at risk in most banks;
• The BNP Paribas settlement stunned the community;
• All major business plans and product initiatives need to be pre-approved;
• Many supervisors have become incredibly interventionist in their activities.

Regulatory fear is the major driving factor in organisational thinking.

If you believe the world is best served by regulators running the show, you will rejoice.

I do not.

In summary, much has been done to make the world a better place. But the jury is out as to whether the banking industry is capable of reverting to a sustainable model that can serve society as a whole.

I hope that I will never see another credit crunch of this nature in my lifetime.