DOLLARS & SENSE

Global Banking Regulation:
What would change and what should be left alone?
By Francisco Suárez, Head of Equity Research at Actinver
• Photos by Jesús de Avila • April 2009

History tells us that downturns caused by a troubled financial industry are usually deeper and take more time to recover from. The current recession was fueled by a crisis in the global financial industry. Many fingers have been pointed at the lack of regulation as one of the culprits behind this mess. Already authorities across the world are rushing towards increased regulation. This article is an opinion on what should be changed and, more importantly, what should be avoided, as it is my view that too much regulation will negatively affect the very nature of banking, with harmful consequences for long-term growth.

Let us first look at the nature of the banking industry. It is based on confidence, and paradoxically, confidence requires taking risks. The act of lending money to someone is risky: the more confident you are in someone’s ability to repay a loan, the more you’ll be willing to lend. The more you lend to that client the more risk you assume should something unusual happen. Banks deal with the risky nature of their business using at least three basic tools: capital, reserves, and diversification; all of these are in turn addressed by regulators.

Diversification. The idea is to have a loan portfolio (as well as an investment portfolio) which is diversified across many different clients, industries, currencies, countries and the like. Greater diversification means that if something goes wrong in a certain industry or country, the rest of your portfolio will weather the storm, provided that the troubled asset class only represents a fraction of the overall portfolio. We now know that the banks were heavily exposed to the housing sector, not only through direct loans but also through derivative instruments in their investment portfolios which were linked to the overall performance of the housing industry and to the value of the typical collateral: US home values, which continue to fall.

Reserves are needed to set aside money for expected future losses. For instance, if a customer has been laid off his risk profile increases and more reserves are required, even if for the moment the customer continues making payments. Different customers need different reserve levels depending on their risk profile. Banks are rare beasts since in good times they will lend more freely and at lower interest rates. Sometimes they lend too much and too cheaply due to competition. The trick is to create enough reserves during good times in order to be better off when a downturn hits. Reserves were at unexpectedly low levels to face this crash. But since many things were unexpected, the problem lay with something else: capital.

Capital is needed for unexpected future losses. By all measures, capital was simply too low for an industry that depended so heavily on the health of the housing sector. Capital is very sensitive to economic conditions: liabilities are by definition a fact, but the value of bank assets is uncertain.When capital is low, small differences in the value of assets can completely wipe out a bank’s capital. That is why governments across the world rushed to recapitalize the banks. The level of capital is something that regulators follow closely. It might not prevent a bank from failing, but it canprovide it valuable time to adjust. A regulator will require more or less capital depending on the risks that a bank takes. But large complex banks are difficult to follow effectively, as their risks might fall under other legal jurisdictions. Also, some risks were hidden in ‘off balance sheet’ items, such as Special Investment Vehicles. Off balance sheet risks required low capital and in some cases even nothing at all. Regulators were simply overwhelmed by the complexity of today’s banking system.

More regulation and supervision are likely outcomes of the current crisis. Particularly, greater coordination between countries is necessary in order to ensure adequate levels of capital internationally. As risks become more accurately disclosed, regulators can require more capital. However, regulators also need to preserve the banking sector’s incentive to invest in risk and promote innovation: essential activities for long-term economic growth. Right now, regulators have the opportunity both to claim greater powers of scrutiny and to provide incentives to promote loan growth and banking sector health.  Email to a friend

Francisco Suárez Savin
E-mail: fsuarez@actinver.com.mx

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• Francisco Suarez is the Head of Equity Research at Actinver. Before joining Actinver in September 2008, he rated financial institutions at Standard & Poor’s for four years and prior to that was an equity analyst at Banorte for eight years.

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