05 February 2012

Banking Banana Skins 2012: Suggesting Restart or New Start?

I was literally dumbfounded when reading the Banking Banana Skins 2012 (published on 31 January 2012), a risk survey of global banking industry that is conducted by the Centre of the Study of Financial Innovation (CSFI) and sponsored by PwC.

The reason was not that the 710 respondents in 58 countries (incl. bankers (69%), observers (28%) and regulators (3%)) found the risk in the financial system to be at a 13-year high (highest since the start of the Banana Skins surveys). The reason was also not that the macro-economic risk ranked number one, and “scored” higher than any other risk in this survey had done ever before.

I was speechless mainly because of this preface to the survey:
“It is all sad, gloomy – and predictable. [...] A few years ago, Basel 3 probably looked like a good idea. Now [...] one wonders whether the core idea that the best way to regulate banks is through tougher capital ratios needs to be fundamentally rethought, i.e. abandoned. [...] At the least, it [the survey] should make us all question some of our most cherished assumptions about how banks are run, what their role in society should be, and how (if at all) they should be regulated.”
[The full text: Banking Banana Skins Survey 2012] Have I understood correctly that now there are serious suggestions to “flush down” Basel III and take (once again) the road of deregulation, and this by a non-profit think-tank? That came as a surprise indeed (not the suggestion as such, but that it was spelled out so soon after the publication of Basel III framework). Plus: fundamentally rethink the way how banks are run... interesting.

I suppose these were the proposed mitigating actions to the following identified top 10 risks in the financial system over the next 2-3 years:
1. Macro-economic risk – the fragility of the world economy;
2. Credit risk – focus on the scale of likely losses and their impact;
3. Liquidity – worries about banks’ funding markets to seize up once again;
4. Capital availability – strong competition on funding; banks not able to provide sufficient returns on capital;
5. Political interference – intrusion by politicians and governments;
6. Regulation – excessive regulations resulting in higher costs, constraints on profitability, reduced capacity to lend etc;
7. Profitability – adverse impacts of higher capital requirements, greater regulatory and compliance costs, higher “stable funding” costs etc;
8. Derivatives – opacity of derivatives; few people really understanding them; true exposures hard to measure;
9. Corporate governance – shortage of adequately qualified people to run organisations of huge complexity;
10. Quality of risk management – risk management systems still lacking the ability to understand “what trouble the human brain can create”.

How to comment?

Apparently, all of these risks are closely interlinked, a la bad macro causes credit losses, credit losses lead to capital strain, capital strain leads to (even more) liquidity problems (that exist anyway because the true value of banks’ assets is far too often uncertain), capital and liquidity problems lead banks to seek help from central banks and governments, this help leads to intrusions by politicians, which in turn means pressures on profitability, which makes attracting more capital a real challenge, which leads banks to (even more) cut back credit, which means even worse macro, etc.

Figure 1 below provides an (incomplete) illustration of the many complex relationships between various risks. I think it’s fair to say, that all the risks taken together are even not measurable, let alone manageable. Indeed, what, for example, is the correlation between the different risks? Well, most probably somewhere close to 100%, because if one risk were to materialise, it would trigger one or another causality chain. That’s why, as a temporary relief, central banks are guaranteeing unlimited liquidity and this way buying time. (Now also the ECB; so, the perceived overall risk level should today be lower than indicated in the survey.) It may be that for a short time, it even happens to restart the credit cycle (i.e. move to the next level of the debt spiral).


So I wonder if the surveyed financial insiders realise that the immediate cause of these risks is too much obscurity and complexity in the financial system, selfish motives and the asymmetric information. (I guess that they do.) I wonder if they understand that the very fundamental problem is the monetary system that by definition creates more debt than it creates money. And if they do, then what are their subjective views on this?

I actually agree with the conclusion of the Banking Banana Skins Survey 2012 that the Basel III and other regulations may not be a good idea, this on the grounds that they add even more complexity into the already way too complex system. Note, however, that I do not keep in mind profitability as many of the survey respondents most probably did. I also do agree that the banking industry is at a crossroads and that something needs to be fundamentally reconsidered here. Yet, we are most probably keeping in mind different things... (I do not mean a simple restart of the credit cycle.) But maybe, just maybe, something has really started to change and that in one day this old cycle of deregulation-innovations-boom-crash-regulation-struggle will be broken.

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