Banks must reassess their role
Thursday, 6 December 2007
Peter Thal LarsenIN recent years, senior bankers have grown fond of using a simple metaphor to sum up the changes taking place in the global financial landscape. Banks, they proclaimed, used to be in the storage industry. But in recent years they have shifted into the moving business. The credit squeeze has raised the prospect that this trend may be reversed, with potentially far-reaching implications for the broader economy.
The moving-storage analogy may be imperfect, but it highlights a broader truth about the shift in banks' business models. Until relatively recently, banks took deposits and extended loans, and made most of their money from the difference in interest rates between the two. But over the course of the past few decades, this began to change. Bankers realised that they could parcel up loans and sell them on to other banks or investors. This would allow them to pocket a fee for arranging the loan, while passing on some - or all - of the risk to others.
During the recent credit boom, this approach became widely accepted as the new orthodoxy. Banks rushed headlong into loan syndication and securitisation. The changes also cleared the way for aggressive new entrants, who started extending credit to companies and individuals who had never been able to borrow on such a scale before. New investors, including hedge funds, queued up to buy the loans, which promised a superior return to more conventional securities. Regulators praised the system for dispersing risks more widely throughout the financial system.
But the innovations also had a profound effect on the economy. Previously, the amount of credit that could be created was effectively limited by the amount of capital on banks' balance sheets. By passing on risks to investors, this constraint was eased, effectively allowing the capital in the banking system to finance much more lending than before. "The supply of credit has effectively become infinite," one experienced banker told me earlier this year.
The correction that began this summer, however, has prompted some bankers to reassess their views. "Previously we had the idea of moving towards a model of origination and distribution," Alessandro Profumo, chief executive of Unicredit, one of Europe's largest banks, told the Financial Times late last month. "This model is not there any more."
This reassessment has been prompted by several factors. First, it has become clear that banks were still ultimately responsible for some risks that they thought they had passed on. This is most starkly illustrated by conduits and structured investment vehicles. These off-balance sheet financing techniques were used to shift hundreds of billions of dollars of assets off banks' balance sheets. What was less clear was that the banks had made large financing commitments to these vehicles. When the market for asset-backed commercial paper dried up this summer, the banks were suddenly on the hook, and the assets came flooding back onto their balance sheets. This pattern has been repeated across the banking system this summer. It helps explain why some investment banks have been forced to write off billions of dollars of exposure to collateralised debt obligations that nobody knew they owned. And it also underscores why even large banks have been reluctant to lend to each other since the crisis hit. They are too busy trying to preserve capital.
The long-term effects of the credit squeeze remain unclear. Yet the shock of the past few months has sparked an intense debate among bankers, politicians and regulators about the future direction of the industry. Some bankers believe that we are seeing little more than a painful correction that will not disrupt the longer-term trends in the industry. Others, however, are beginning to rethink their whole approach, arguing that banks will in future have to keep more of the risks they underwrite.
It will be several years before the debate is resolved. The answer depends partly on how regulators and governments respond, and what reforms are made to the system of credit ratings.
Nevertheless, it is clear we are entering a more cautious period. Banks will probably need more capital - if not to finance their current, expanded obligations, then to allow them to make new loans. Whole classes of investors who were previously willing buyers of risk have withdrawn from the market, and may never return. Credit has once again become a scarce resource. This is bound to have an impact.
In the first few months of the credit squeeze, many observers remarked on how this was a purely financial crisis. Corporations that had resisted the temptation to leverage up their balance sheets were still able to borrow at largely similar rates to before. Industries such as the commodities sector continue to boom. Large pools of foreign exchange reserves in Asia and the Middle East suggested that there was still plenty of liquidity in the system.
But this disconnect cannot last. For the past five years, banks have been at the centre of a mechanism that has multiplied the amount of credit in the economy by a much greater factor than before. This effect has now gone into reverse, at least temporarily. The extent of the adjustment depends largely on how the banking system adapts to the new reality. What is clear, however, is that bankers are in future likely to spend less time talking about the relative merits of the moving industry and the storage business. It may be time for someone to come up with a new metaphor.
................................
Under syndication
arrangement with FE
The moving-storage analogy may be imperfect, but it highlights a broader truth about the shift in banks' business models. Until relatively recently, banks took deposits and extended loans, and made most of their money from the difference in interest rates between the two. But over the course of the past few decades, this began to change. Bankers realised that they could parcel up loans and sell them on to other banks or investors. This would allow them to pocket a fee for arranging the loan, while passing on some - or all - of the risk to others.
During the recent credit boom, this approach became widely accepted as the new orthodoxy. Banks rushed headlong into loan syndication and securitisation. The changes also cleared the way for aggressive new entrants, who started extending credit to companies and individuals who had never been able to borrow on such a scale before. New investors, including hedge funds, queued up to buy the loans, which promised a superior return to more conventional securities. Regulators praised the system for dispersing risks more widely throughout the financial system.
But the innovations also had a profound effect on the economy. Previously, the amount of credit that could be created was effectively limited by the amount of capital on banks' balance sheets. By passing on risks to investors, this constraint was eased, effectively allowing the capital in the banking system to finance much more lending than before. "The supply of credit has effectively become infinite," one experienced banker told me earlier this year.
The correction that began this summer, however, has prompted some bankers to reassess their views. "Previously we had the idea of moving towards a model of origination and distribution," Alessandro Profumo, chief executive of Unicredit, one of Europe's largest banks, told the Financial Times late last month. "This model is not there any more."
This reassessment has been prompted by several factors. First, it has become clear that banks were still ultimately responsible for some risks that they thought they had passed on. This is most starkly illustrated by conduits and structured investment vehicles. These off-balance sheet financing techniques were used to shift hundreds of billions of dollars of assets off banks' balance sheets. What was less clear was that the banks had made large financing commitments to these vehicles. When the market for asset-backed commercial paper dried up this summer, the banks were suddenly on the hook, and the assets came flooding back onto their balance sheets. This pattern has been repeated across the banking system this summer. It helps explain why some investment banks have been forced to write off billions of dollars of exposure to collateralised debt obligations that nobody knew they owned. And it also underscores why even large banks have been reluctant to lend to each other since the crisis hit. They are too busy trying to preserve capital.
The long-term effects of the credit squeeze remain unclear. Yet the shock of the past few months has sparked an intense debate among bankers, politicians and regulators about the future direction of the industry. Some bankers believe that we are seeing little more than a painful correction that will not disrupt the longer-term trends in the industry. Others, however, are beginning to rethink their whole approach, arguing that banks will in future have to keep more of the risks they underwrite.
It will be several years before the debate is resolved. The answer depends partly on how regulators and governments respond, and what reforms are made to the system of credit ratings.
Nevertheless, it is clear we are entering a more cautious period. Banks will probably need more capital - if not to finance their current, expanded obligations, then to allow them to make new loans. Whole classes of investors who were previously willing buyers of risk have withdrawn from the market, and may never return. Credit has once again become a scarce resource. This is bound to have an impact.
In the first few months of the credit squeeze, many observers remarked on how this was a purely financial crisis. Corporations that had resisted the temptation to leverage up their balance sheets were still able to borrow at largely similar rates to before. Industries such as the commodities sector continue to boom. Large pools of foreign exchange reserves in Asia and the Middle East suggested that there was still plenty of liquidity in the system.
But this disconnect cannot last. For the past five years, banks have been at the centre of a mechanism that has multiplied the amount of credit in the economy by a much greater factor than before. This effect has now gone into reverse, at least temporarily. The extent of the adjustment depends largely on how the banking system adapts to the new reality. What is clear, however, is that bankers are in future likely to spend less time talking about the relative merits of the moving industry and the storage business. It may be time for someone to come up with a new metaphor.
................................
Under syndication
arrangement with FE