Ushering in a 'New Financial World' While Avoiding the Excesses of the OldPublished: July 14, 2010 in Knowledge@Wharton
A panel at the recent Wharton Global Alumni Forum in Madrid was titled, "The New Financial World." "So, one might ask, what happened to the old financial world?" was the question posed to Forum participants by Wharton finance professor Richard Marston, who moderated the panel. "I never imagined in my career that we would have two days as dangerous and frightening as those two days [in September 2008] when Lehman Brothers failed and Merrill Lynch disappeared."
If nothing else, the financial crisis has laid bare fundamental weaknesses in the global economy. Confidence in the market as the main mechanism for efficiently allocating resources for economic growth has dropped dramatically, and debate now centers on what new regulations and additional restrictions are needed in the future. Marston asked his panel to discuss the causes of the economic crisis, the ways in which increased market volatility should be managed, and how the world can address credibility issues related to global imbalances.
Ana Patricia Botín, executive chairman of Madrid-based Banesto, noted that "we live in a very unbalanced world going back to the 1980s with globalization trends, with billions of people coming into the labor market, with very low interest rates and with a set of countries promising too much and a set of countries consuming too much." Latin American countries have been running "big trade surpluses, while the U.S. consumer is running the growth in the world and is very much in debt, with help from other countries."
At the end of the day, said Botín -- who also worked at Banco Santander beginning in 1988, directing the bank's international expansion in the 1990s with responsibility for the Latin American, corporate banking, asset management and treasury areas -- "the sources of the crisis cannot just be indentified with finance. The banks are not 100% to blame, and thus the way out is not 100% in the hands of banks."
As for lessons to be learned, Botín cited the importance of countercyclical measures and liquidity, the risks caused by non-intrusive supervision, and the limitations of local regulators. "We need supervisors who are on top of the situation and see [trends/events] as they happen. Supervisors seem to better understand regular banks, like us, rather than investment banks." In addition, the industry has relied on local regulators and local supervisors "with zero coordination on the global level." And finally, "we did not have in place mechanisms that allowed big banks to fail in an orderly way. There is no way to avoid systemic risk without" the ability to intervene when necessary. "The rules were mostly there, but everybody seemed not to ask the tough questions -- not the regulators, the equity investors, the ratings agencies or even some of the risk committees of the banks themselves."
Botín made several suggestions for how to move forward -- such as setting up "a new institutional design in Europe" that would include better measurement of risk, better liquidity management and more attention to countercyclical policies as well as better coordination among supervisors at the world level. She also noted proposals on the table which "are not helpful.... One is to focus on the size of banks. Being big is not necessarily bad. Banks that created the problems were those that were too risky, too leveraged, too badly managed, or running risks that were not being measured." Other "not-helpful" proposals are those that advocate levies on banks, and those that focus on bank compensation rather than on the roots of the financial crisis, she stated.
Panelist Ángel Cano Fernández, CEO of BBVA in Madrid, noted that the most recent stage of the financial crisis began in March when Greece's high debt levels became apparent; the situation was further aggravated by the lack of credibility surrounding official statistics. "This caused a lack of confidence that has spread to other European countries and has been made worse by growing concern about growth capacity within the eurozone and about the wisdom of a single currency." As a result, he said, "the EU is starting to be perceived as a set of fragmented parts rather than as a whole."
Although Fernández thinks that banks are better able to handle the situation than they were when Lehman Brothers went bankrupt, "the situation is far from stabilized. Better coordination measures are needed to assure convergence of fiscal policies among European countries ... and state aid programs should include tough conditions." The financial system of the future "must have high capital requirements but more liquidity and greater customer protection. If we don't think globally, we will make the same mistakes as in the past."
Panelist Corrado Passera, managing director and CEO of Intesa Sanpaolo in Milan, offered his view of the main causes of the financial crisis, including excessive leverage and lack of transparency in the derivatives market. As for how to fix the situation going forward, he noted that his remarks could have been titled, "Rules, Please." People think banks don't want rules, he said, "but they do; they just want the right rules. When crisis happens, sometimes people go all the way in one direction and forget that the economy and society have complex sets of needs." In addition, he noted, "we should not forget that sustained economic growth is priority number one, and new employment is the objective" toward which everyone is working.
He also cautioned against making the banking industry "so safe that it becomes so unprofitable and unattractive that it simply disappears." Any rules that are enacted should keep the banking industry, "or at least the good part of it," attractive to investors.
Passera's three priorities for moving forward include first, focusing on limits to total leverage. "In the end, the enormous explosion of indebtedness during the last few years has been at the very root of the crisis, both net leverage and gross leverage. We need to account not just for on-balance sheet liabilities but off-balance sheet liabilities ... all the components of real indebtedness." Second, the new rules must make sure that liquidity management is under control. "You don't go bankrupt because of lack of equity, but because you get in trouble with your liquidity. If you raise money short-term but lend money long-term, sooner or later you simply blow up." Third, "we need to put derivatives under control by moving towards standardization and in the direction of having these instruments only on regulated exchanges."
Basel III is addressing these points, he said, referring to new banking regulations under consideration by the Basel Committee on Banking Supervision, the international banking watchdog. But Basel III, in Passera's view, risks coming up with regulations that are so stringent that they "create a credit crunch that we have so far avoided. We have to make sure that the new limits, the new features of the regulatory framework, are not excessive and are introduced gradually."
Passera also advised regulators to keep in mind that "real economy banks, commercial banks, are very different from trading houses. The one-size-fits-all approach does not work.... I am not suggesting that we break down big banks, but that the two separate activities should be managed, regulated and supervised differently." In addition, the rules have to be applied consistently throughout the world, and they must be reasonably simple, few and understandable. "Today, one of the problems we are suffering from is technicalities that make the language of regulators, politicians, bankers and consumers so different that discussion and cooperation become very difficult."
Panelist Carlos Trascasa, a director at McKinsey in Madrid who co-leads the financial service practice in Europe, addressed the situation in Spain in particular, describing the Spanish banking system as "one of the healthiest I have seen.... The central bank of Spain has a good grasp of the situation after overcoming some political pushback at the beginning of the process; I think a few years down the road we will be enjoying double digit arrows." His view of the Spanish economy overall was also optimistic. "Our level of debt to GDP is lower than [that of many other countries]. It's true that if you were to forecast the deficit for the next 10 years, the numbers don't look that good.... But we have a cap on the growth of the public deficit." Trascasa suggested that this will imply a lower GDP growth during the next two to three years, "but we still expect Spain to grow over the European average five years down the road."
In response to a question from Marston as to whether governments should force banks to lend, Botín noted that while most banks want to lend, the real issue is the need to reduce the level of debt. "Some companies have excess capacity while others may be too weak to borrow. The combination of those two factors means a lower level of solvent credit demand. That is the root of the problem."
Marston posed the question a different way: Right now, he said, the U.S. banking system has enormous liquidity. The Fed has more than doubled the size of its balance sheet and most of that is sitting as cash balances in commercial banks in the U.S. "If you were the Fed, how would you encourage the banks to use some of that cash to fuel the economy?" Botín's response: "I know what I would tell them not to do. If banks have an uncertain level of capital, it's logical they will be extra prudent. At the end of the day, we have to see the economy recovering and we have to see de-leveraging. Unfortunately, some customers are asking to be refinanced who perhaps do not merit it."
The problem, added Passera, "is you cannot push growth only through credit. You can contribute to it, but if there is not enough real growth, there is no lending.... We all have to push together in the direction of economic growth." He also made a distinction between short-term liquidity and "the relatively difficult market of medium- and long-term liquidity. Long-term money is still very expensive."
Marston raised the question of credit rating agency reform. Leading up to the financial crisis, credit rating agencies, such as Moody's, Fitch and Standard & Poor's, gave triple-A ratings to a broad spectrum of subprime mortgage securities -- implying that they were nearly risk-free when, as it soon became clear, they were not. The U.S. government and Congress have been looking at rating agency reform in an attempt to eliminate conflicts of interest, to set requirements as to how much information ratings agencies should be required to disclose, and to determine whether the agencies should be held liable for their ratings, among other issues. "One U.S. senator has suggested that the assignment of ratings be random, so that you remove the ability of companies" to shop around for the rating agency that tends to give the highest ratings, Marston noted. "But is this enough? If you have a complex new security, and banks say there is very little risk, you are asking a lot of the ratings agencies to tell [investment banks] that they are wrong, that there is really a lot more risk. So I'm not sure the randomization solution is enough."
There are "tremendous incentives in banking to be very smart," Marston added. "Whatever regulatory set-up you establish, [bankers] will figure out a way around it. That always happens.... We need regulators who can understand banking well enough to make sure that the really extreme behavior is avoided in the future."