With this month marking the one-year anniversary of the collapse of American bank Lehman Brothers – the biggest bankruptcy in U.S. history – debate continues to rage around the world about what must be done to avoid repeating the events that brought the financial-services sector – not to mention the global economy — to the brink of collapse.
It was timely then that regulators, bankers and academics gathered in Shanghai to weigh in on the debate at the third annual China Bankers Forum on September 5. Jointly organized by the China Europe International Business School (CEIBS) and the finance magazine CAIJING, speakers included current and former officials from China’s central bank — the People’s Bank of China — as well as banking executives, financial-market observers and academics. While questions remain, the consensus among the participants was clear: regulatory oversight and governance need a major overhaul. As one speaker put it: “It’s very clear that you need a healthy banking system in order to have a healthy economy.”
In dissecting the massive challenge that lies ahead, the forum’s participants covered five broad themes:
The first step, asserted Shen Liantao, a banking veteran and chief adviser at the China Banking Regulatory Committee (CBRC), requires looking at today’s outdated regulatory frameworks from a new perspective. Shen did that by borrowing a term more often associated with the Internet – Metcalfe’s Law. Ever since the rapid rise of the Web, technology experts have used Metcalfe’s Law to explain how the cross-connections of an IT network grow as the number of computers and users increases. According to Shen, a similar cross-connection has prevailed in global banking since its rapid growth over the past 10 years or so. “Today’s finance industry is a network,” he said, noting that the current crisis is proof of how banking has become “interactive, complicated and interconnected.”
For better or for worse, the financial market has now become an interconnected network comprising banks, insurance companies, fund management firms and the like, said Shen. Nowhere is this more evident than in the use of derivatives, which played a major role in amalgamating all these segments while also rapidly becoming the source of unmanageable risk throughout the entire system.
“The nature of the crisis clearly calls for a fundamental change in the way we think about this network and its features,” he said.
In an ideal world, Shen added that regulation and oversight should be multidimensional, involving management across countries, currencies, regions, products, industries, client groups and counterparties. But while the market for financial services is global, banking’s management structure isn’t. Therein lies the challenge.
In a similar vein, John McCormick, chairman of Royal Bank of Scotland Group in Asia Pacific, noted: “Every aspect of our financial industry is intrinsically interconnected.” As such, changes have to happen “in a coordinated package.” In other words, he explained, banking reforms need to go hand in hand with reforms in other parts of the industry, such as hedge funds. “You can’t focus too narrowly on banks without addressing all the supporting infrastructure, such as credit rating institutions.” Equally, no country or institution can make reforms in isolation.
Despite the urgency, however, it will take time before we see light at the end of the tunnel. “My view is we should anticipate a global reform program that may well go on for at least another seven to 10 years,” he said.
A New Risk Era
Amid all the new-fangled and sophisticated financial tools, “one thing that has not developed is market discipline,” noted Frank Newman, chairman of the board and CEO of Shenzhen Development Bank, the first local bank to have hired a western CEO. “And we have evidence that the market is not wise at all, so we need regulators.”
Financial institutions also need better risk management. Part of the reason is the sheer complexity of many of the products and services that banks now offer. Consider derivatives. The global derivatives market today is worth $596 trillion, 12 times that of the global GDP, and it accounts for more than half of the entire finance industry, according to Shen. But, he says, it has become “so complicated that no one really understands it.”
It’s not just derivatives, of course. There are many different kinds of risk, noted Newman, including credit, operational, legal, regulatory and reputational, all of which interact with each other. “In an organization like a bank, how do you manage them?,” asked Newman. In one sense, risk management “is an integral part of everything we do. Managing risk is part of your job, part of the things you do everyday,” he said. “At the same time, you need [dedicated risk management specialists] because things can become so complex.”
Like other forum participants, Newman believes a key will be in raising the profile of risk managers within financial institutions. Their skills, too, will have to change to reflect this elevated role, encompassing much more than top-notch risk modeling techniques. But those skills alone won’t suffice. Risk managers also need to be an independent voice. “It has been an issue for a number of banks around the world,” he said. “If you don’t have enough independence for specialists, and when people don’t have enough political clout within the bank, things will run them over. There has to be some tension and I will provide balance to that tension.”
Newman called for less dependence on formulas and more on principles. Because banking has become so complex, over-dependence on formulas “presents a risk of missing what’s really going on … Rules can be contradictory as they are set up in different circumstances.” The transition to a principles-based perspective is already starting to happen. “In China, it seems to me that things are changing from less of a focus on rules and formulas, to more of a focus on … principles,” he said. “That’s the evolution that I think is really interesting.”
Pay on Display
The financial crisis has not been bad for everyone. In 1999, executive remuneration at the top ten banks in the U.S. was $31 billion. By 2008, it had more than doubled to $75 billion, noted Shen. In contrast, that same year, shareholders of these banks received $17.5 billion of dividends. In other words, management earned more than four times more their shareholders. Yet it was shareholders who had to inject capital into the failing institutions. In such a scenario, who came out on top?, he asked.
It’s no surprise that banks’ executive remuneration is on political agendas around the world, and will be a hot topic at the upcoming G20 Summit later this month.
And it’s not just the size of the pay packages that warrant attention, but also how and whether they are adequately linked to individual and corporate performance. As Phil Rivett, global financial services assurance leader of PricewaterhouseCoopers, puts it, remuneration systems are too focused on the short term.
The issues are as numerous as they are contentious: bonus accruals that don’t take into account shareholder value, reliance on non-risk-adjusted metrics such as earnings per share, conflicts of interest, the imbalance of financial and non-financial performance measures, bonuses paid primarily in cash, and infrequent linking use of deferred bonuses, to name a few. According to Rivett, remuneration systems should be better aligned with a bank’s risk appetite and strategy, while the role of remuneration committees also needs reassessing.
So how can the financial-services sector regain public confidence? “By continuing to seek ways to improve corporate governance standards and practices is the obvious answer,” replied Vincent Cheng, chairman of HSBC Asia Pacific. Comparing a robust corporate governance structure to a well-constructed building, he said, “both require a solid foundation,” and the best corporate governance foundation “emphasizes personal integrity and is based on long-standing values.” Both a building and governance also require regular maintenance, he added.
The current crisis, he predicted, will result in a “reshaping” of the financial industry, with a focus on “a long-term, sustainable and ethical approach to the business of banking. Corporate governance will once again be on the top of many agendas.”
And have the sector learned enough to assure the public that it will avoid another crisis? As Gerard Lyons, chief economist and group head of global research of Standard Chartered Bank, said, “there were countless concerns that markets were not pricing for risk. To quote a federal governor, who spoke at a conference I was at two years ago, ‘People heard but did not listen.’ This is a critical lesson. And it explains much of what went wrong.”
There was widespread agreement at the forum that for many of the reforms to take hold, the global economy needs to change accordingly.
To put one part of the debate into context, Guo Shuqing, chairman of China Construction Bank, the third largest bank in the world by market value, observed: “There is no doubt that the U.S. is still by far the strongest and most competitive economy in the world. Nonetheless, the economic and social structures of the U.S. are very unique, and very strange as both high-efficiency and low-efficiency coexist.” The way he sees it, “a free and competitive market and American idealism have integrated very well in the U.S.,” he said. “Second, it is implied that the American dream, symbolized by owning one’s own home and car, can be attained through hard work. This is an ideology, a social value and is representative of the government’s values as well.”
That means addressing imbalances. A case in point: corporate and household debt, said Zhu Min, executive vice president of the Bank of China Group, the second largest bank in the world by market value. According to figures referred to during the forum, total debt in the U.S. has grown from US$2.1 trillion in 1974 to US$52.5 trillion in 2008. The financial sector is the biggest debtor, accounting for about 32.5% of the total, with households at 26.3% and the commercial sector at 21.2%.
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