Five years after Lehman, five challanges for banking
The banking crisis remains the severest shock experienced by the Kingdom of Belgium in the post-war period. Its origin lies in the collapse of business trust around the world. Despite this, it holds useful lessons for the Belgian financial system.
The first lesson concerns the needed recapitalization of the banks. Two types of investors with asymmetric profiles are present in any bank: shareholders and depositors (i.e. savers). The shareholders bring equity capital to the table. As owners of the business, they seek returns in the form of dividends and capital gains. In exchange for these hoped for rewards, they are the first to suffer any losses. At the same time, shareholders never have to settle the bank's liabilities, i.e. to cover any shortfalls with new capital. This is the basic principle of a joint stock company.
Technically speaking, shareholders bear the risk of initial losses in order to protect depositors. That is why a bank must have sufficient equity capital to shield savers from any significant losses. The equity capital owned by the shareholders serves as a shock absorber. It is a buffer designed to dampen the effects of any impairments to assets. This is one of the reasons why it is imperative that shareholders should fulfill their supervisory duties and why there should be greater transparency in the way banks are managed.
Academic theorists had long feared that prudential requirements for equity capital around the world were generally insufficient to cope with extreme shocks. Without wishing to be ironic, it can be argued that the crisis supplied the right answer to an unexpected question, namely the right calibration of banking equity capital in the event of a planetary wide shock.
This explains why the public authorities were involved in rescuing overstretched banks. As banks play a crucial role in the economy and a bank's shareholders cannot be forced to meet its liabilities, additional equity capital has to be provided by government or by new key shareholders. Government acts as shareholder of last resort since it guarantees the depositors, thereby avoiding any domino effects. The takeover of banks by the public authorities should not be interpreted as an ideological move but as an empirical response to a problem that is technical in nature. When the public authorities finally sell their shareholdings, they will do so in a process negotiated with controlling shareholders from the private sector. The latter will in turn have to shore up the equity capital of these lending institutions. Reinforcing the banks' equity capital will have a dilutive effect on the share ownership and lead inevitably to a wave of consolidations.
In the meantime, an implied contract between the banking sector and the government has been breached. A tacit understanding enabled financial institutions to profit from their oligopolistic position as rent seekers. But in return for the freedom to generate profits, the banks were obliged to manage themselves sufficiently prudently so that they never needed government help.
The implied contract served as the basis for the now questionable "too big to fail" thesis. The argument was that some financial institutions are so important that they cannot be left to collapse. The demise of Lehman Bros illustrated the concept's limitations in the United States, whereas in Belgium the government adhered scrupulously to the terms of the implied contract by rescuing Fortis, KBC and Dexia.
It is consequently unhealthy for a government to stay as a bank's shareholder for long. Doing so puts the authorities in a delicate position, as they have to cover the bank's losses as shareholders and protect the depositors as deposit insurers. If shareholders' equity capital is to serve as a buffer to protect depositors, government can only combine share ownership and deposit insurance temporarily or in exceptional circumstances.
A second lesson concerns the deposit base of the lending institutions. A retail bank is reliant on the stability of its retail customers' accounts. It is therefore important to understand how savings are used and to require certain investment banking activities to be ring fenced and gambles, like those made by the former Dexia, prohibited. Some economists advocate a return to banks which are simpler and closer to the post-war model. That model cannot, however, serve as a benchmark, as the postwar era was characterized by stable currencies and interest rates. That is no longer the case. On the contrary, banks need to diversify their activities adequately to deal with volatility shocks and to spread risk if it is deemed too concentrated. A worst-case scenario would be an overly simplified banking model triggering a banking exodus that would consign the sector to the role of managing private individuals' savings deposits.
A third lesson relates to human resource management. Banking operations have been managed in a more automated and mathematical way in recent years. The banking profession has become less improvised and more statistical. This transition will require confirmed technical and scientific skills. Legal counselors will give way to economists, engineers and statisticians. Financial strategists will increasingly appear on boards of directors.
A fourth lesson relates to the completion of the computerization of banking processes. While this could have been planned in advance, development efforts were delayed and even sidetracked by various factors such as the Millennium Bug and the new compliance, accounting (the switch to IFRS standards) and risk management (Basel I & II) requirements. The pressing need to achieve computerization synergies was additionally masked by the growth in earnings and economic windfall effects. This issue incidentally explains why cross-border banking mergers are so difficult. The crisis will accelerate the simplification of data processing and operating procedures. Major outsourcing decisions will have to be taken, particularly for back-office work. The future development path of Belgian banking needs to be clarified. Most lending institutions will need to continue to put their distribution networks on a multichannel footing (branches, Internet, etc.) and embrace interactive banking via new technology. For the past 15 years some commentators have been predicting that the banking business model would undergo a similar revolution to that of the automobile sector. That change is underway.
Lastly, the real challenge facing the banking sector is not its inherent fragility. Belgian private banks are robust and well capitalized. They have been hit today by the seismic shock of collapsing euro zone interest rates. The shockwave manifests itself in the lowly valuations, which the market assigns to banking stocks on the grounds of their vulnerability to sovereign defaults, debt consolidation moves or runaway interest rates and inflation. The situation is made worse by (almost) no requirement for banks to hold equity capital against their sovereign bond holdings, unlike ordinary loans. This creates a circulatory loop by means of which governments can dilute their own deficits into those of the banks. Great dexterity will be needed to escape from this situation.
It is important to look beyond this analysis and to focus on the organic development of the banking sector. Its future prospects should be the subject of a detailed and wide-ranging debate between the banks, their controlling shareholders and the public authorities to map out how the sector can best contribute in a difficult economic environment. Belgium enjoys a very high savings rate. It would be disastrous if public spending crowded out consumption and investment because the public authorities expropriated domestic savings for their own purposes.
