The new regulators:
Banking's seven sins

The recent deadly banking crisis was triggered by a long sequence of events, each adding a little stress to the system until a collapse became inevitable. Keith Ruxton and Vince Slaven of Kinetik Training highlight the seven deadliest links in this destructive chain.

1. Leverage

Traditional lending requires that long-term loans be backed by retail deposits. During the heady days of the pre-crisis banking world, the drive to increase lending tempted banks to fund themselves with short-term debt. Leverage has always been a key focus for regulators via the minimum capital ratio. In the angelic new BIS III rules, the minimum common equity ratio is set to increase from 2 per cent to 7 per cent making banks safer but reducing their RoE.

2. Liquidity

The first rule of business – don’t run out of cash. On the day Lehman Brothers went bust, their regulatory ratios were fine but they just didn’t have any money! In BIS II, perhaps due to the fact that liquidity risk cannot be solved through capital alone, there were no specific liquidity metrics. In BIS III there are two. The liquidity coverage ratio will force banks to hold more liquid, low-yielding assets which will provide a buffer against liquidity risk but will, once again, reduce profitability.

3. Credit skills

There’s something sinful when a $16k per year strawberry picker can raise a sub-prime mortgage to buy a $720k house. Such absurd lending was made possible by highly complex securitization products, which were so complex that no-one truly understood their risk. While the regulators have increased the risk weights for these specific products one can only hope that banks will in future follow Einstein’s angelic advice: “Make everything as simple as possible, but no simpler.”

4. Risk management

Quantitative models enabled the creation of deadly securitizations. With such models merrily informing us that the crisis was an impossible event they were not just useless – they were dangerous. Going forward, expect regulators and banks to make greater use of stress tests and rely less on incomprehensible statistics. Simplicity is the path to righteousness.

5. Culture

Most banks have strongly hierarchical structures, in which employees feel constrained in legitimately challenging their seniors All banks should ask themselves the litmus question: “Who are we doing this for?” There is only one correct answer: the customer. There is a huge opportunity to restore reputation by always asking this question when considering customer service. Not lip service. Customer service. Real customer service.

6. Globalisation

The financial crisis has increased the clamour for banks to be broken up. But the evidence from the global crisis actually showed that integrated banks weathered the storm best of all. Consolidation helped.

This also agrees with the findings from The Great Depression. The bank failure rate for national, integrated banks was just over a quarter that of all national banks.

With increasing globalisation of economies, integration makes sense and better prepares banks to do business in the 21st century.

7. You

Finally we come to a key player, indeed a major sinner in the financial crisis. You! Yes, you, dear reader! And everyone else who interacts with the banks and the economy.

Just as the banks need to return to sound, prudent banking, so we as individuals need to play our part and resist taking on credit we can’t service. To this end, the banks and the Institute, through the Financial Education Partnership, are doing sterling work in educating schoolchildren in financial prudence and this should be encouraged and indeed applauded.

The recent crisis has put the spotlight on banking as never before. Salvation lies in ensuring that banks return to the principles of prudence and keen risk management and that share performance is enhanced by concentrating on truly putting the customer first. Amen.

Back to Special Report contents
Back to Magazine contents