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By: Ma. Fernanda Gómez

There is no disaster that can’t become a blessing, and no blessing that can’t become a disaster.

Richard Bach

Our planet has been hit by countless disasters in recent years.  Devastating earthquakes, volcanic eruptions, floods, hurricanes, tsunamis and other events have put humanity to the test.  Most recently, on March 11, 2011, Japan was struck by the most intense earthquake in the last 140 years, 8.9 points on the Richter scale.  A crushing wall of water swept away rice fields, flooded villages, tore homes from their foundations and leveled everything in its wake.  This was no mere accident; it was an unexpected event that practically destroyed the country.  Little more than a year after this tragic event, Japan is barely beginning to recover.

But the fury of nature, despite the human tragedy that it causes, would seem less dangerous than what we ourselves do as a species.  What better example than the recent and persistent debacle in the financial markets?  Volatility and skittishness in the markets have shaken the largest and most prestigious corporations and institutions in the world and have tested Latin American, Asian and European countries at various moments.  Who would have thought that General Motors, the age-old automotive giant and creator of prestigious brands like Buick, Cadillac and Chevrolet, would be on the verge of collapse, or that Lehman Brothers, the fourth-largest investment bank in the United States and with more than 150 years of history, could crumble from one day to the next?  The social, productive, political and economic implications of the markets’ vulnerability have proven a costly burden for society.  What exactly has happened?

What history tells us

Some years ago, financial crises were the result of current-account problems.  What often happened was that a country might have a trade deficit because of an overvaluation of its currency, and over expansion of its economy, or both.  Then the countries would run up debt and have little money to pay the interest; reserves were rapidly exhausted and there were no available loans.  Savings levels were low and inflation rates relatively high.  As a result, a devaluation or recession would improve the situation of national accounts, but this had an inevitable impact on families’ pocketbooks.

More recent crises, like Mexico in 1994-1995, have also affected the private sector and its financial health.  In these cases, borrowers found it impossible to refinance their debt and the financial system verged on collapse.  In Mexico’s case, factors like excess confidence among investors with the signing of the North American Free Trade  Agreement (NAFTA) fueled an excess of credit, an unrestricted inflow and outflow of capital, and a lack of regulation, oversight and transparency, which weakened the financial structure and led to a deep recession, collapse and later bailout of the system.  Interest rates rose, the peso devalued and many families and businesses went broke.  The cost was equivalent to 14% of the country’s gross domestic product.  Many lessons were learned: the banks were sold off to foreign investors, the regulatory framework was strengthened, monitoring was perfected and today we have a banking system that meets international criteria for liquidity, solvency and capital sufficiency.

Mexico’s crisis had little impact on the international financial architecture.  But the Asian crisis, which began with the devaluation of the Thai baht on July 2, 1997, fueled a wave of turbulence that affected eastern Asia and other countries like Argentina, Brazil and Russia.  It also unleashed a chain of devaluations in the region and an unprecedented plunge in the stock markets of various countries.  At the corporate level, the expansion of bank lending to the private sector was excessive.  Much of this debt was in foreign currency, at short terms, and was used for long-term investments in foreign currency, creating a mismatch in both expiration terms and currency denominations.  Vulnerability was also created by the derivative market risk of leveraged positions in high-risk financial assets.  The weakness of the banking system and lack of market discipline encouraged excessive risk-taking.  Weak prudential regulations and dubious accounting practices enable banks to hide their real situation, even though they were on the verge of bankruptcy.

Traditional economic indicators, like economic growth, inflation, trade deficits and reserves, were no longer enough to explain the real situation.  Indicators of financial vulnerability of the nation or a business became more important.  Participants began to insist on developing an appropriate body of regulation with adequate capitalization level and continuous oversight; the Basel Committee on Banking Supervision issued a first guide on Bank corporate governance.

A few years later, history repeated itself with a new financial disaster: the subprime crisis of 2008.  Companies that seem solid collapsed.  The breakup of Lehman Brothers, the acquisition of Bear Stearns by J.P. Morgan, the sale of Merrill Lynch to Bank of America and the bailout of AIG all once again revealed how vulnerable the financial system had become, and chaos was inevitable.

The reasons behind this new crisis involved economic, financial, institutional and regulatory factors.  Among these were the following:

• Current account imbalances in various countries.  Asian and exporting countries had surpluses, while the United States, the United Kingdom and several European countries had a deficit.
• The increasing sophistication of financial instruments, which make them difficult to value and more risky, while low interest rates elsewhere in the market drove investors toward these high-yield instruments.
• An expansion of mortgage credit to families in the United States and the United Kingdom, accompanied by relaxation of credit rating standards and an initial rise in real estate prices.
• An increase in bank leverage and the development of an unregulated parallel banking system (called the “shadow banking system”), with deep positions in securitized mortgage credits and related derivatives.
• A lack of liquidity in the system, as the volume of financial instruments grew more rapidly than economic activity and outstripped the financial system’s capacity to raise enough liquidity from its deposits.
• An incompatibility between executive bonus and incentive systems, risk management, and internal controls.

The result was a weakening and loss of confidence in the financial system, which fell into a profound economic recession from which it has still not entirely recovered.

In 2010, two years after the subprime crisis, a crisis began in the euro zone.  What seemed like a dream has become a nightmare.  The very validity of this monetary union, intended to eliminate exchange-rate crises, promote growth and multiply the economic power of Europe, is now being questioned.  The system worked for two decades, during which time a less productive companies, like Greece, Portugal and Spain, came up to the levels of their more productive peers, like Germany and France.

The purchase of luxury cars and beach houses, construction of airports, highways and hospitals proved to be a fleeting satisfaction.  Today, Greece is bracing to exit the euro zone.  The Spanish government and banks are facing tremendous challenges.  Italy does not know how much longer it can hold on.  Among the biggest difficulties facing the euro zone are:

• High debt levels and budget deficits in some countries of the zone.
• The weakness of the European banking system in an economy heavily dependent on banking.  According to figures from the European Banking Federation, in November 2010, the percentage of bank assets to total financial assets in Europe was 75%, while in the United States it was only 25%.
• Economic recession and high unemployment in some countries of the euro zone.
• Persistent trade balance weakness within the euro zone.
• Differing opinions between Germany, France and the European Central Bank on how to respond crisis.
• The lack of a true fiscal and financial union.

Some factors seem similar to those of other crises and, as on previous occasions, the banking system is involved, despite regulatory changes, complex financial models and studies on corporate governance.  Why?

What makes banking different from other industries

The basic role of banks is to serve as middlemen between  parties offering and demanding funds, and channeling those resources to more productive activities.  This contributes to the growth of the country and the well-being of society (Figure 1).

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Figure 1.  The traditional role of banking

In this process of intermediation, there are two characteristics that define banking operations and make them unique:

1. Qualitative transformation of assets.  The banks, in their traditional function, attract resources from savers at short terms and low risk, and turns them into loans that it extends at long terms and high risk.
2. Brokerage operations.  The bank has the capacity to develop economies of scale, with which it can obtain and analyze information efficiently, and facilitate economic transactions.

Only banks can conduct these activities efficiently.  The model seems clear and simple; but the current situation shows this is not the case.  What has happened?

Regulatory changes, globalization, the advance of technology and appearance of new participants and instruments in the financial markets have all led to a sweeping transformation of the basic functions of banks.  Today, banks act as investment banks by placing instruments, speculating as brokerage firms, and seek to place the greatest number of loans in order to improve their returns.  They have become large, complex financial institutions (LCFI) that are difficult to manage, regulate and monitor.  For example, the five largest banks in the United States are: J.P. Morgan Chase and Company (JPM), Bank of America Corp. (BAC), Citigroup Inc., Wells Fargo and Company (WFC) and Goldman Sachs Group Inc.  These banks had 8.5 trillion dollars in assets at the end of 2011, equivalent to 56% of the US economy, according to the Federal Reserve. Their large-scale international businesses make them more dependent on market stability, so liquidity and market risk are increasingly correlated and risk management becomes even more important.  The system requires strong international cooperation to supervise their activities, and it would seem that regulations have not progressed toward this mandate.

Unlike other companies, what jeopardizes banks are the following characteristics:

1. The qualitative transformation of assetsleads banks to operate with an imbalance between the term of the assets and the term of the liabilities; this is known as a maturity gap.  The former are long-term, illiquid, and high risk; the latter are short term, low risk and highly liquid.  For any other company, this would create liquidity problems and would be unsustainable.In this case, the banks are viable, but their survival depends on their access to an ongoing flow of liquidity through the deposits themselves, short term financing in the interbank market or with the central bank asking as lender of last resort.  If this does not happen, they can face serious liquidity risks.
2. Capital structure.  Banks are highly leveraged financial institutions that can have up to 85% more of debt in their capital structure, while industrial companies generally have only as much as 40% in debt, with a significant portion at short terms.  Banks also do business by placing a large number of long-term loans, which means they assume risk and charge interest in return.  The banks seek to finance these loans or assets as cheaply as possible through deposits.Financial theory predicts that when we increase leverage, risk rises, which means savers and shareholders demand higher yields.  But does this really happen?  Perhaps shareholders in the financial markets do demand higher premiums; but it would seem that the savers who deposit their money to organize their daily transactions do not monitor the process appropriately.  This is in part because there is a safety net (insurance deposit) that makes them less sensitive to banking risk than other investors, and therefore they do not ask for a satisfactory compensation for the risk assumed.  Also, banks can raise cheap funding, which encourages the availability of attractive investment opportunities that might otherwise not appear.
3. Bank balance sheets are more “opaque” then those of non-financial firms.  Bank assets are not clearly observable and it is difficult to determine the quality of a loan or the investments made.  In industrial company, for example a carmaker, a group of individuals can determine the quality of the vehicles, but the same thing does not happen with a loan or deposit.
4. There is a significant interrelation between joint operations in the banking system.  In contrast to non-financial firms, Banks’ competitors can be “commercial partners,” which increases counterparty risk and generates a major systemic risk.  Systemic risk occurs when a trigger event, like the failure of the company, provokes a chain reaction that affects other institutions, the market, and the economy at large.  The banking system is particularly vulnerable to systemic risk, because problems can spread from bank to bank, to the financial system, to the economy and to other countries.  It is also an industry that is closely related to the productive sector.  A weakened banking system cannot finance company growth; in turn, a weak corporate sector hampers the development of the banking industry, as we saw in the Asian crisis.
5. The nature of assets and the risk profile can change rapidly when firms hold portfolios of derivative instruments or securities with options attached.  This is possible because complex derivatives are exposed to risk factors that make them sensitive to market conditions.  Banks may renegotiate loans with those who cannot pay, making the work of rating agencies more difficult.
6. Finally, banking firms are highly regulated and monitored institutions, because they are sources of systemic risk.  The objective of regulations is to avoid problems of moral hazard and adverse selection resulting from the asymmetry of information.  Despite the progress in efforts made, recent events have revealed some major loopholes in both control and supervision.  In response, a new prudential framework has been created for bank capitalization levels, an important part of which is liquidity and operational risk.

What remains to be done

It would seem that crises are increasingly frequent, global and long-lasting; they require difficult and radical decisions to remodel international architecture.  Whether the result of an economic cycle, disequilibrium in the balance of payment or the sophistication of markets, investors and financial systems, the costs are enormous.  If we cannot avoid crises, what can we do to contain them once they arise?

• Banks are part of the system, and their objectives, elements and interdependence should be congruent with the interests of all participants.
• Regulation is one element in the system, but it is not the solution. The regulatory framework should be clear and transparent, but we must also watch out for overregulation or the proliferation of complex and unnecessary rules.
• Economic analysis should be incorporated into Prudential regulation, because the two are closely related.
• Financial models, methodologies and techniques can help us to understand and measure risk, but they are not a crystal ball. Understanding, interpreting and making decisions depends on who makes the decisions, on what criteria, and for what objectives.
• It is impossible, and inordinately expensive, to eliminate all risk, but we must try to keep it at tolerable levels.
• The function of the banking system will continue to evolve. Financial innovation must go on, because this is just as important in the financial system as it is in any other industry.

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Referencess

Kaminsky, Graciela, y Reinhart, Carmen M., “Financial crisis in Asia and Latin America: Then and now”, American Economic Review, vol. 88, mayo de 1998: 444-449.

Musacchio, Aldo, “Mexico’s Financial Crisis of 1994-1995″, Harvard Business School Working Paper, núm. 12-101, mayo de 2012.

Nelson, Rebecca M., Belkin, Paul, et al. “The Eurozone Crisis: Overview and Issues for Congress”, Congressional Research Service, mayo de 2012.

Mulbert, Peter O., “Corporate Governance of Banks after the Financial Crisis – Theory, Evidence, Reforms”, EGCI Working Paper, abril de 2010.

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