Banking on tougher rules to protect lenders

Banking on tougher rules to protect lenders
PHOTO: Banking on tougher rules to protect lenders

Actions by central banks such as the US Federal Reserve in areas such as interest rates tend to grab financial news headlines across the globe.

Yet, the recent steps they have taken to make banking safer hardly attract any attention at all.

This is ironic. A simple analysis of the causes of the stock market roller-coasters in the past five years would show that most of them were almost certainly triggered by some banking crisis brewing somewhere in the world.

The measures by bank regulators may sound technical and lack the populist appeal of moves such as a cap on bankers' bonuses or a tax on financial transactions. But the measures will have a fundamental impact on how banks work and will hopefully lessen the chance of them failing in the next major financial crisis.

Last week, the US Fed said that US banks would need to obey the new, tougher international Basel III standards, which require lenders to increase their capital to at least 7 per cent equity against their risk-weighted assets over a period of five years.

Put simply, this essentially means that for every $1 which a US bank lends out, it must be backed by seven cents of the lender's own money. That may not sound like much if the lender were to face a sudden cash crunch, but US banks were used to even lower capital requirements before the 2008 global financial crisis.

In contrast, Singapore lenders have had to put up with much tougher capital adequacy ratio arrangements.

OCBC Bank has a total capital adequacy ratio of 18.1 per cent, followed by United Overseas Bank with 18 per cent and DBS Group, whose capital adequacy ratio is 15.5 per cent.

The other big reform taking place is the drive to push derivatives being traded over the counter among banks to trading on exchanges and settling within clearing houses.

It addresses one of the biggest weaknesses exposed by the 2008 financial crisis - the over-the-counter trading of credit default swaps, which led to the near-collapse of US insurance giant AIG.

Put simply, it allows a lender to offload the risks it is taking by lending to a major customer by buying a form of insurance known as a credit default swap (CDS) with a big insurer such as AIG or an investment bank such as Lehman Brothers.

While the cost of the CDS is hefty, it allows the lender to release its capital to do even more lending.

Until 2008, this worked nicely for everyone. The insurer, which sold the CDS, rewarded traders with hefty bonuses while the lender made outsized profits, which it shared with shareholders because it was able to lend out more than what its capital allowed it to.

But the charade started unravelling when Lehman Brothers faced a credit crunch and failed, causing a calamitous run across Wall Street investment banks indulging in similar practices.

So in making such CDS deals more transparent by pushing their clearing through exchanges, banks would need to set aside capital as margins for the trades and cannot reap similarly juicy profits.

Why are the measures necessary? Many people just assume banking is inherently safe.

In fact, it is an extremely risky business as we may understand if we encounter a bank run.

We put our money in a savings account with a bank and reserve the right to withdraw it instantly.

However, the bank must have sufficient cash to meet withdrawal requests each day, even as it puts the money it has collected from savers to work by lending it out on a longer-term basis.

This is, of course, a large part of how banks make profits.

So, the issue each time a banking crisis blows up is really due to the insufficient cushion of cash which a bank keeps by its side to satisfy all the demands imposed upon it.

That, in turn, precipitates a systemic risk: If one bank does not have sufficient cash to pay another bank, which may then find itself short of cash as well, it sets off a chain reaction which may cause a series of lenders to fail.

That is unless the central bank steps in as the banker of last resort to lend to all of them.

One good example would be the jitters in China's money market two weeks ago, when Chinese banks started hoarding cash and refused to lend it to each other for reasons which remain unclear.

It caused the Chinese short-term interest rates to spike and sparked fears of a "Lehman moment" among Chinese lenders before the People's Bank of China belatedly stepped in to inject liquidity.

The fallout was the 5.9 per cent plunge in the Shanghai stock market in the past fortnight before the bourse regained its poise.

For investors in mainland banks, it was a calamity. In the same period, mid-sized China Minsheng Bank plunged by as much as 10.1 per cent, while even mighty ICBC - China's biggest bank by assets - lost up to 7.4 per cent.

engyeow@sph.com.sg


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