METAMORFOSIS

The Credit Crisis that has hit the world has impacted the world’s financial institutions. The lack of liquidity and trust in financial institutions is just starting to trickle down and impact “main streets” in countries around the world. Governments around the world have decided to start nationalizing banks and to insure a wider range of their transactions to restore trust amongst banks.

The world of global banking is complex, with many different partners, each playing its own role in keeping the local, national, and global economy running smoothly. There is no one set of rules governing global banking, but a patchwork of national and sometimes regional regulations. Despite the lack of an international body in charge of oversight, many state banks are working together to coordinate their responses to the credit crisis.

This analysis will examine the roles and function of different types of banking, discuss some of the challenges facing the global banking system, and highlight existing regulations that govern global banking.

Types of Banks
Commercial Banks
There are many different types of types of banks, including, commercial banks, retail banks, community banks, saving banks, offshore banks, Islamic banks, development banks, private banks, and others. However, many banks have multiple divisions offering services in multiple sectors.

Commercial banking takes place in the home country, in the greater region, and around the world. The structure of international banks includes: a headquarters and branches in the home country (collectively known as the parent bank) and subsidiaries (with their own legal entity) in their home countries and it other countries.¹

Commercial banks make money from fees associated with different types of accounts and services, buying and selling corporate and government bonds, selling their loans (car loans, mortgages, student loans, etc) and the associated insurance (credit swaps) to other financial institutions, and by investing in debt securities. The leveraged debt ratio for commercial banks varies by country and by institution, but, in general, the rates are much lower for commercial banks than investment banks

Investment Banks
Traditionally the difference between investment banks and commercial banks was that investment banks used to be limited to “capital market” activities, such as investments and insurance services, while commercial banks, which accepted deposits and gave loans, were housed in separate institutions. However in 1999, the Gramm-Leach-Bliley Act was passed in the U.S., allowing banks to have investment divisions and commercial divisions.²

Investment banks offer strategic advice on mergers and acquisitions, divestitures, and other financial services, including trading in derivatives, fixed income foreign exchange, commodity and equity services.

Many investment banks offer “buy” and “sell” side services. “Sell” services include trading securities for cash or securities and under-writing investments. “Buy” services include dealing with mutual funds, pension funds, and hedge funds.

The last top-tier US-based, investment banks, Goldman Sachs and Morgan Stanley decided to change over to bank holding companies, which will allow them to create commercial bank subsidiaries.

Government Banks and Quasi-governmental banks
Most countries have a central banking system. Most central banks are fully independent; they set their own policy goals (although some do so in concert with government departments/ministries), determine the best way to carry out their goals, and run their own operations without too much government interference. Some central banks have private members, such as the U.S. Federal Reserve system.

The roles of a central bank include:

• preventing banking panics and maintain the stability of the banking sector;
• supervising the bank industry, such as regulating bank holding companies and protecting credit rights of consumers;
• managing the nation’s money supply by issuing and distributing its currency;
• developing the country’s monetary policy by addressing topics such as interest rates and subsidized loans;
• providing financial services to the government and foreign official institutions, such as maintaining the country’s payment system and buying and selling government bonds and treasury notes; and,
• acting as a lender of “last resort” to banks and financial institutions.

Bank for International Settlements
Central banks turn to the Bank for International Settlements, an international organization, to serve as their central bank. The BIS provides a forum for discussion amongst central banks and policy analysts, provides economic and monetary research, serves as counterparty for central bank transactions, and serves as an agent or trustee in international financial operations.³ BIS deals with international banking regulations, through the development of the Basil Concordat and Basil II, discussed below.

Banking Cycles
A 2008 McKinsey Quarterly report describes the natural ebbs and flows that exist in global banking. 2006 saw historic highs for global, after-tax profits for banking reaching $788 billion, up from $372 billion in 2000. The profits for U.S. Banks in 2006 were larger than the combined profits of retailing, pharmaceutical, and automotive industries. Both this level of growth and prosperity is unsustainable.

Similar “busts” took place on “Black Monday” in 1987, and the “Dot-Com” bust of 2001. Despite these past busts, the fundamentals of global banking remained strong. In this report, McKinsey predicted that banking profits and revenues would double by 2016.⁴

Nonetheless the current crisis is deeper and even more challenging than all recent crises, and many banking fundamentals may change because of it. The nationalization of banks, while considered necessary, is a fundamental change to the system of privatization, supported by most international monetary institutions.

General Challenges Facing Global Banking
There are many challenges facing the banking industry, the most imminent is the current credit crisis, but other issues such as unregulated hedge funds and money laundering are also of concern.

Credit Crisis
The credit crisis affecting banks around the world can be traced to the subprime mortgage crisis (link the G101 article). Banks have these toxic loans and have sold these toxic loans to other financial institutions, hence the crisis is not just hitting banks, but any company who buys and sells derivatives of these toxic loans. Since no one knows the values of these loans and how many more homes will foreclose, banks are wary of lending money to companies, consumers and to each-other, which can be described as a crisis in liquidity.

An additional element of this crisis is tied to credit default swaps, in which insurance policies for loans are sold, aggregated, and resold. The trillion-dollar credit default swap crisis-in-the-making, has yet to be addressed.

In response to this crisis, G-8 countries have pledged to inject capital into the top tier banks in their countries, thus allowing them to start making loans and address the liquidity aspect of this crisis.

Hedge funds
There are about 900 hedge funds worldwide, which are managing $1.2 trillion dollars in investments. These funds trade in secondary debt, which they buy from banks and corporations. Acting as middlemen, they repackage the debt into new securities and sell them. Hedge funds are also originating loans as well, which can lead to conflict of interest. Many hedge funds have extremely high leveraged debt ratios; they are not regulated and take higher risks than banks and other financial institutions.⁵

When markets are down and hedge funds have extremely high leveraged debt ratios, such as 30:1, then when they are not able to make back the processes, they are forced to close.

As credit is drying up, many small businesses are turning to hedge funds, rather than banks, for their loans. This furthers the downward cycles facing banks who are worried about lending. Major concerns for hedge funds are investor protection and systemic risk.
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Money-laundering
Money –laundering is a huge challenge faced by many banks around the world. About $500 million to $1 trillion dollars is laundered every year; it is estimated that half of that money comes from the U.S. This number is larger than the banking needs of nearly every legitimate industry. Laundering is often done through private banking and correspondent banking; most major banks have been accused of laundering during the past decade.⁶

Heavy fines are levied against banks found guilty of laundering money. There is no set of global anti-money laundering (AML) regulations, each country has its own rules and regulations; thus compliance is difficult given the worldwide range of AML regulations.

Some compliance laws address due diligence (US), while others focus on maintaining information on clients and their transactions and then submitting this information to auditors and other oversight mechanisms. Other AML regulations focus on the role of the front office in battling laundering, since they tend to know their clients better. In the U.S., the Federal Financial Institutions Examiners Council (FFIEC) provides a set of guidelines to address client interactions.

Other tactics include the use of AML software to monitor accounts. Expenses for AML software is expected to reach $375 million, by 2009.⁷

Patchwork of Regulations
National regulations often cover bankruptcy laws, anti-discrimination rules, disclosure rules, required reserve levels, consumer protections for electronic fund transfers, rules concerning giving credit to insiders, notification requirements on privacy issues, rules on interest on deposits, rules concerning credit extensions and restrictions to brokers and dealers, fair credit reporting requirements, bank acquisition policies, rules on non-banking activities, consumer complaint procedures, fund withdrawal availability, and others.⁸ National deposit insurance programs also vary from country to country, although these programs are often bypassed during a government bail-out program.⁹

In an effort to harmonize banking regulations across the globe, the BIS passed the Basel Concordat of 1975, which addressed regulations of internationally-based banks by the host country. It focuses on the system of communications and coordination amongst national regulators. It was substantially revised in 1983 to include the concept of consolidated supervision and supplemented in 1990 to include recommendations on supervisory collaboration, amongst other measures.¹⁰

In 2004, after the Asian financial crisis, regulators passed Basil II Principles to further harmonize different country’s banking regulations and to devise a set of common rules.¹¹ Basil II was only put into action within the last year and is not expected to be phased in the U.S. until 2009. Basil II will require banks to match the size of the capital cushion based on the riskiness of their loans and securities. Basil II puts a larger burden on bank shareholders, who will have to absorb losses before the depositors or taxpayers are burdened. The riskier the loan, the larger the buffer required by shareholders.¹²

There are a number of weaknesses with Basil II. Some believe Basil II contributed to the current crisis, since banks found ways around the system by taking risky loans off their books through securitizing and selling them, thus decreasing the buffer amount. The lack of transparency of banks makes it very difficult to fix the credit crisis, since it is hard to estimate the depth of the problem associated with mortgage crisis.¹³

Under Basil II, banks have misjudged risk, therefore further miscalculated the needed capital cushion. Basil II also relies on current market prices for assessing risk vs. using historical data. Overseers of Basil II state that instead banks can estimate average risk based on historical data. This contraction of interpretation must make it difficult to carry-out.¹⁴

Some banks view Basil II as problematic because it may lead to less lending overall, causing a downward spiral in economy. In a downturn, there may be few shareholders willing to invest, thus the banks fail or are merged with stronger institutions. Supporters believe Basil II is an important step to increasing financial oversight, insuring trust in institutions, and decreasing the need for a taxpayer bailout.¹⁵

Looking Forward
In response the financial crisis, bank nationalization is taking place around the world. As a first step to recovery, the G-8 countries and additional European countries have provided large amounts of extra capital to banks to guarantee new loans. Soon discussions will address the issues of toxic loans and other financial institutions. These measures are widely touted as necessary and as the right step to move forward.

Yet other factors loom on the horizon. What will be the effect of all this new capital on the global economy? The basics of inflation tell us that if more money is printed or made available, the value of that money decreases. When billions of dollars are flooded into the banking system, inflation is bound to occur at some point. There are normal cycles of inflation and deflation within an economy, periods of growth and periods of contraction. Going too far in either direction is not a good idea. Policymakers are correct in their need to prevent a major-worldwide depression, with all available tools; hopefully they are thinking about long-term outcomes as well as short-term.