The recent turmoil in the international financial markets, following the US sub-market debacle, has caused some unease about the health of the financial industry, on whether the worst seems to be over in terms of coming clean on the extent of non-performing loans. At the same time, there is a growing consensus emerging that the financial sector as a whole is in dire need of some sweeping internal reforms. Even central banks have joined the chorus of criticism of current banking lending practices, with the Bank of England bluntly stating in a hash statement that Britain’s financial system could be vulnerable to further crises after having ignored repeated warnings about “seriously flawed methods” used to expand lending.
If one of the most conservative and cautious central banks of the world is admitting to this, what of other financial systems, and are regional financial systems exposed?
What are the perceived flaws in current financial models that have seen one household financial institution after another reel from bad debt provisioning following the subprime market fiasco? The figures for bad debt provisioning have been devastating. Merrill Lynch tops the list to date with a write-down of $5.5 billion, making Merrill the latest in a string of investment banks to reveal the extent of their bad loan exposure. This follows announcements from Citigroup ($3.9 billion in write-down and extra credit), UBS and Credit Suisse. This is embarrassing for the world’s premier financial market shakers and movers, as it was only this summer that Citi’s Chief Executive Chuck Price was telling the Financial Times that the bank was “still dancing” in the private equity market. That dance seems to have turned into a mournful funeral march for many.
According to internal examination of what went so horribly wrong, the indications point to the same: lack of adequate information about the true extent of credit risk of the underling financial instruments, an excessive dependence on rating agencies which have seen their own reputation taking a battering, and above all, an inadequate liquidity risk management system — the basic bread and butter tool of any Treasurer worth his salt. While some of these flaws might have been lurking under the surface, it was the speed, force and depth of events, which when combined, took them to lethal levels not seen before on the markets, and with few predicting the severity of this financial mismanagement cocktail.
However all is not lost. Steps are under way to restore investor confidence and trust and some corrective measures have already started to be implemented. This is especially so in the area of risk management, the review of off-balance sheet conduits and special purpose vehicles, and better ways to value complex structured financial products. A way has to be found to price such derivatives, especially in periods of eroding prices when such pricing is made difficult in a free fall market, as happened with the subprime meltdown. Bankers are warning that there could be more financial dislocation if such corrective measures are not implanted to counter the market’s insatiable demand for higher yields, especially in a period of falling interest rates that have lead to inadequate spreads and lack of attention to fundamentals and market risk differentiation.
There is also a risk that financial institutions would take fright at recent market turbulence and become more cautious in their lending to fellow institutions, leading to a knock on effect for economic growth. To avoid such an illiquid market scenario, especially if it spreads to other markets such as real estate, some of the major banks have come together to establish standby credit facilities to rescue those with short term liquidity problems. As such, Barclays and Royal Bank of Scotland have joined others like Citigroup, Bank of America, JP MorganChase, and Deutsche Bank, to participate in a $30 billion facility to be managed by the Federal Reserve.
However it is not only the wider financial industry that seems to require putting its house in order. Some central banks have been too slow to react to changing market developments in terms of products and trading environments, and thus have not kept pace with appropriate oversight and supervisory tools to monitor such developments. This was the case with the Federal Reserve under former chairman Alan Greenspan, who seemed to allow a more free market spirit to evolve in the financial markets that inadvertently fostered speculative excesses.
Disdain for regulations sowed the seeds for future threats, which current Fed Chairman Ben Bernanke seems to be facing in the subprime market debacle. A central bankers’ burden though, is a heavy one as they need to find a right balance to restrain between the market’s need for better regulation and a spirit of innovation and efficiency, which if unrestrained, might lead to excesses. Under-regulation can pose just as risky as over-regulation.
For financial institutions in the Kingdom, SAMA seems to have struck just the right balance in supervision and product innovation, as there have been no sign of any systematic bank risk emerging, and the monetary agency prides itself in being at the forefront of new product supervision and control. The question though, is whether a worldwide credit squeeze can be successfully shielded by regional financial institutions, however well regulated and supervised. This is the price of globalization.
Dr. Mohamed A. Ramady is a visiting associate professor, finance and economics, King Fahd University of Petroleum and Minerals.