Our guest blogger today is Alan Craft of Craft Financial Advice. Alan has worked for Chase Manhattan Bank, Dresdner Kleinwort's, ING, and Lloyds TSB with postings in the USA, Singapore, and Greece, as well as the UK. He has been at the forefront of developments in banking and finance such as Basle II, operational risk, active portfolio management, capital allocation models, expert credit judgment systems, hedge funds and governance reviews. He has also worked in front office marketing, relationship management and has a unique specialisation in risk management.
He was a leading contributor to ACCA's Corporate Governance and the Credit Crunch discussion paper [pdf 318kb].
This blog is based on comments Alan made at a private dinner of the British Accounting Association Corporate Governance Special Interest Group in December.
I was asked to make some comments about the current financial situation, but make them light hearted. I find this rather difficult given the state of the banking world at the moment. However, I would like to give you a message of concern about the current state of play, but also a view for some optimism for the future...
The credit crunch is really a Confidence Crunch. We have all suddenly lost confidence in the whole system. Banking is essentially a simple business with low margins…rather like a traditional utility business. But in a period of low inflation and with the repeal of most of the laws segregating roles in banking, leverage became the word of the moment... we have learnt the expression EBITDA to denote the importance of cash flow to service debt at previously unheard of multiples.
Financial leverage became the great barometer of confidence. The higher the multiples the greater seemed the validity of the system. But in comparison with the recessions of 1973, 1987, and 1992, this is what has caused the severity of the downturn... Higher Highs and then Lower Lows!! The levels of debt, the complexity of products, the aggregate level of exposures, and the ability to trade on thin margins led to a velocity of money and apparent value and a huge degree of volatility.
Herein lies a very interesting paradox…much of the activity underlying this volatility ...in derivatives for example…was apparently aimed at taking risk out of the transactions undertaken and the balance sheets concerned; or place it where it was best housed…not usually banks with their specific regulatory regime.
What happened was that the complexity and speed of such business led to another form of leverage, even more problematical than financial leverage….I will call it 'behavioural leverage':
- people acting out of character or against what years of experience had taught them,
- people following the current mantra of the market leaders,
- Confidence was built on sandy foundations,
- Incentivisation that emphasised short term gains and personal benefit,
- Awareness of what was going on and the taking of responsibility gave way to Hubris and selective hearing,
- Reliance on mathematical models that suggested credit risk was really just a variation on market risk,
- Management balance of risk and return gave way to a lowly after the event role for risk management.
The speed and extent of the loss of confidence was what staggered many people. Its cause lay in the globalisation of the financial markets. The rise of the internet and the power of computerisation meant that 24/7 trading and price movements had become a reality. The changes in regulation had removed the barriers to global markets and the speed of data processing and movement enabled ideas and trades to travel uninterrupted.
The demise of Lehman Brothers has proved to be the single most significant event in the collapse of the markets in 2008. This was because it revealed just how interwoven the activities of even a mid sized bank had become and with its demise came the impact on prime brokers, hedge funds, investment banks, commercial banks, insurance companies, and ultimately the general public... most of whom had never heard its name before….
But it is not all doom and gloom. The darkest point is often the beginning of the return of normality. We are seeing a number of positive developments:
- The break up of banks that had become too big to manage successfully is now likely,
- There is a more enlightened dialogue between banks and their institutional investors on risk and return,
- We have seen the curtailment of the most exotic and over egged structured products. Leverage…both sorts... is being taken out of the system,
- More appropriate incentivisation is being brought into place.
There will be more pain to come and the successful outcome is not expected very soon. But the market is resilient and over the next 2 to 3 years there will be significant upward movement.
Even this time next year we may well be talking of the credit crunch that was rather than the credit crunch that is...
One should note that bigger banks have the advantage of bigger capital base to withstand the vagaries of the economy. That explains the rationale of emerging economies like Malaysia to consolidate the banking industry after the experience with their 1997 financial crisis.
The dilemma now is that when banks become too big, it also becomes too big to fail and too hard to manage. I do not really think at the mean time there is a simple solution to this. It is always a question of chicken and egg.
I think a good lesson for the world to learn from this financial crisis is the consequence of excessive lending and leveraging. Due to the excessive global liquidity over the years, funds are flushed to everywhere and created a global bubble. When credit market crashed, funds are withdrawn from everywhere as well and the bubble burst. The overall global market movement has become 'systematic' as a result leaving diversification becoming less effective.
Posted by: Daniel Wong | 06 February 2009 at 03:25