Eddielogic

– Thoughts on Strategy and Management

The new future of bank regulation?

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A large number of articles concerning the financial crisis have been published these days. In sum all write offs in financial institutions (worldwide) have reached a total of 485 billion USD this week. 42 billion USD write offs can be found among banks in Germany. The amount of recapitalization (worldwide) within banks is 459 billion USD. All figures illustrate the galactic size of financial risks among various financial products and the risk potential of instable linkages within the capital markets.

Lesson 1: We had to learn the “to big to fail” is not always a reliable option; under specific circumstance (say hello to the Black Swan) everything is possible. Lesson 2: Liquidity is not just a question of price (in this particular case: spread), it is more a question of trust and price…and therefore illiquidity is not always available for everyone in the market place. What Lehman Brothers was for the US, was Hypo Real Estate and its subsidiary DEPFA for Germany. But this is not specific enough: There is a similarity and a difference. The similarity is: Both banks (the collapse of Lehman and the nearly collapse of HRE) represent the watershed how the Governments and their authorities managed these issues. After two risks situations for a collapse of HRE (yes, we had two situations for the same bank, since the organization was not able to quantify their liquidity needs precisely enough) Germany had to learn that the financial crisis would affect the German financial landscape “a little bit more” than predicted. The difference is: Since the Lehman collapse and its dramatic impact on the financial markets took place before HRE, the German government was prepared mentally to act…So let’s describe it this way; Germany and other countries had luck since they could observe a collapse of a large bank and its impact on the market place.

Is this the end of the story? No, definitely it is not. The next months we will struggle with secondary effects in the real industry. But I would like to have a brief look at the regulatory side. What can we expect in terms of new regulatory issues?

  • Existing sophisticated risk management systems/approaches were not able to enough to protect banks against financial losses from credit default risks (evaluation risks). Banks focused on external ratings instead of really analyzing the background of structured products; rating agencies could not offer reliable data.
  • Liquidity risk management approaches used assumptions that not were valid in stress situations.
  • Write offs in assets reduced the tier 1 capital, hence banks came under pressure to find new capital sources. In the past some banks had optimized their equity in order to establish the mathematical fundament for very high ROE ratio.

Taking these issues into consideration, I assume that

  • Banks will change the management of their equity and will operate their business with a larger amount in terms of tier 1 capital. The process to manage equity in stress situations will become more important.
  • The regulator will establish / define specific risk scenarios or even stress tests for liquidity management. Furthermore the regulator will focus more on the underlying assumptions that have been employed to assess risk situations.
  • The regulator will force banks to check the value of their assets not only on the fundament of external ratings. A look-trough approach will gain more importance.
  • The regulator will check whether the salary structure and the benefit scheme might cause risk situations and might lower the attention for long term success.
  • Accounting of SPVs, SEV and derivative financial instruments will become more complex in order to address the inherent risks of those products and operations.

In sum this situation will change how banks manage their business and their risk situation. The perception of the banking industry has got a negative touch. It will take years to reconstitute trust.

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