I tend to draw the conclusions from my years in the banking and corporate treasury industries that we need what I call “common-sense” banking as opposed to regulatory prone arm’s-length banking. Lending practices must be based on sound understanding what the banks lend money to and to whom. Too overregulated, or incorrectly regulated, banks tend to rely too much on procedures and rules. Regulation is a dangerous tool that can make practitioners very easy neglect their own responsibility in making wise and well analyzed decisions. When looking around for clues in a situation that is as uncharted as this one I recently got my hands on a paper from the IMF “CHAPTER 4: Financial Stress and Economic Downturns”.
The article concludes in its opening remarks “Countries with more arm’s-length financial systems seem particularly vulnerable to sharp contractions in economic activity, because of the greater procyclicality of leverage in their banking systems.” The article states that countries with less arm’s-length financial system instead using relationship banking to a large part succeed better. They do not experience so severe downturns from financial stress. The idea of arm’s-length banking is the foundation for the present regulation and legislation (Basel and Fair Value) and I quote “The general trend toward greater reliance on arm’s-length financing and less reliance on relationship-based lending may have left economies better able to absorb financial stress, as both households and firms can now substitute away from banks to markets (and thus benefit from the so-called twin engines of the financial system).” However later in the article they conclude: “Countries with more arm’s-length financial systems appear to be vulnerable to sharper contractions in economic activity in the wake of banking stress, because leverage in the banking system appears to be more pro-cyclical in countries characterized by greater financial innovations”.
How I read this is since the banks do not any longer have direct corporate lending as core product they need to develop advanced financial products that is difficult to risk asses and even more difficult to manage. I quote again: “Why do banks remain crucial despite the financial innovation and the emergence of nonbank sources of funding? Financial innovation would seem able to reduce the pivotal role of banks by providing alternative channels for firms and households to access financing, channels that loosen collateral constraints for borrowers and soften the adverse impact of financial stress on the cost of capital for banks.” Why did the regulators and politicians want this to happen? Why do the governments want households and corporates borrow outside the banking system? I can only see one answer and that is to save the banks from the risk of lending (=Basel II). A clear focus on saving the banks and let other parties do the dangerous business of lending money. Instead the banks performing financial innovation to a degree that they do not even understand the exposures and bubbles they create. The whole banking legislation is weird. A bank is a process industry for money; money in and money out. And a bank shall not be built on peculiar rule sets and bureaucrats’ belief that collateralized lending is safer than relationship or common sense banking.Who came up with the idea that banks should not lend to corporates and households in the first place? Was that such a clever idea? I like the paper and basically they are saying that the banks do too much of financial innovation instead of core banking (read “plain vanilla lending”) and that increases risks and economic shocks. I do not know what to expect now. Maybe the researchers should take another good look at it and continue the logic to conclude that we need proper financial institutions that understand and work with the corporate sector and judges them on common sense banking principles. Let the best banks survive and prosper and the badly run banks default. The banks cannot be saved from society (=Basel II). The banks should instead serve society.
I believe that bankers must understand they lend money to enterprises, with employees, investments, services and products and above all Clients. The degree of financial innovation has been too elaborative and has distanced the banks from the real economy. Lending money and investing has become something else than what it actually is and it has gotten a life of its own – a Frankenstein’s monster if you wish. This is basically a result of automating bank risk management with policies such as Basel II, which is a highly theoretical framework for determining risk without performing a common sense analysis on the actual borrowers. The borrowers are derived to figures and abstractions in elaborate checklists and software algorithmic. This is in essence what arm’s-length banking is all about. Valuation of the creditworthiness has become a purely mathematical exercise that even can be traded.
What we need is much more relationships banking with a long term relation making the bank and the corporation work in partnership to develop markets, products and services and Client relations and agree on financial discipline. Common sense banking is working together with the corporates over economic cycles and phases of restructuring and growth. To transfer we need to scrap the whole foundation of the Basel Frameworks (=banks shall not lend to corporates) and the Fair Value principles (=market prices are always the correct valuation). The banks shall be in the financial center and not capitulating out to the periphery working several layers away from the corporations, that’s sure to fail. Arm’s-length banking is not a sensible principle now and has never been. Probably we will soon realize that arm's-length banking is the core problem that made this crisis so extremely severe.
The other part of the coin is how to ensure sensible lending practices and for that reason we could turn to France to learn. With common sense banking the corporate sector will not be able to borrow more than is reasonable. The problem will instead be to constrain the private lending practices. I do not think that we shall try to regulate the banks we shall instead regulate how private individuals can borrow. In France you can not mortgage your house for whatever purpose you like. The whole borrowing process is very bureaucratic and you are only allowed to take out mortgage on your house to improve it. No option to take out a little extra to buy a new car for instance. This has avoided the French to be overly indebted as are many other countries’ tax payer. Indeed an efficient model. If you combine that model with attractive financial incentives for hard work and above all enterprising (basically low taxation and reasonable risks for employing) you will have a winning formula. Unfortunately France has not adopted this second part making them fail in building prosperity but that is another story.
IMF CHAPTER 4: Financial Stress and Economic Downturns”: The main authors of this chapter are Subir Lall, Roberto Cardarelli, and Selim Elekdag, with support from Angela Espiritu and Gavin Asdorian. Hyun Song Shin provided consultancy support. Jörg Decressin and Tim Lane were chapter supervisors.
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