Is banking at breaking point?

Written by: Dave Waller Posted: 09/03/2017

banking riskJust when we thought everything was tickety-boo in the world of banking, a new series of shocks suggests we’re heading into another crisis

Remember how adverts for banks used to sound so reassuring? Midland was the ‘listening bank’, Lloyds the ‘thoroughbred bank’, NatWest was ‘here to make life easier’. Everything seemed so stable and secure.

owadays, banks may trot out adverts that make them sound like they’re your best mate, like they’re safe places to stash your cash, but the public are far more cynical. And considering banking’s recent history, it’s not surprising.

When the world’s oldest bank, Monte dei Paschi di Siena, is getting a bailout from the Italian government, RBS is failing the stress test set by the Bank of England, and Deutsche Bank is handing over a whopping $7.3bn to the US Department of Justice for its conduct in the lead-up to the 2008 crash. Offers of financial security would be more convincing coming from an advert for mattresses than from a bank. 

Indeed, there’s a long list of factors giving banks sleepless nights – the incredibly low interest rates we’ve had for eight years; the hefty fines banks are swallowing, thanks to their pre-crash negligence; turmoil in the Middle East; dented consumer confidence; the sovereign downgrade of South Africa; the ever-evolving threat of cyber attacks; Brexit destabilising the UK; and the continued economic uncertainty that’s given rise to populism across the US and Europe. 

All this comes with deep and extended market, credit and liquidity risks, while the spectres of Greece and Iceland loom large, showing just how wrong things can go. 

“I’ve never known banks face such a range of risks,” says Mark Sumner, Director for Supervision and Risk at the Jersey Financial Services Commission (JFSC). “It all paints a picture that, at its worst, suggests turmoil, and is certainly one of vulnerability. It’s a very challenging time for banks at the moment.”

The reassuring thing is that various authorities have introduced processes to prevent failures in future – well aware, of course, that many of the existing problems came from these very organisations being too loosely supervised. Europe has replaced taxpayer-funded bailouts of struggling banks with a nifty idea: get creditors to bail them in. 

The UK’s larger banks have been forced to ringfence their operations, splitting their retail and investment wings to protect their books. Meanwhile, Basel III stipulates that banks must hold more capital, and reduce the liquidity gaps they have. 

“Banks have to keep raising more capital to stay ahead,” says Jeremiah O’Keeffe, CEO of JCap Treasury Services. “European stress tests are keeping banks on their toes, and these tests are getting stricter every year. They run lots of scenarios to test how resilient the banks are – for example, could they weather a 20 per cent collapse of the property market, or five years in which house prices drop 30 per cent, or the devaluation of the pound?”

Measuring risk

Yet while such measures do protect the populace from the dangers of banking excess, it also makes it more difficult (and expensive) for the banks to do what they’re meant to be doing – enabling the growth of the economy. The changing regulatory requirements mean they have to raise more capital, while also fronting up the cost of all the reorganisation that comes with measures such as ringfencing. 

“Some argue these controls are having an impact on banks’ ability to make profits,” says O’Keeffe. “That’s one reason why banks’ share prices are struggling.”

It’s also one reason why, despite these measures, there’s still a great deal of concern around how risky banks remain. One issue is that no one knows whether some of the new measures will actually work. Because no one’s seen a bail-in happen, for example, no one knows the knock-on effects it’ll have. It may be that investors don’t have the appetite to get involved once they’ve seen how the first one turns out. 

O’Keeffe also believes there’s an inherent flaw in the role played by ratings agencies when it comes to managing risk. Yes, they’ve become much stricter since the crash, when they were castigated for the often generous ratings they’d been dishing out. But even now, their controls may not be as effective as people think.

“Banks get reviewed quarterly or annually by the ratings agency, and they tend to use lagging indicators,” says O’Keeffe. “They generally rate a bank’s long-term debt, maybe up to 30 years, looking only at bonds. 

“But issues like credit default swap prices and share price performance are the early warning indicators, and far more pertinent than long-term risks. We suggest looking at short-term risks – like that of a depositor not getting their deposit and interest back from the bank.”

O’Keeffe cites Deutsche Bank. “We saw the warning signs four or five months ago and brought it to the attention of clients in a timely manner,” he says. “If you’d  looked at only its long-term ratings, you wouldn’t have taken any action.”

Knock-on effect

So what impact does all this have on the Channel Islands? In a recent JFSC survey on financial risk, which covered everything from loss as a result of incompetence through to market abuse, industry figures and JFSC staff ranked the failure of banking as the highest risk facing the island (alongside the funding of terrorism). 

Yet O’Keeffe is confident that the Channel Islands remain well protected, even if he does caution that fiduciaries really should be looking more closely at their banking partners’ risks. He points to the quality of Channel Island banks, which act prudently and without over-exposure to risky assets. 

“Most local banks have cautiously managed balance sheets, and business failures and mortgage arrears are at a low level in the islands,” he says. “Jersey also has a depositor compensation scheme that provides individual depositors with protection for up to £50,000 in the event that a Jersey bank should fail.” 

But, he concedes, you can’t ignore that risk entirely. “The JFSC signalled in 2016 that the financial failure of a Jersey bank would have a significantly higher impact than the failure of other firms in the island,” he says. “Therefore it is considered a material risk.”

Over at the JFSC, Sumner points out that two thirds of Jersey’s banks are branches of larger operations, and thus benefit from the financial strength of that larger player. The other third are subsidiaries of international banking groups incorporated in Jersey. Yet this brings other risks that the regulator must remain on top of. 

“The biggest risk our subsidiaries face is that they upstream funds to their parent,” says Sumner. “But if we have concerns, we will take action. Jersey is proud to say it that didn’t lose a bank in the crisis, but we were affected – we were having dialogue with overseas regulators, whose banks we took an opinion of when it came to risk. If any banking group under severe stress had a bank here, we had a dialogue with them. A number of banks left the islands – we became uncomfortable with the credit risk their upstreaming represented.”

Regulation can be seen as a pendulum – swing too far one way and banks become too carefree, nothing is controlled, mistakes are made and everything crashes; too far the other way and banks are safe but stifled, unable to play their proper part in economic growth. 

So is there a risk of more regulation coming in and stifling activity in the Channel Islands? Probably not. While they follow international developments closely, and meet standards where appropriate, the islands’ regulation is more open to interpretation, and less prescriptive, than it is in the UK. And as they’re independent and small, they can be more agile in responding to crises. 

Questions will no doubt arise – the JFSC is currently consulting on what access to Europe must look like in the wake of Brexit, for example, and how this affects meeting European standards. But the regulator has no intention of crushing the island’s bankers under a pile of new regulation. “It’s about meeting international standards and being a good neighbour, where customers and other jurisdictions can have confidence.”

Indeed, you can’t ignore the risks, nor the fact that the global picture’s not going to become suddenly settled any time soon – no matter how thoroughbred the banks are or how good they are at listening. Banks must be allowed to be banks. So we should keep that pendulum swinging – just not too far.

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