By Gerren Bethel, Deputy Editor, Finance Publishing
The landscape of the banking sector has been changing substantially over the last few years and is forecast to experience further major changes as the year unfolds. At the heart of these major changes is the implementation of regulation across the global-banking marketplace. The reforms have been under discussion since the financial crisis over five years ago and are now being widely adopted by banks and financial-services firms worldwide. Major international banks are seeing dramatic changes in their operations – with strict restrictions being put in place on activity and banking relationships. Banks across the globe are cutting down their operations by pulling out of certain geographic regions and investment sectors in order to meet regulatory requirements and avoid legal prosecution, which is becoming increasingly punitive and damaging to major bulge-bracket banks, and smaller firms as well. Lines of business are being removed from banks’ operational frameworks so as to avoid attention, scrutiny and punishment from relevant authorities. This phase of removing risk is changing the banking terrain at a rapid pace, and the fallout remains to be fully realised and assessed. Networks and relationships are being broken down at a previously unexperienced pace and in an unprecedented fashion and will no doubt affect the direction of the global-financial system into the future. Industry participants are now commenting that these fraying relationships are likely to increase costs of finance for poorer countries and people, and restrict investment in areas already suffering from less favourable terms. Furthermore, these parties are likely to see worsening terms as the risk-awareness environment tightens restrictions.
Although risk-management is a primary concern for the stability of the financial system going forward, there are now new risks on the horizon – those that stem from a decreasing level of integration and interconnectedness. As major banking institutions focus so fervently on reducing and restraining exposures to fall within defined boundaries and areas of investment, the wider financial-arena risks are becoming disjointed, exclusionary and inefficient. For example, the system of correspondent banking – the informal set of arrangements that allow customers of a bank in one country to send money to another person in a foreign nation, even if the bank in question does not have a branch in the domestic nation – is retreating to meet regulatory requirements. This correspondent-banking system has been a central cog to the larger international-banking machinery and marketplace historically and is now under threat by the overzealous implementation and enforcement of regulatory rules that have been designed to prevent money-laundering and terrorist-funding activities.
One of the main functions of a global-banking marketplace is the provision of linkages – serving numerous functions that provide connections between markets and over geographic boundaries, while allowing efficient flows of capital. The number of these links through the banking system has been on the decline over the last five years, and the system is not showings signs of retracing them. With consolidation occurring across the banking industry in general, and now swathes of cuts from the big international banks, the linkage-network and commensurate functionality is shrinking. Banks and financial-services firms have had to be ruthless in meeting regulatory requirements when it comes to cutting financial-industry relationships and ties – with many large firms citing that they have had to drop up to a third of corresponding banking ties. The reduction of the banking network will have a wide impact as these institutions provide channels and ties for global-financial transactions and processes – driving growth for economies and businesses worldwide.
Banks across the globe have firmly placed escaping legal prosecution at the top of their priorities, and this is currently trickling down to wider banking activity and setting the investment and finance-sector agenda. This is especially the case in America, where a number of big international banks have been charged with failing to adequately control banking activity relating to money-laundering, sanctions and the financing of terrorism. The costs of these types of prosecutions can be huge for major global banks – not only in terms of the fines levied but in terms of the negative publicity and the fall in share prices. These types of trials put major banks under the spotlight, and understandably bank executives want to direct their efforts towards avoiding these costs. For example, HSBC paid a $1.9-billion fine under US prosecution, and France’s largest bank, BNP Paribas, may have to pay a fine of up to $10 billion on charges related to breaches of US sanctions against Cuba, Sudan and Iran. Substantial fines have also been paid by Standard Chartered, ING and Barclays under similar charges. From these cases, it is evident that US regulators and prosecutors are fervently set out to apply tougher standards and penalties when it comes to enforcing regulation. The punishments being given over the last year are substantially tougher than those given by the Financial Action Task Force (FATF) – the intergovernmental body launched in 2001 to oversee the implementation of international rules on terrorist-financing and money-laundering. While the FATF required banks to know who their customers are and what these customers are planning to do with their funds, American regulators are now demanding that banks additionally know who the customers’ customers are when it comes to banking activity. As to be expected, banks in countries such as Ethiopia, Pakistan, Indonesia and Myanmar – those that were initially deemed as high risk even by FATF standards – have seen the most extreme change in activity. JPMorgan ended its relationship with Al-Rajhi Bank, Saudi Arabia’s largest publicly traded bank, in 2013, and in Pakistan, only one large Western bank remains operational in retail banking.
However, it is not through direct evidence of banking misdeeds that larger banks are terminating relationships with these high-risk institutions – it is predominantly a case of meeting regulatory requirements. To avoid the cost of potential regulatory scrutiny is far more worthwhile for the larger banks, who would rather avoid the hassle than capture the relatively small profits generated for them through these international relationships. This effect is further exacerbated by ambiguous details regarding the regulations, with many senior bankers noting that the rules frequently change and are often unclear and complex when it comes to international-banking activity. For them, it is therefore often easier to refrain from global banking altogether.
In some cases, stricter regulatory enforcement has generated the intended results – with significant positive outcomes. For example, a number of banks in poorer countries are being forced to adopt developed-world approaches to controls on money-laundering to avoid being cut off from the global-finance marketplace. These countries are subsequently seeing a reduction in unethical and illegal banking activity within their borders as well as improved economic efficiency. However, the price of this positive result is an expensive one. Costs of doing international business are rising – especially in countries such as Mali and Indonesia – and often these costs are passed on to some of the worse-off in the supply and production chain – for example, farmers of crops and raw materials such as cotton. A significant case in point is that of Africa, where remittances have been hit hard –
the cost of which fell from approximately €8 ($11) per transaction several years ago to as low as €1. These fees have now reverted to prior levels in many markets across the African continent as local remittance firms have lost access to developed-world banking services. Foreign students, foreign diplomats, embassies and general international-banking consumers have also complained of increased costs and inconvenience when it comes to international finance and banking access. Further to this, charities are being affected negatively – such as The Red Cross and Save the Children – who are struggling to transfer funds to countries that may desperately need aid, such as Syria, due to sanctions of banking activity stemming from political turmoil and risk. Even with regulatory approval, many of these parties struggle to complete banking processes as the fundamental operational-banking framework has been reshaped to restrict activity.
One solution may be for technology to bridge the gaps being created in the banking-services network. For example, mobile-money systems provide clear channels for financial transactions to take place and are proving successful in countries such as Kenya – with the M-PESA system facilitating banking processes easily and smoothly, with proper and full ingoing and outgoing records. A further example is the government-payment system implemented in Pakistan to pay police-service employees directly, leading to a substantial reduction in corruption. Going forward, the key will be for politicians and regulatory policy-setters to balance the costs and benefits of enforced global-banking restrictions. Regulations that lead to exclusion and poverty have other negative knock-on effects, which in turn affect the global economy as a whole. These outcomes can have the counter-productive effect of increasing the type of criminal and terrorist activity that the regulations were designed to prevent in the first place. Without adapting and evolving to the economic terrain, tough regulatory changes may leave some countries and markets without access to international funds, and this will feed other unethical financial activity – such as a system of shadow banking that has grown substantially across the globe, especially in Asia. Left unchecked, this kind of activity poses larger systemic risks than that found in the formal-banking system – leaving the wider economy actually worse off in the long run.
The risk appetite is returning to the global economy, and with tougher restrictions curbing activity in the formal sector, the alternative financial market has grown. The shadow market is evolving to meet growing demands. Central banks across the globe are being tasked with deciding on plans of action to meet economic-recovery trajectories, whilst keeping control of the cost of borrowing so as to maintain control of the financial system. This will be a tricky balancing act for policy-makers, as on the one hand, they are seeking to feed growth, but on the other, they are aiming to maintain a firmer grip of control and risk-management than that previously in place. As restrictions tighten on banking activity within the formal- banking sector, and business needs grow, shadow banking is becoming an increasingly popular choice for servicing financial needs. By attempting to prevent future financial excessive risk-taking and collapses, regulators have driven market participants into shadow-banking avenues. This shadow-banking arena is difficult to monitor, is not under the scrutiny of regulators and is bringing with it another range of risks that need to be addressed.
Although substantial progress has been made to date in reforming the banking system across the globe, financial markets and economies are now focussed on driving the recovery forward and are looking for creative ways to meet those needs. Shadow banking is growing and has been successfully meeting the needs of business and financial-market participants, who have been refused access to financial services through the formal channels – specifically, the provision of credit facilities from shadow-banking firms has grown significantly over the last few years and is forecast to grow further over the coming years if left unchecked. Regulators and policy-makers need to make efforts to shed light on this shadow industry before systemic risks in the shadow sector build up to uncontrollable levels that may put the global economy at risk of a future crisis. In 2009, at the Pittsburgh summit, the Financial Stability Board was formed by G20 leaders to overhaul the global financial system, and the concern and discussion around shadow banking was brought to the table. Since the start of 2014, momentum for reform has been growing, and talks are now specifically turning towards reform designed to bring light and regulation into this part of the financial sector. The changes will be designed to deliver improved transparency, resilience and sustainability to the financial-services market – in particular focussing on funding sources of market-based financing.
During the time running up to the financial crisis, the levels of opacity in the shadow-banking sector were rising and led to an increase in irresponsible risk-taking from many market participants – further leading to increased levels of leverage and an unfavourable, high-risk reliance on short-term wholesale funding. Mismatched incentives in opaque and complex structures weakened borrowing standards leading to poor-quality securitisation of assets. Authorities may recognise that reform of the banking system is improving resilience, but they must also take notice of the parties being pushed into carrying out financial activity through the shadow sector. Restrictions need to be applied to prevent the shadow-banking sector from getting out of control. An effective and efficient financial-standards system needs to extend outside of the traditional-banking sector and into the realm of shadow banking as well as into other areas of financial services in which systemic-risk build-up may be a concern.
If properly regulated, the shadow-banking sector can provide a valuable alternative to, as well as healthy competition for, the formal-banking sector when it comes to funding real economic growth. Diversified sources of funds improve the efficiency of credit markets if properly regulated and monitored. Proper regulation provides the sustainability and stability that the system requires to grow into the future and will also allow for poor-quality assets and ventures to be identified and for financing to securely reach worthy projects whilst keeping the global economy moving forward. Shadow banking can only perform its role effectively with the suitable controls in place. G20 discussions have now led to implementation of some, albeit small at the moment, changes in this area. New standards are to be put in place so that large exposure of traditional banks to shadow banks are limited – preventing a spread of uncontrolled risk between the two sectors. Essentially this means that should a shock occur in the shadow sector, the formal sector will remain protected and functional. This type of regulation should facilitate intermediation between banking sectors – both formal and informal. In addition, reforms are to be imposed on shadow-banking firms and institutions themselves in order to make them more stable and resilient. Further to this, minimum margin requirements are being implemented to prevent excessive borrowing that may be at a high risk of default if faced with liquidity tightening. Additionally, incentives are being more closely matched to reduce the risks of misaligned securitisation structuring and transactions.
Reform is being increasingly tailored to get the shadow-banking sector under adequate control and is being directed in such a way as to protect the wider financial-services and banking system. By establishing a framework of policy regulations and standards for co-operation between financial-market participants, reform will succeed in avoiding a fragmentation of the global-financial system. This will be an ongoing and evolving process. Oversight of the overall shadow-banking sector is being strengthened so that leverage and liquidity risks in this area can be flagged and dealt with at the earliest opportunity – before they spiral out of control and damage the economic recovery. The key approach will be one of oversight on a system-wide basis – one that focusses on regulatory requirements regarding interconnectivity amongst a plethora of additional banking considerations. National authorities in markets across the globe are aware that regulation needs to evolve and keep pace with the innovation and arbitrage that shadow banking is so talented in offering. Therefore, regulatory scope will need to be continually adaptive – it cannot be fixed to particular situations and types of institutions and needs to be a function of what services institutions perform rather than based on the title, structure and labelling of a firm. Regulators and policy-makers across the world are focussing on applying a coordinated effort in tackling shadow-banking challenges. Regulation will be expanded to deal with unintended consequences in a way that allows them to be identified and addressed at the earliest possible opportunity – and authorities across the globe are particularly keeping a close eye on proper securitisation activity in the marketplace. By focussing on a goal of replacing shadow-banking activity (which poses risks of poor quality and excess risk-taking) with a system that feeds sustainable and balanced growth of the worldwide economy, regulators and banking participants are taking positive steps.
There is still much to be done. The G20 may have flagged these risks years ago, but only moderate action has been set in motion beyond talks and discussion points. As the core financial system is being rebuilt, shadow-banking reform needs to be considered hand in hand. Otherwise, what is achieved in one area will be jeopardised in the other, with efforts wasted and unfruitful.
Although the market is five years on from the global financial collapse, the risks of leverage and liquidity are still major concerns. The current marketplace may be showing some signs of recovery, but the stability of this recovery is still a challenge going forward. Careful and comprehensive consideration of a sustainable recovery and market-climate conditions need to be incorporated into banking and financial-market activity. Almost six years after the collapse of Lehman Brothers, financial systems remain vulnerable to economic and geopolitical shocks. Trading and asset-market activity, on the other hand, is indicating a climate of calm and stability, which may lull financial-market participants and investors into a false sense of security. As stock prices have been sent surging in markets across the globe, volatility in equity markets has dropped off substantially. The FTSE All-World and S&P 500 indices have reached historic record highs over the last month, and volatility in the marketplace appears to have disappeared. The VIX – a commonly accepted indicator of market volatility – is currently approaching a seven-year low. This may falsely lead many to believe that the period of market turmoil and risk has ended – and has been replaced by a period of calm, stable and well-performing markets. With major geopolitical shocks, such as those stemming from Ukraine-centred tensions, leaving only minor dents in market performance, this response is not entirely surprising. However, this interpretation is misguided. Industry participants are warning that historically extended periods of low volatility precede blow-ups down the line. This is a significant concern for the wider global banking system.
Over the last few years, central banks across the globe have taken the lead from the US Fed and have acted to avert financial-system catastrophes to the greatest extent possible. However, central banks are now facing the difficult challenge of attempting to stimulate somewhat dormant economic systems. Central-bank executives remain aware that artificial calm may create increased risks in the areas of leverage and liquidity, as the calm feeds an attitude of excessive risk-taking, over-leveraging and resource misallocation. A further risk of this misapprehension is that of certain trades in the marketplace becoming crowded out and squeezed into drastic default situations should market conditions turn around. Both the global financial crisis of 2007 and the Asian financial crisis of 1997 were preceded by periods of slumping volatility, and according to Société Générale, the 1929 Wall Street crash was similarly preceded by a period of market calm.
The question remains as to whether the actions of central banks over the last few years have been effective in adding stability to the market. If the changes to the financial system prove to be false, as well as the sense of security stemming from depressed volatility levels, then the global economy faces wide and deep risks into the future. Have the emergency measures and subsequent actions put in place by banks across the globe been applied effectively? Or are they too feeding a false sense of security? Could the reality of hidden instability be compounded on both fronts? Central-bankers may be able to harness the marketplace in current conditions, but what if a sudden turn in conditions occurs? A certain amount of volatility in the market is self-preserving, acting as a deterrent to excessive risk-taking and maintaining some control on participant activity. The problem is uncertainty. Market participants are unsure of just how effective policy is and has been and equally how much real volatility and risk is inherent in the market. As low volatility persists, market participants are left wondering how much artificial central-bank support is being applied to global markets – and when real financial circumstances will be brought to the fore.
Optimists in this area argue that the global economy has reached a “new normal” set of conditions and that lower market volatility has been the result of increased regulatory efforts. They believe improved regulation has successfully made the financial system safer. Further to this, they argue that this “new normal” climate (with the new reforms in place) is not comparable to previous periods of calm. The reforms applied to the market since the last financial crisis have elevated the costs to banks – especially and directly those related to dealing services. There has been a widespread reduction of trading activity on banking-institution books. Trading volumes and volatility have also fallen in the currency markets, and regulation has ramped up in this area following allegations and charges of benchmark fixing and manipulation. These current and particular changes to trading activity make it difficult to compare this phase with historical periods of low volatility. There are further important differences when comparing the current climate with the past, such as an absence of extreme leveraging and opaque off-balance sheet exposures that were prevalent during the pre-2007 crisis time.
A further concern in this market climate is that of distortion. The large-scale quantitative-easing asset-purchase programmes set in place by central banks across the globe designed to stimulate economic development have led to a source of misrepresentation of real market conditions. Many banking participants are concerned that the global economy is not functioning efficiently or normally, and that the low-volatility environment the markets are experiencing currently is a result of central-bank intervention. Capital markets are supposed to act as self-adjusting mechanisms for financial activity, and this mechanism has been disrupted – how will it be reset effectively? Central banks across the globe are attempting to control market activity to prevent any future shocks, but by doing so, they are encouraging a false sense of security, which may encourage more risk-taking – acting against the very purpose of the central-bank intervention.
Going forward, divergences in central-bank policies worldwide are likely to raise volatility. Financial authorities and banking leaders across the globe are tasked with directing the forces of recovery within their geographic boundaries and conditions. These approaches will differ through the recovery and may lead to conflicting interests that will drive volatility – and perhaps also drive normal market functionality— into the future. The ECB (European Central Bank) recently announced further cuts in interest rates and fresh injections of liquidity into the financial system within the eurozone. Meanwhile, The Bank of Japan (BOJ) also remains aggressive in purchasing; Credit Suisse has estimated that if Japanese asset-buying continues at the current pace, the BOJ will hold almost 40 percent of outstanding five- to 10-year Japanese government bonds by March 2015. The US Federal Reserve is, on the other hand, gradually scaling back monthly asset purchases.
Although some volatility returned to the marketplace last year when the US announced plans to taper quantitative easing, it has since dropped off again. Going forward, the success of the marketplace hangs in a significant way on the actions of central bankers and monetary-policy setters across the globe. The task of unwinding large balance-sheet positions will be a tricky one that must be handled delicately so as not to undo the stability and confidence that has been brought back to the market. The substantial growth in reserves of central banks poses potential risks to global financial stability – in particular, the asset and currency composition of foreign-exchange reserves has the potential to destabilise exchange rates and financial markets across the globe. Reforms should be put in place urgently to enhance domestic and international transparency and accountability for this central-banking activity. Optimism and faith in market functionality and the ability of central banks to serve the needs of the wider economy effectively will be pivotal to fostering sustainable economic growth for the future.