By Daniel Archibald | CFA
As we know, money makes the world go round. It greases the wheels of business, allowing for trust, capital and risk to be exchanged between willing buyers and sellers. In as much as money is the metaphorical 'oil' of the global economy, banks and the financial system are its oil distribution and control mechanisms. And just like running an automobile, care needs to be taken to ensure that the financial system has the right level and speed of flow of money. Else, the global engine can freeze up or burn out - also known as financial crisis.
The history of finance is littered with examples of such calamities. In the 1850's, the first real global financial crisis saw financial systems in America and Europe fail, primarily as a result of slump in railway stocks and property lending. And in 1930, following the October 1929 crash of the stock market, hundreds of banks in the U.S. and around the world collapsed under the weight of bank runs and asset losses.
With the economic evolution of banks from privately-owned financing institutions to world-dominating megabanks, the impact of financial crises on the global economy has grown. Following the potentially, systemic bankruptcy of Bankhaus Herstatt, the Basel Committee was formed in order to promote greater stability and security in the global banking world.
Following a decade of working with national bank supervisors and regulators, the Basel Committee released the 'Basel Capital Accord'. This called for global banks to adopt a minimum capital ratio of 8% of risk-weighted assets (i.e. equity of 8% and borrowings of 92%). Of course, for any other industry, such a low level of equity would be a cause for concern, but as a bank's main products are deposits and loans a high level of debt is essential.
The definition of 'risk-weighted' in the accord was meant to adjust the measure of assets based on the amount of credit risk inherent in the asset. For example, a loan (which is an asset for a bank) backed by a residential mortgage would have a lower risk-weighting than an unsecured loan to a business and a higher risk-weighting than a holding of Government bonds. This measure, however, did not take into account other risks to assets such as interest rate changes and fraud.
The Basel II reforms of 1999 looked to add to the risk-weighting of assets by requiring banks to not only incorporate credit risk, but also market and operational risks. The reforms also mandated supervisory audit and governance processes, as well as disclosure requirements. Even though some countries were slow to adopt the new measures (the main laggard was the U.S.), by 2006, most internationally significant banks were following the '3 Pillars' of the Basel II framework. So, of course, the world was at last safe from financial turmoil...
The practices and weaknesses within the financial system that lead to the 2008/09 GFC are well understood. A general lack of liquidity awareness and the misuse of structured products led to an environment of hidden (off-balance sheet) leverage and risks. The fraudulent mis-selling of financial products, particular those related to sub-prime mortgages in the U.S., and its eventual collapse, was enough to see the interbank markets freeze up and capital markets to head into a tailspin. Basel II was not enough to circumvent greed and dishonesty.
Basel III reforms were released in 2010 and are the most recent attempt to try and reduce the likelihood of banking failures. While strengthening the Basel II framework (increasing capital requirements, greater focus on systemically important banks), the new reforms also called for liquidity and leverage targets. These additional layers specifically address the root causes of the GFC (other than banker greed). It is important to learn from mistakes and to try and build appropriate defenses against high impact risks.
The Basel reforms aim to do just that, even though complacency tends to be a recurring theme. In the wave of banking scandals that have unfolded since the GFC, it is a reminder that external regulation and requirements can only go so far. The bigger threat to banks, and any business for that matter, is likely to be the extent to which an internal culture of ethical behaviour and conduct has been established. In regards to the banking community, the jury is still out on this one...