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The year 2014 was a painful one that most bankers would prefer to forget rather than
remember.
First, it was a year of record fines on banks. At last count, the fines and settlements
were over US$100 billion and still counting. Ignore the fact that more than half the
value of fines was for geopolitical “non-compliance with trading with the enemy”,
rather than doing bad for customers, the regulators finally exuded power as to who is
the boss.
Second, 2014 marked the end of the regulatory debate, when the November G20
Summit in Brisbane endorsed the regulatory deal on Basel III and total loss absorbing
capacity (TLAC) that claim to fix too-big-to-fail banks without any need for bailout by
public funds. The fight over the content of the regulatory reforms is largely over, but
the implementation battle is only beginning.
If there is one forecast one can make with certainty, it is that when they review Basel
III outcome by 2019, it will be a hotch-potch of national versions of macro-prudential
stability, which everyone claims to be Basel III compliant.
Third, commercial banks are facing the biggest challenge to their business model
with the listing of Alibaba.com, an electronic marketplace that was not even licensed
as a bank. Founded less than 10 years ago, its market capitalization at US$250
billion today is larger than JP Morgan. AliPay and ApplePay together threaten to
revolutionize payments and also mobile finance, eating into the lunch of traditional
retail banking.
Fourth, consolidation of banking is happening even as the industry becomes more
concentrated. The globally systemically significant banks are gaining market share
through mergers and acquisitions, whilst smaller banks are exiting the business.
Since the passing of Gramm-Leach-Bliley Act of 1999, the number of U.S. community
banks declined by one-quarter from 8,263 to 6,279.
Fifth, the banks are no longer drivers of credit conditions, thanks to the massive
intervention of reserve central banks in interest rates, liquidity, risk and duration
through quantitative easing (QE). The Fed is trying to withdraw, even as the
European Central Bank (ECB) and the Bank of Japan are embarking on major
expansion of their balance sheets. Central bank balance sheets have increased by
almost US$1 trillion annually since 2007, bringing their share of global financial
assets to US$24 trillion or 8 per cent of total by the end of 2013.
Two reports by the World Bank and the U.S. Office of Financial Research illustrate
the complex challenges faced by banking.
Firstly, the World Bank, a bastion of financial liberal orthodoxy, has finally admitted
that the economic thinking behind development should be revamped to take into
consideration the three principles of human decision-making – thinking automatically,
thinking socially and thinking with mental models. To use an analogy by the World
Bank Development Report , ignoring these is like cockpit design to help pilots steer
aircraft. In doing so, the gadget-filled cockpit became so complex that pilots were
focusing on the indicators, rather than on where the plane was really going. Similarly,
those who design ever-complex rules for macro-prudential stability forget that those
who rely on airbags for safety have found that airbags could be also killers.
Secondly, the U.S. Office of Financial Research 2014 Annual Report highlighted
three areas of threats to financial stability. They saw excessive risk-taking during the
extended period of low interest rates and low volatility; evidence of brittle markets due
to sudden liquidity stops and asset fire sales, and the migration of financial activity to
shadow banking where high-impact risks are more difficult to assess because of
opacity.
Specifically, QE and low interest rates have suppressed volatility and encouraged the
revival of carry-trade. 2014 was marked by nearly three quarters of market
exuberance and low volatility, followed by sharp declines in mid-September and
October 2014. The sell-off of risky assets, particularly emerging market bonds and
equity, indicated that investors were nervous as to fundamentals.
On October 15, the U.S. Treasury market suffered a short sharp spike equivalent to a
“flash crash”, described as a five standard deviation move. This was partly due to
regulatory restrictions on market makers to take positions and high volume trading by
algorithmic trading systems.
Consequently, banking systems today face huge policy and regulatory risks on top of
market and technology risks. This is also true for banks operating in Asia.
The burden of QE adjustments will fall on emerging market economies (EMEs),
because the relationship between advanced market interest rates and risk premia
and EME rates and spreads are non-linear. A return to advanced country normal
interest rates will cause EME real interest rates to spike, resulting in slower growth.
Greater ECB and Bank of Japan intervention would invite more carry trade
speculation against EME asset markets and exchange rates. The sharp depreciation
of Asian exchange rates in November/December reflected such volatile capital flows.
Market and policy risks are high because liquidity and rates depend largely on central
bank policies and on the uneven/uncertain implementation of the agreed regulatory
rules, many of which do not necessarily reflect Asian conditions and risks. Because of
low rates, portfolio duration has become higher in bonds and loans. The OFR
estimated that a 100 basis point rise in Fed rates shock would result in 5.6 per cent
loss or US$212 billion unhedged loss to U.S. bond mutual funds. That would spark-
off another round of EME asset sales.
In the meantime, social inequity and consequences of climate change (natural
disasters) add to new risks in the form of social protests, geopolitical tension and
weather change impact on food security. Furthermore, commodity prices and exports
are all under pressure due to the slowdown of China and the advanced markets.
All these belie Mark Carney, Chairman of the Financial Stability Board’s heroic
argument that thanks to regulatory agreement, the banking system “is simpler, safe
and fairer.”
The only bright lining is the drop in oil prices, which is equivalent to a US$1 trillion
transfer from producers to consumers. This however depends on whether consumers
use this transfer to repair their balance sheets or use them for consumption
purposes. If the former, further deflation is inevitable.
The world has excess capacity in old industrial production and shortage in new
knowledge products and services that are transforming life styles. Asian banks are
caught by that creative destruction in both their customer balance sheets and in their
own business model facing the invasion of Alipay, ApplePay and Bitcoin models of
settlement on top of a regulatory squeeze. Fortunately, Asia remains still the fastest
growing region in the world and has the room to adjust to this transformative change.
Nevertheless, midstream in a phase of post-crisis deflation, those who adapt, reform
and restructure their operations fastest to the new normal of high volatility and risks
will survive. The year 2015 will be another continuous stress test of the survival of
the fittest.
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Endnotes
[1] World Bank. 2015. “World Development Report 2015: Mind, Society and
Behavior.” Washington, DC: World Bank.
[2] U.S. Office of Financial Research. 2014. “Office of Financial Research Annual
Report 2014.”
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