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What are banks for? “A return to fundamentals”

Guilty! Weren’t the banks accused of being responsible for the financial crisis triggered in 2007? A necessary vent for the economic difficulties, they continue to face legitimate criticism. And yet, without banks, there is no economy.

I believe that it is now time for a number of important ideas to take centre stage.

Commercial banks play a fundamental role: they take in savings and make loans, acting as intermediaries between those with financing capacity and those requiring financing. In developing countries, a significant proportion of national savings never enters any rational and efficient allocation system. The majority of the population do not have a bank account and invest in assets or hoard their cash. This system is inefficient as savings are not invested to produce growth, namely in support of individual and corporate projects. The financial markets are de facto exclusively the reserve of a few, large companies, due to the costly and regular requirement to produce information to attract investors for bond issues.

Thanks to their in-depth understanding of clients, households, professionals, SMEs and even large companies, the banks are better able to assess the borrower’s profile, and therefore to make appropriate allowances for the credit risk. By their very nature, they are able to minimise the information imbalance that exists between the lender and borrower. They therefore enable numerous economic stakeholders to finance their projects.

Furthermore, by investing in banking products, savers take a risk with the bank and not with the multitude of borrowers to whom the bank lends. Through its role as intermediary, the bank also plays a crucial economic and social role.

The second function of the commercial bank is to take on the so-called transformation risk associated with interest rates and liquidity. Such risks emanate from the fact that both households and companies most often favour short-term and readily available investments, while borrowers most often require long-term financing of a sufficient duration so as to make the investment profitable or to generate a savings capacity to repay a property loan.

The commercial bank therefore acts in the interests of the economy by centralising risk which it assumes in place of other economic stakeholders, thereby promoting growth. For their part, the financial markets bring sufficiently large and well-informed borrowers and lenders into direct contact, leaving them to manage all such risks.

There is a clear understanding of the importance of defining the most appropriate regulations to enable the banks to fulfil their role while guaranteeing maximum security for their depositor clients and, more broadly, the financial system as a whole.

The most recent crisis confirmed the intrinsic instability of finance. And the inescapable necessity of effective bank regulation. But it has to be given in the right doses. Any overreaction which excessively restricts the risks taken by the banks would give rise to another – and equally worrying – danger, namely that of strangling the economy by curbing the availability of finance. Only in very limited circumstances can the markets take the place of the banks. Excessive restrictions may also push the banks into transferring risk to companies and the general public by directly or indirectly selling them their securitised loans or, for example, by primarily only granting variable-rate property loans. This could also encourage a form of parallel, “shadow” banking system which is virtually unregulated.

By over-reducing bank risk due to the otherwise perfectly legitimate desire of obtaining “Phoenix banks” rising out of their own ashes (bail-in) and not needing to be saved by the state (bail-out), could lead to the trading risk taken by the commercial banks being transferred to other players in the economy, ultimately the taxpayers.

So correct regulation can only be arrived at through precise analysis of the situation in question. The indispensable and irreducible role of the banks in the economy must therefore be correctly understood to avoid an outcome contrary to the desired objective.

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Bank Global economy

What are banks for ?

Banks have been widely held responsible for the financial crisis which began in 2007. The reality is more complex, although banks – especially those in the US and UK – were certainly implicated in the crisis and may have aggravated it. However, our purpose here is not to hark back to the origins of the crisis but rather to answer questions regarding the purpose of banks and their usefulness in support of the economy.

The fundamental role of a commercial bank is to collect savings and make loans. This may be self-evident, but it is at the heart of the matter. And this can be demonstrated in developing economies, including emerging economies, where banking among the wider population is rare. In such countries a proportion of national savings, the largest proportion, does not flow within a rational and efficient allocation circuit. Most of the population invest in assets, sometimes leading to bubbles, or hoard their assets in cash. This is an inefficient system at the end of the day, as savings are not invested in support of growth, namely in individual and company projects.

The reality is somewhat different in France, of course, as the multiplication of branches since the 1960s has led to nearly 100% of the population holding a bank account. In developed countries, banks therefore play an essential role in the collection and proper allocation of savings. In particular, the ability to obtain loans from economic players in the financial markets has been severely reduced, with the exception of large companies and certain medium-sized ones. Issuing debt on these markets means you have to be known, you must make regular issues, frequently use rating agencies and therefore spend significant amounts of money to ensure the abundance of information about yourself. You have to be of a certain size to be able to absorb the costs involved, to entice investors to analyse your accounts and, accordingly, reduce what is known in economics as information asymmetry between the lender and borrower.

Yet all players in the economy have financing requirements. And this is precisely the role filled by banks thanks to their in-depth knowledge of borrowers, whether households, professionals, SMEs, medium-sized companies and even large concerns. Over time such in-depth knowledge enables banks to understand the profile of the borrower, the context of the loan and therefore to adequately take into account the credit risk. They are also helped in this by their management of their clients’ payment flows.

The usefulness of banks is also clear for savers (investors). Most lack sufficient financial standing to take on a concentrated credit risk with just a few debt issuers. So it is the bank’s role to borrow from savers and to take the credit risk with clients requiring financing which, in the event of a proven risk, has an impact on its own balance sheet. In other words, by investing in banking products, savers take a risk with the bank and not with the multitude of borrowers to whom the bank lends. Through its intermediation, the bank therefore plays a crucial economic and social role, both by matching up financing needs and capacities and itself taking on credit risk instead of the savers.

The second role of a bank is to take on interest-rate and liquidity risks which arise from its activities of collecting savings and granting loans. This is its activity of “transformation” (of deposit and loan maturities). In practice, households and companies alike most often favour short-term investments that are readily available. But most borrowers wish to borrow over the long-term that is over a sufficiently long duration so as to make a return on an investment in a company or gradually generate a savings capacity to pay off a property loan, for example.

The markets can certainly play a role in this respect. But purchasing a seven-year bond issued by a company, for instance, not only carries a credit risk for the investor over many years, it also entails an interest-rate risk that gives rise to a risk of capital loss in the event of resale prior to the term. Purchasing bonds or any other type of debt entails a capital gain/loss risk, according to fluctuations in interest rates.

These may vary wildly as has happened many times over the past thirty years. On the other hand, if a saver makes an investment through a bank, then he bears no risk of capital gain or loss, as the interest-rate risk has been transferred to the bank which has the required professional expertise to manage it, and which complies with prudential regulations in such matters. The bank records any losses associated with the occurrence of such a risk in its own books, yet without undermining the value of the investments of its saver-customers, unless the bank itself goes under.

In addition to interest-rate risk, lending over the medium term and borrowing over the short term entails a liquidity risk. Savers who have made short-term investments or deposits may wish to withdraw their money while it is frozen by the bank in medium-term loans. In the markets, the liquidity risk is offset in principle by the secondary market. A share or bond can in principle be sold on this market at a capital gain or loss (see above). But in reality liquidity is “self-referential”.

A market is not liquid intrinsically but because investors believe in it. Should this belief disappear and investors have fears about liquidity, they will stop buying and no sales will take place or only at prices way in excess of the “normal” value of the securities in question. This liquidity risk is borne by everyone who directly participates in the financial markets. In the case of the banks, liquidity risk is managed by the bank on a professional basis and, once again, in compliance with ad hoc prudential ratios. As a last resort, central banks may intervene and provide liquidity for the banks. This happened on an international scale in 2008, and then again in 2011 during the euro zone’s specific liquidity crisis.

In summary, banks are not only indispensable for the rational allocation of savings but also, and unlike the markets, they also assume credit risk, interest-rate risk and liquidity risk in the place of their customers. And such risks are taken under regulation and supervision. Banks’ specific and irreducible economic and social usefulness is based on these functions as a whole.

In this paper we will not cover investment banks, which play an advisory role and whose purpose is to participate in the financial markets as an intermediary, placing buyers and sellers in direct contact and originating securities on behalf of borrowers.

One question needs to be addressed today: do the new banking regulations improve banks’ ability to manage risk? Macro-prudential regulations are vital, as the markets can regularly become disconnected from economic fundamentals. The more markets are globalised, the more volatile they become and the greater the risk of bubbles emerging. Self-evident market errors therefore occur regularly.

For example banks, like the markets, may be encouraged in more euphoric times to lend too much, causing borrowers to incur too much debt, thereby contributing to the development of credit bubbles on assets (shares, property, etc.). This then leads to turnarounds and overly sudden credit rationing and sharp falls in asset prices. Furthermore, and this is the historic basis of regulation, micro-financial regulation is required to protect savers’ deposits in every bank and hence ensure the stability of the banking and financial system, which is indispensable to a smooth-running economy. But when clear and repeated market errors occur, regulatory errors can also be made.

Given the requirement to comply with minimum solvency ratios, regulation obliges banks to hold sufficient capital in light of the risks they assume (market and credit risks). Regulation also makes it possible to reduce liquidity risk since Basel III.

Yet some regulations at times have undesired effects. For example, certain conditions were pro-cyclical under Basel II. They actually exaggerated both euphoric and depressive effects. By enabling banks to reduce their capital or increase their commitments in the event of an upturn in the economy and financial markets, they encouraged greater risk-taking, leading to speculative bubbles (credit, market and other). Conversely, in the event of a downturn, banks had to increase their capital or reduce their commitments without delay, while making provisions on loans and adopting negative positions in the financial markets, thereby accentuating the depressed economy. Basel III has at least partially corrected these pro-cyclical effects by requiring contra-cyclical capital buffers. Sometimes a regulator over-corrects past crises and fails to anticipate future crises.

One problem is always encountered with each new phase of prudential regulation: how to strike a balance between too little regulation, which would pose a risk to financial stability, and too much regulation, which poses a no less tangible risk to growth and, potentially, to financial stability itself. Cutting too sharply the interest-rate, credit and liquidity risks taken on by banks within the context of their commercial activities would in turn hamper economic activity or transfer such risks to other participants in the economy, namely businesses, the general public or professionals.

For example, to avoid taking interest-rate risks, UK and Spanish banks developed variable-rate mortgages. As rates rise, borrowers find themselves under pressure, even trapped. Unlike the banks, non-bank players in the economy are only rarely able to manage such risks, which are inherent to economic activity and to a discrepancy between the wishes of economic players with financing capacity and those who require financing. Accordingly, each time banks are asked to take too few risks resulting from their economic activity as lender and collector of savings[1], this risk is transferred to players who are neither regulated, supervised nor professional.

Too much regulation excessively reducing the ability of commercial banks to take on the risk inherent to their economic role would in practice lead to a reduction in their business activities, transferring risks to non-regulated players – either directly to economic participants who are ill-suited to manage such risks or to the “shadow banking” sector, leading to a build-up of uncontrolled risk. This is what has once again been happening over the past three years on a very large scale, as the IMF, very recently pointed out by sounding the alarm over the potential danger of systemic risk.

Furthermore, if in order to reduce the volume of risks taken by banks we encourage them to further securitise their loans, they once again transfer their interest-rate, credit and liquidity risks to investors which are little or not at all regulated. To which it should be added that securitisation increases the volatility of banks’ earnings.

Normally, a variation in commercial banks’ earnings is a slow process as they live off the margins between the interest rate on their stocks of loans and that on their borrowings and deposits, and off the commissions on the services and products they market. But if banks were tomorrow required to securitise their loans much more, instead of being calculated on their stocks of loans, their earnings would be dependent on the volume of loans produced in a year, on throughput, making their earnings unsteady – hardly conducive to overall financial stability.

Though a source of instability in many ways (inconsistent earnings by banks and transfer of risks from regulated banks to other, unregulated players), securitisation can nevertheless be positive, provided it takes place on a marginal basis and under the right conditions. The sub-prime example is proof enough that banks are capable of the very worst in this area.

To avoid such excesses, banks must remain responsible for the loans they provide (retaining a minimal percentage of risk on securitisation as provided for in Basel III, in order to avoid the “moral hazard” effect), and they must retain most of their loans on the balance sheet. Securitisation can only be a supplementary – and regulated – solution if financial stability is to be maintained.

Following the financial crisis a new objective emerged, one that is understandable, but dangerous if becomes obsessional, namely that of never again bailing out the banks from the public purse, that is, the taxpayers. Hence all the new regulations and those being worked on to avoid government bail-outs or to force bail-ins via the banks’ shareholders and creditors, following the idea of a “Phoenix” bank rising from the flames. The objective is laudable, but it must be well targeted. Remember that in France banks have paid back all the money lent by the state during the crisis. But above all, the wish not to have to bail out the banks via the taxpayer, though it must legitimately lead to more effective prudential rules, must not excessively trim the risks naturally taken by banks in the course of their commercial activities.

Banks are simply the risk depositaries, notably interest-rate, credit and liquidity risk, as stated above. Let us repeat it once again, the banks themselves take on the risks. And this enables other economic players to take significantly fewer risks or avoid them altogether. They do this in a professional and regulated manner, under supervision which must be unfailing. If the risks taken by banks are overly reduced, this will not lead to taxpayers spending less. If the banks themselves no longer adequately concentrated all the risks, the economy would be strangled or, without actually reducing risk and even increasing it for the reasons stated above, it would be transferred upstream to other economic players, namely the taxpayers. This would increase precariousness in times of tension or crisis; risk would be scattered and its traceability lost. With time, general financial instability would be increased.

Of course, here we are interested in the risks inherent to banks’ commercial activities and not to their proprietary market activities. So these different situations must be clearly separated out in order to establish fair regulation. The indispensable and irreducible role of banks in the economy must be properly understood to avoid harming the economy and possibly causing an outcome that is the opposite of the one being sought. And finally, as is so often the case, effective and durable solutions require judgement and moderation.

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[1] Thoughts in Basel are currently turning to implementing stricter regulations for the interest-rate risks taken on by commercial banks by modifying agreements for flows of sight deposits, considering – contrary at least to the French experience – that deposits are less stable; this therefore further constrains the ability of banks to convert short-term savings into long-term loans. This would then prompt banks either to increase securitisation or transfer their interest-rate and liquidity risk to non-banking economic players.

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Olivier Klein and Karine Berger discuss the draft law on the separation and regulation of banking activities

At the roundtable, which took place on 27 June and was jointly organised by law firm Carbonnier Lamaze Rasle & Associés (CARLARA), Bulletin Quotidien and Correspondance Economique, Karine Berger, the French member of parliament (PS) for the Hautes-Alpes and rapporteur for the draft law on the separation and regulation of banking activities, and Olivier Klein, CEO of Bred Banque Populaire and a professor at HEC, emphasised the need to reduce financial instability whilst maintaining the competitiveness of French banks.

The discussion, which was introduced by Edouard de Lamaze, focused on the draft law on the separation and regulation of banking activities. The draft law, which was passed by the French Senate at its second reading on 27 June and is scheduled for review by a joint committee today (before a formal vote on 17 July), is a key measure in President François Hollande’s programme, as Mr. de Lamaze pointed out. Alongside Germany, France will be one of the first countries in Europe to implement the separation of banking activities.

Reducing the systemic risk and moral hazard that lead to financial instability

Ms. Berger and Mr. Klein stressed the need to regulate the systemic risk and moral hazard intrinsic to the financial system to avoid recurrent financial crises. Ms. Berger said that the separation of speculative banking activities from those that are useful for the economy (Title 1 of the draft law) was an effort to respond to this issue. “To understand speculation, we have to go right back to the roots of the crisis in the autumn of 2008. A combination of insufficient liquidity and solvency was involved, which Basel 3 is designed to tackle, but the most important aspect was the discovery of systemic risk and moral hazard.

The systemic risk can be seen in the fact that a single bank can jeopardise an entire economy by ceasing to operate. The fact that the banks know that their governments will rescue them whatever happens, effectively encouraging them to take unacceptable risks, represents moral hazard,” she said. Michel Rouger, chairman and joint founder of the PRESAJE institute (the French thinktank that carries out social research in the fields of law and economics), former chairman of the Paris commercial court (1992/1995) and former chairman of the Consortium de Realisation (the defeasance entity for Crédit Lyonnais) (1995/1998), argued that the system should “have the courage to allow banks to fail, which the French people and their government refuse to do, for the good reason of protecting ‘deposits, which are just what is available before taxation takes it off you.’ (…) The Americans didn’t hesitate with Lehman Brothers, and neither did the UK. The only truly effective way of making bankers responsible is confronting them with their own failure.”

Mr. Klein said that the 2008 crisis had not, in the strictest sense, originated with the banks, but “from a transitional phase in the globalisation process, with global overproduction, which had been masked for some time by global over-indebtedness. The financial system was at fault in that the investment banks, particularly in the US and the UK, found highly imaginative ways of preventing this over-indebtedness from coming to light.” BRED’s CEO stressed the “intrinsically procyclical and unstable” nature of finance.

“Finance cannot self-regulate indefinitely, as traditional economic theory suggested, because there is no clear equilibrium value for the price of financial assets that are based on a promise of future return when the future is hard to predict. This is why prudential regulation is necessary.” However, he added, although there were market errors, these had been compounded by errors in economic policy and prudential regulation. These regulations need to be appropriate and take full account of their macro-economic effects, avoiding any procyclical tendencies.

Picking up on a road safety analogy made by Ms. Berger, Christian Walter, associate professor at the IAE at the Université Paris 1 Panthéon-Sorbonne and head of science for the History and Epistemology of Finance programme at social research institute FMSH, pointed out the limitations of the conventional diagnosis of the crisis, and, therefore, of the remedy provided by the new banking regulation, because the blinding effect of the technical instruments used had not been taken into account: “Even if the highway code (regulation) has been properly established and the signage (information) is in place, and even if he is driving legally and not under the influence of alcohol or drugs (ethics), if the speedometer is faulty, the driver will believe that he is travelling at 30km/h rather than 100km/h, and the car will come off the road.

The current remedies (regulation, information, ethics) do not include instruments. Misleading instruments helped to destabilise finance and increase moral hazard.” Mr. Walter wondered whether the problem could be due to “a faulty speedometer. Even if the highway code is rewritten, if the driver believes he is travelling at 30km/h when he is at 100km/h the rules are not enough.”
Ms. Berger responded that “information has a cost, and the asymmetry of information is precisely why the financial markets are not efficient. But there is no solution, it’s a negative factor that we cannot correct.”

In view of this, international financial regulation would appear to be necessary. However, Yves Jacquot, Deputy Chief Executive of BRED, commented that errors in regulation could also represent a “systemic macro-risk”. Ms. Berger, citing the example of the International Financial Reporting Standards, which have created “volatility and instability”, said that it was international debate that led progressively to good regulation, and that she no longer had faith in purely local regulations. Mr. Klein agreed, stressing that regulation had to be international to avoid risks relating to inadequate regulation.

Mr. Klein also said that the issue of the separation of banking activities needs to be supported with a raft of measures, such as stronger bank solvency and liquidity rules (cf. Basel III), spreading risk-takers’ remuneration and adequate regulation of “shadow-banking”. Title II of the draft law therefore aims to establish a winding-up mechanism to prevent crisis contagion. “This is a vital tool, as the crisis in Cyprus showed,” said Karine Berger. “But it’s not enough – we have to have international regulation, starting with Europe and the creation of banking union.”

The creation of a High Authority for Financial Stability (Title III) by the draft law – “a first in France and in Europe,” as Ms. Berger pointed out – would improve supervision of systemic risks. Equipped with “extraordinary macro-prudential powers”, the authority could, amongst other things, “decide on the unilateral reinforcement of prudential solvency and liquidity ratios.”

“There are indicators for speculative drift, which can pick up bubble development with a good level of probability, alert the markets and act accordingly at macro-prudential level,” added Mr. Klein. On this subject, Michel Rasle, a partner at CARLARA, enquired about the situation in the Chinese banking system. Ms. Berger reassured him that it was not a global systemic problem. China had a combination of too-rapid lending growth and over-developed shadow banking, which had created some jerkiness, she said. But China definitely had the means to regulate this, because national savings as a percentage of GDP were very substantial and the central bank had huge reserves.

Separating useful market activities from speculation: the dividing line is hard to establish

The key thrust of the legislation, which is the separation between speculative market activities, to be ring-fenced within a specialised subsidiary, and activities regarded as “useful for the economy”, was not easy to define, pointed out Ms. Berger. The Liikanen report, submitted to Brussels, recommended hiving off all market activities, including market making, within a single subsidiary. The French legislation initially stipulated only the separation of proprietary market activities, leaving market making within the parent company.

Mr. Klein said that, while there was “some porosity” between trading and market making, the two activities were different: “Pure trading relies on short-term market price variations. It is, in theory, and in practice, useful for setting an equilibrium price on the markets: but since the equilibrium price is hard to define, pure trading, through mimetic behaviour, may also strengthen speculative bubbles. Trading should therefore be allowed, but it should be regulated to make these transactions slightly more difficult to carry out. Market making, which consists of transactions carried out according to the requirements of buyers and sellers, is useful in creating liquidity and depth in the financial markets, allowing each party to find the appropriate counterparty at the right time.” In the end, the legislation had achieved a good balance in this regard, he said.

Ms. Berger said that she had reached the conclusion that market making was no different from any other market activity, which was why the National Assembly wanted to go further, with an amendment enabling the minister for the economy to set the proportion of market making to be separated by ministerial order. The decree would allow for a posteriori adjustment to European legislation, separating out 0 to 100% of market making. Olivier Klein shared this concern: “The banking law relies on France and Germany being able to influence Europe upstream. If European legislation doesn’t go our way, we have to make an adjustment to avoid a patchwork of regulation in Europe and a potential disadvantage for French banks.”

Philippe Croizat, a partner at CARLARA in Lyon, expressed concern about spin-off costs for the parent company, remarking that the subsidiary dedicated to speculative activities would have to be overcapitalised. Ms. Berger said that there had been some difficulty with communication on this subject, but that she could categorically state that the major risk criterion would prohibit the parent from transferring equity or cash above a certain ratio. She explained that the parent company would not be 100% responsible for the segregated subsidiary, but would regard it as a third party, and therefore could not lend to it as it did under current legislation, which stipulated risk limited to 25% of equity, when in practice a 10% limit was applied. The subsidiary would therefore have to seek third-party financing and be subject to scrutiny, which would increase its borrowing costs. Mr. Klein concluded by saying, “I don’t think that many subsidiaries will be created, because they will probably be very expensive to operate. But while we know that speculative risk must not be allowed to place banks in fundamental danger, we have to be careful not to suppress trading completely.” He added that, if any danger of systemic risk relating to derivatives was to be avoided, their use had to be subject to better international regulation, favouring organised markets, which offered more security.

In response to a question about banking governance from Arnould Bacot, a chartered accountant at audit firm Tilia, Karine Berger explained that the draft law had been designed to ensure that members of the board of directors could not hold office simultaneously in parent companies and subsidiaries. The subsidiaries would also have different managers and different names from the banks spinning them off. Thibaud de Gouttes, executive director in charge of the hedging of financial institutions at Nomura Bank in Paris, wondered whether the draft law would be compatible with mutual and cooperative groups formed of regional banks and central bodies. Mr. Klein said that, regardless of their structure, if these groups had to segregate their activities, they would be able to create their subsidiaries under the terms of the law.

Safeguarding competitiveness in the French banking industry

The roundtable members also voiced concerns about the effects of the draft law on the competitiveness of French banks. Mr. Klein pointed out that “market making also includes the derivatives markets, in which the French banking industry is strong. We also have to protect the French banks’ market-making capacity so that this position is not destroyed by non-French banks.”

Another cause for concern is the bank charges payable in the event of payment incidents. The caps on these charges are the main bone of contention between the National Assembly and the Senate. The lower chamber wants to establish a single, universal cap for all consumers, while the upper chamber aims to set a second, lower cap for the more vulnerable.

Mr. Klein said, “Over the past five years, we have undergone so many successive regulations on bank charges that we have lost 4.5% of net banking income.” He warned that the environment was so unfavourable to growth in net banking income that banks’ profitability models could be negatively affected and they might stop hiring when the banking sector employs over 400,000 people. He also said that, as well as removing responsibility from the persons concerned, there was a risk that “low-cost” banks could be created, with no customer service, which would eventually penalise the French economy. “The bank charges regulation should only concern the most vulnerable,” he added.

“The new international standards tend to generalise the Anglo-Saxon model of financial disintermediation whose excesses caused the 2008 crisis. Is it not worrying to see European banks withdrawing from their core business by offloading their debt portfolios onto insurers seeking returns? Doesn’t this new wave of securitisation carry new risks?” said Yves Bazin de Jessey, director of institutional management at Banque Saint Olive. Ms. Berger stressed that the phenomenon of loan securitisation by banks was still marginal in France and was worth an estimated €10 billion: “We shall do all we can to ensure that banks continue to carry out their business, i.e. lending. But on this issue, I am more concerned about the choices banks may make with regard to returns than about the impact of the regulations.” 

O.Klein-K.Berger discuss the draft law on the separation and regulation of banking activities (PDF)

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Olivier Klein’s Preface for “Digital Banking”

I was open to the idea of this book on digital banking for two reasons.

First, I know the Exton Consulting partners owing to my five years working with them. I highly valued their ability to understand the issues with which they were confronted and the remarkable support they provided to us in an effective and pragmatic way.

Second, digital banking has been, for several years, my top-most concern because it is at the heart of discussions on the multi-channel bank and the client distant relationship management. It has been my main concern both as a banker, including in the developed strategy the challenges that the client relationship poses on digital channels, and as an economist, aware of the need to anticipate the technological and societal developments of our times.

The traditional French banking sector has been faced for several years already with structural and economic phenomena that are a prelude to a thorough, but necessary transformation. The growth of digital banking is, within this context of changes, a key and even major driver of this transformation.

The first phenomenon is heightened competition reinforced by the crisis. The banking sector has had to bear the brunt of very strong competitive pressure (deposits, credit, insurance, and services). This pressure has had an impact on both lending volumes and on profit margins, but also on fees and bank charges. As a result, the rise in net banking income of French retail banks has been very sluggish since 2006. The French retail banking market is stagnant or is growing very slowly as a result of weak economic growth, slow population growth and because most people already have a bank. Consequently, banks must find other growth outlets in order to stop attrition: each bank therefore tries to bolster its position by trying to win over potential clients and offering its existing clients new products and services. The growth of multi-channel and digital banking is crucial to the French retail banking sector to ensure that such growth is profitable.

The second phenomenon is the thorough transformation of the client relationship. This is what I have called the “client revolution”. Because clients have become very demanding, banks must be able to meet these new client expectations which arise from a strong need for local relationships regardless of the channel used, ease of use, as well relevance and personalization of the advisory services provided. Ease of use, as clients want a simpler, easier-to-use and easier-to-reach bank. Ease of use means availability, extended operating hours and being able to do business with the same person. Relevance of advisory services, as clients also want more advisory services that are increasingly tailored to their needs. They also demand that these services be truly personalized. This means that they want to be able to do business recurrently with the same advisor.

The technological revolution intensifies the client revolution and the need for more ease of use and relevance. The availability and immediacy that new technologies offer gives clients the impression that that there are no limits to the flow of information and they expect their bank to be more accessible as well as a new means of providing assistance. Keeping and maintaining a special relationship with them must now require using the internet and mobile telephony devices as indispensable and major channels in the relationship, which come to supplement the relationship with the advisor. These developments will only accelerate with the arrival of new generations of clients who have grown up using digital technology on a day-to-day basis.

Without going into the analysis and examples outlined by Exton on the following pages, which will allow the reader, according to his or her concerns – payments, social networks, new client experiences, etc. – to round out his or her vision of the need to expand digital services, I would like to leave you with some thoughts on the near future for retail banking in France, a country which must put all efforts in digital banking.

Think clients first

Have banks forgotten over these last ten years that the major difference between banking and other product and service distribution sectors is the personalized relationship the banker has with his or her client? As a provider of advisory services, a bank must know its client one-to-one. The bank is not a provider of products and services for immediate consumption. It is not there to meet its clients’ short-term needs.

First and foremost, a bank is a local institution which must inspire trust. It is an institution with which the client enters into a long-term relationship and which advises the client on life and family projects. The various product categories such as savings, credit and non-life insurance are by their very essence links to the present and future that make it possible to achieve life projects. To better meet these needs, we need to think about the client first before thinking about the product.

This paradigm shift is the key to selling more products and services and sustainably so. It is also the key to increasing their satisfaction, loyalty and word-of-mouth recommendations. We must promote the process which consists in knowing the client, identifying their expectations, their needs and those of their friends and families in order to offer them suitable products and services. This process will allow banks to develop a unique, trust-filled relationship over time. This relationship is, so to speak, a win-win relationship with clients. In addition, it gives advisors more independence and is more worthwhile and satisfying for them. It is also good for the sales staff.

Thinking about the client first is a response to the client revolution. It must include digital banking in order to meet the challenges facing the retail banking sector.

Digital is a must for creating a distance-less, multi-channel bank.

Not long ago, knowing and optimizing the client relationship via telephone and the internet was the mantra. Today, it is no longer the concept of remote banking which makes sense, but rather the idea of a distance-less bank. This will make it possible to nurture the ties between the client and the bank, and specifically with the bank advisor at all times over all the channels through which banking products and services are provided.

This new proximity is felt by both the client and advisor and is reflected in a multi-channel vision of the bank, in fact, the bank branch itself. The bank advisor is the key asset in this new relationship which puts the client at the heart of the relationship; he is at the heart of the multi-channel relationship. Regardless of the channels used, it is the bank advisor who performs a thorough overview and understanding of the client’s needs and meets these needs.

The bank advisor gets an overall understanding based on all of the client’s needs by offering the entire range of products and services to come up with the best banking solution working together with his/her client who now acts as both consumer and decision-maker. The client, who consumes products and services through various channels, chooses the channels that he or she will use to do business with the bank. These channels and their interactions, whether they consist of a face-to-face appointment at a branch or an online or mobile device contact, must be overhauled, mutually enriched and the walls between them torn down.

The successful bank of today and tomorrow will be a bank that is able to respond to this client revolution profitably and sustainably, i.e., to satisfy new client demands. The response will be a client-oriented, digital bank in which the bank advisor acts as the key player. It will also mean the blending of the best of the traditional and modern bank.

These topics are the heart of the BPCE Group’s strategy, both at the Banques Populaires as well as the Caisses d’Epargne. The goal is a new, digital definition of banking to spur everyone, both clients and advisors, to act.

Categories
Bank Economical and financial crisis

Financial crisis : something old, something new

Financial crisis follows financial crisis, each one originating and playing out in fundamentally similar ways, while also displaying some unique characteristics. Every financial crisis takes at least one of the three classic forms that have been regularly observed from the 19th century to the present day. They often take the three forms in turn or simultaneously. The following analysis is inspired by the work of Michel Aglietta and economists from the Bank of International Settlements.

The first form of any banking crisis, past or present – we could even say it is the oldest form of crisis – is the speculative crisis. How is it that assets (shares, property, gold, etc.) can become the subject of speculative bubbles? It is because their prices, unlike those of reproducible industrial or commercial goods or services, do not depend on their cost price, or what economists call their marginal cost. That is why they can diverge so significantly from their manufacturing cost.

Asymmetries

The price of a financial asset is ultimately a function of the confidence that people have in the promise of future earnings it could yield, a promise made by the issuer. But determining the price also requires each player to anticipate how much confidence others will have in that promise. Everyone is thinking along the same lines.

As long as information is not readily shared (between the lender and the borrower, the shareholder and management, or between market players themselves) and the future remains highly uncertain, these informational asymmetries and this fundamental uncertainty drives players to imitate one another. Under these circumstances, it is very difficult to ascertain the intrinsic value of the asset in question and thus to bet on it. In this case, the market is dictated by others, as it is a pure product of the majority opinion that emerges. Players imitate each other rationally in an effort to anticipate and play on market trends, and this process is entirely self-referential. That is how strong, long-lasting speculative bubbles arise. These bubbles end by bursting suddenly when the majority opinion swings in the opposite direction, in an even more dramatic fashion than during the previous phase.

The market is a pure product of the majority opinion that emerges.

Euphoria

The second form, a credit crisis, occurs when a long period of growth causes everyone (banks and borrowers) to gradually forget the possibility of a crisis and to believe that there is no limit to the expansion. During this euphoric phase, lenders dangerously lower their sensitivity to risk and leveraging (the ratio of debt to wealth or income for households or net assets for companies) reaches levels that any objective observer would consider inadvisable. And this phenomenon is further amplified when lenders stop evaluating borrower solvability on the basis of their likely future earnings and begin using the metric of the expected value of the financed assets (especially shares or property) or of those that are used for collateral.

During this phase they also accept margins that will not cover the future cost of risk for the credit in order to compete with others. The financial situation of these economic actors proves to be extremely exposed when the reversal occurs. Then, when the crisis finally arrives, lenders (banks and markets) have an extreme change of heart in terms of their willingness to take on risk, and they run to the opposite extreme in terms of volume and margins, until a credit crunch occurs, further worsening the economic crisis that caused it.

Distrust

The third classic form of crisis: a liquidity crisis. During the dramatic events of financial crises, a contagious sort of distrust takes hold. This is typical of the financial and banking crises we know today. For some banks, this distrust leads their customers to withdraw their money in what experts call a bank run, causing the bank to fail.

It can also cause banks to slow down or even stop lending to each other altogether, fearing a chain reaction of failures. This illiquidity in the market for interbank financing – unless central banks intervene as lenders of last resort – produces the very failures they feared. There are other forms of illiquidity that can occur. Some financial markets go from being liquid one day to illiquid the next, due to the fact that the idea of market liquidity is again highly self-referential, as an analysis by André Orléan shows. A market is only liquid if the players think it is. If they begin to doubt its liquidity, all the players will try to sell so they can exit the market, and by doing so they cause the illiquidity problem from within. In the current crisis, the most emblematic case is the market for ABS (asset-backed securities).

A market is only liquid if the players think it is.

One Thing Leads to Another

These types of crises often intersect and join forces to create an extremely serious situation. For instance, credit can expand too rapidly, through abnormally high growth in the prices for the assets being used as collateral for these loans. This makes asset prices balloon, as additional purchases are made possible by these easily obtained loans. That is when a self-fulfilling and potentially long-lasting phenomenon takes hold with markets that are unable to return by themselves to “normal” levels. By the same token, the liquidity crisis may be caused by a sudden panic about the value of the bank bonds and financial assets held by financial institutions.

Looking for liquidity, banks invest less in the economy and attempt to sell off their assets. In turn, this fans the flames of the speculative crisis and the credit crisis. The devastating crisis that began in earnest in 2007 is, like previous crises, a combination of all three of these forms. It first began as a speculative housing bubble, especially in the United States, the United Kingdom and Spain. Then it became a credit crisis caused by a dangerous rise in household debt levels in these same countries and overleveraged investment banks, LBOs and hedge funds. And finally it turned into a liquidity crisis in securitisation and interbank financing markets resulting from the after-effects of the Lehman Brothers bankruptcy. Each crisis aggravated the others in a self-perpetuating cycle.

Hidden Aspects

What makes the current crisis unique is the rapid development in the last few years of securitised debt instruments.
Through securitisation, credit institutions were able to transfer debt instruments for individuals, companies and even municipalities off their balance sheets. These instruments were then haphazardly combined into bundles into that were themselves overleveraged; these were then sold to other banks, to insurers and to investment funds, in short, to anyone and everyone.

Securitisation helped increase the financing of the global economy, as it enabled banks to grant more loans than they would have been able to if the loans had remained on their balance sheets. But this technique led the banks who used it the most (notably in the United States) to significantly lower their standards for selecting and monitoring borrowers and to provide loans to agents that were increasingly insolvent, because once they were securitised the loans no longer posed a threat to the banks. That is how the number of subprime loans proliferated, which further amplified the credit crisis that hit after the housing bubble burst.

Unregulated securitisation significantly aggravated the credit and liquidity crises. The fact that the loans were so difficult to track and the practice of bundling good and bad loans into the same securities, along with the opacity and complexity of the securitised instruments (CDOs made of CDOs, etc.), expanded the scope of the crisis as well. As the players involved no longer had any confidence in the quality of these kinds of investments, or even in their own understanding of them, liquidity was suddenly brought to a halt. Fears about the assets held on bank and insurer balance sheets caused a liquidity crisis in one fell swoop, especially for interbank lending, on a level that many had thought would never be seen again. Governments found themselves faced with the increasingly difficult task of solving these problems. The first lesson to take away from this has to do with the unregulated boom in securitisation and the role this mechanism should play for banking in the future.

Deception

Ratings agencies also played a huge role, as they gave the highest rating (AAA) to tranches of these instruments based on mathematical models that used poorly understood restrictive assumptions and solely analysed past series. This rating proved to be essentially worthless as the crisis unfolded. These ratings, which did not cover the liquidity risk, led many investors, including banks, to falsely reassure themselves about the quality of their financial assets, without thinking too deeply about how an AAA-rated investment could offer such a high rate of return. Reforms are needed to ensure that these agencies can re-establish objectivity in their work and the credibility that they need to survive.

The combination of the three classic forms of financial crises and the unique features of the current crisis explain the extreme gravity of the situation, involving distressed banks, panicked investors, an ongoing credit crunch and a severe economic crisis. Only strong measures from public authorities, at a time when players have no faith in anyone else, have been able to begin to relax the interbank market and prevent the entire financial system from imploding. Now is the time to act to counter the economic consequences of the financial and banking crisis and to prevent us from finding ourselves in a similarly dire situation again in the near future.

Categories
Bank Conjoncture Economical policy

Escaping banking’s vicious circle

The crisis has led to many banks worldwide suffering losses. And yet, they cannot raise new equity capital in the marketplace since investors fear the health of the banks may deteriorate further. In order to respect their solvency ratio (Basel 2), they are therefore forced to reduce their assets so that they again meet the maximum regulation multiple return (12.5 times) of their equity capital. So governments are intervening by going directly into the banks’ capital, supplanting the market and so counteracting as best they can a credit “crunch” which would be otherwise inevitable.

If this sequence of events is familiar, Basel 2 provokes another one sequence less well known, however dangerous. Even when the banks are not at a loss, when times are rough they are driven to reduce their credits and their market positions. The financial and economic crisis triggers an increasing effect on the calculated value of the banks’ assets. It is not the occurrence of nominal assets but of assets weighted by the risk they represent (risk weighted assets or RWA). This risk is measured by volatility of the positions in the financial markets, and by the probability of failure in the case of credits. In both cases the calculation of risk is based on the events of the recent past. The observation of the price drop in financial assets and of the increase of their volatility raises the value of their weighted assets by their risk and thus leads to the increase of the required level of their equity capital.

At the same time, the deterioration of borrower’s grading caused by the economic crisis mechanically increases the value of banks’ risk weighted credits, and so too their need for equity capital. And yet if, because the stock market doesn’t allow it as is the case today, the banks cannot manage to increase their equity capital to re-establish their ratio, they can only reduce their market positions by selling a portion of their financial assets. In doing so, they worsen the drop in the markets and their volatility, so provoking a new increase in their risk value. In the same way, on the credit side they cannot reduce their borrowings and so de facto they further weaken the economic agents, and the risk value of existing credits. It is here that at this point the vicious circle is perfectly complete!

Of course, faced with this risk of endless deterioration of asset prices and the economy, the Governments have thankfully reacted very quickly by directly investing in banks’ capital or by guaranteeing some of their assets at risk, or more precisely by buying these assets directly. This is absolutely necessary but the action which would help to break the vicious circle at the very moment that it is formed would be to urgently revise the methods of calculation of risk to the banks’ assets, by stopping their worrying procyclicity since they are largely based on recently observed risks. Or instead, by conserving the same methods, to adjust the required level of equity capital in an anticyclical way against the assets calculated in this way. Although today, while the economy and markets are doing well, the banks can take more and more risks with unchanged equity capital, thus strengthening the possibility of a boom. And conversely in the event of a reversal of speculation and the markets. It would clearly be preferable to progressively demand more equity capital since everything improves and maintains the same conservative level when everything deteriorates as it has today.

Even if that is insufficient, this necessary reform requires an international agreement, whereas the Governments intervene nationally. This is why the scope of the current crisis is forcing Governments to act without delay. However, with a certain parallelism, the IFRS standards which themselves are strongly procyclical have been significantly softened as soon as the end of 2008. And yet the urgency for a revision of prudential standards is also imposed. The progressive nationalisation of banks or the investment to their equity capital of funds borrowed by the Governments themselves is obviously essential but cannot be a long-term solution. It must be combined with a conservative structural reform of the calculation of bank equity capital required by Basel 2.