In banking, sophistication and innovation are not necessarily synonyms for 'effective'.
“Regulators have to recognise that the rules of the game failed to keep up with the progressive fusion of banking, capital markets and insurance.” Bank of England Deputy-Governor Paul Tucker
Forgive the title. However, given my nom de plume and the bank named below, it was hard to resist. It’s inspiration was a recent article in the Financial Times (£) one of an increasing number of stories about “new funding models”. This one just happens to have been adopted by Credit Agricole.
The justification for the new approach – for which it is reasonable to assume Credit Agricole Corporate and Investment Bank CEO Jean-Yves Hocher and his team will earn better than execrable fees on relatively large transactions (doing little for smaller french exporters then?) – was described thus:-
his model – which should be in place by the end of the year – will be different from the heavily criticised US version, since he is creating a new organisation within the investment bank in charge of both originating and distributing. The bank will also remain an interested party in the loans by keeping 20 per cent of them.
It may be a step in the right direction (assuming a 20% quota-share retention through the life of the transaction by the bank). But let’s be frank; one step is a short-distance in a marathon.
The methodology is unlikely to improve ‘all-in’ funding costs significantly for the vast majority of corporate customers. ‘Better than bad’ is not exactly a winning line. And it is hardly news that banks are seeking to shift assets off their balance sheets to reduce Risk Weighted Asset exposure amounts. Nor is ‘risk sharing’ through syndication or risk participation agreements a new or innovative methodology.
In reality, we are currently at an economic point where it almost doesn’t matter what funding methodology is proposed by sophisticated [sic] market participants to non-financial corporates seeking to access liquidity. Methods suggested could be bank or non-bank funding; secured (highly likely) or unsecured (highly unlikely) debt, recourse or non-recourse, ABS or ABL, Revolving Credit Facilities, Bond Issuance, Invoice Discounting, overdraft, credit card, private placement or ABCP just for starters. The underlying problems that caused the global financial crisis remain. Credit flow has been slowed by a loss of trust in the quality of existing funding processes and the motivations of credit intermediaries and the uncertainty that Principal will be returned.
This is why it is vital that credit intermediaries begin to address some of the problems that precipitated the collapse in confidence. This means they will need to make more effort to prove how they add value to the funding process rather than extract value from it. It also means they should improve the quality of disclosure to investors (bank and institutional) that moves some way towards establishing that :-
- the gross and net financial interests of transaction participants are – and are likely to remain – reasonably and fairly aligned for the transaction term.
- transaction risks can be monitored and operationally controlled in a timely manner by all transaction participants.
- the Marked value of granular assets – rather than a portfolio of often ineligible assets (aka “a sack of shit“) – used to collateralise funding can be crystallised wherever located (assuming that information is known) on the occurrence of a default event (assuming that has been clearly and legally defined) or the loan successfully repaid if unsecured which may ultimately rely on
- truly effective credit risk mitigation. (see Greece CDS & BIS paper)
- Credit Risk and counter-party data that is high quality, reliable, available to all transaction participants and that supports regulatory oversight of systemic risk. It also enables national supervisors to look inside the ‘black-box’ used to calculate Risk Weighted Asset exposure amounts, funding margins calculated and credit risk monitored on an ongoing basis.
This extract from a BusinessWeek article written by the noted economist Hernando de Soto explains why these issues are so important:-
When then-Treasury Secretary Henry Paulson initiated his Troubled Asset Relief Program (TARP) in September 2008, I assumed the objective was to restore trust in the market by identifying and weeding out the “troubled assets” held by the world’s financial institutions. Three weeks later, when I asked American friends why Paulson had switched strategies and was injecting hundreds of billions of dollars into struggling financial institutions, I was told that there were so many idiosyncratic types of paper scattered around the world that no one had any clear idea of how many there were, where they were, how to value them, or who was holding the risk. These securities had slipped outside the recorded memory systems and were no longer easy to connect to the assets from which they had originally been derived. Oh, and their notional value was somewhere between $600 trillion and $700 trillion dollars, 10 times the annual production of the entire world.
Without addressing these currently unresolved issues, many of the so-called new funding methodologies won’t support the funding pace necessary for Real Economic recovery. The cost of capital will rise as trust in bank-modeled reality slips further.
Without banks fixing the causes of increasing risk premia, the restoration of market confidence will lack resilience.
Whether banks use money-market funds, repo markets, Central bank discount windows, Central Bank artificial respirators, qualifying institutional buyers, other financial institutions, pension funds, insurance companies or retail depositors to provide the necessary liquidity required for transactions to the Real Economy, investors will demand greater returns to replace diminishing certainty.
The challenge for banks is to prove to investors that there is value in investing in bank equity or debt supporting sustainable business models that serve the Real Economy. If there is the faintest whiff that the greater purpose of direct investment in a bank is to create “innovative” solutions that fund bonus pools without offering real social value, commercial banking will simply become value-destroying conduits.
The financial sector must address the clarity and effectiveness of the financial infrastructure they build to connect investors and borrowers. Without doing so, much of their innovation will be seen as sophistry which much of it has been. To survive, winning banks will drop their epistemic arrogance and reliance on structuring complexity and look beyond their own skill-sets for solutions. As Paul Tucker suggests, the financial sector is fusing.
Sadly, the opinions of many of those at the wheel of the school-bus when it crashed are still sought by policymakers. The lack of understanding about the broader role of financial markets (which includes the role of regulated insurance in providing economic safety nets and social value for hundreds of years) is limiting the effectiveness of policymakers responses. As a result, progress through the sludge of reducing global economic activity will remain slow. Moreover, the medicine the banks prescribe which is “more-of-the-same-but-repackaged-and-more-expensive” remains the drug of choice for policymakers and opinion formers but may end up killing the patient.