International banking
Risk and reward
May 17th 2007 From The Economist print edition
Worried about credit risk? You should fret more about pension funds than banks
REMEMBER the days when loans were discussed over lunch at the Rotary Club and sealed with a handshake? Pretty soon, the idea of a banker knowing the name of the person he is lending to—let alone inside details of his credit history—could be as quaint a feature of banking's past as bowler hats and Bonnie and Clyde.
Thanks to technological and financial wizardry, loans are now made with little contact between borrower and lender, and are shuffled around the financial system like so many cards at a poker table. Lately, the results of this “arm's length” banking model have looked reassuringly positive. As our survey in this issue describes, international investment banks such as Goldman Sachs and Deutsche Bank have become vast financial-liquidity factories, turning loans into tradable securities, selling them on and earning record profits as a reward. With banks' risk portfolios more diversified and less stodgy than before, banking crises are rare: the closure of a small bank near Pittsburgh in February was the first such institution in America to fold since June 2004.
Yet just because credit risk is more evenly spread does not necessarily mean the system as a whole is safe. Indeed, it may be prone to less frequent, but more violent, shocks, spreading from individual banks throughout the financial system. Thanks to the relentless dealmaking between financial institutions, if (or rather when) liquidity dries up, risks that the banks think they have outsourced to hedge funds, insurance companies and pension funds might cascade back onto their books.
Three forces have enabled the biggest banks to boost the volume and complexity of financial instruments, and the speed at which they are traded. Each has an element of recklessness. The first is the explosion of credit derivatives, which protect buyers from the risk of default. By selling these, banks have brokered insurance contracts to the new holders of risk that in good times produce steady streams of income, but could require huge payouts if markets ever seize up.
The second is the rating agencies, the new arbiters of credit risk. Banks were once the experts on whom they lent to, with inside knowledge on their borrowers. Now that they sell their exposures, they have blithely passed this responsibility on to outsiders, such as Moody's, Standard & Poor's and Fitch Ratings. The agencies have done fabulously well from the stream of new business, but they are further away from borrowers.
Third, the ability of banks to sell their loans may well have led to a lowering of lending standards. Why double-check somebody's books if you are selling on the risk in a matter of days (or even hours)? That became painfully evident this year after American finance companies lent to needy borrowers with poor credit records in the “subprime” mortgage market. Borrowing is also getting easier for private-equity firms, one of which this week threw yet more caution to the wind by proposing to buy Chrysler (see article). Banks have started lending to them with worryingly easy-going covenants, which give lenders scant power to intervene if a loan risks going bad.
Basel: more exciting than you thought
Privately, virtually every investment banker expresses nervousness about the hard-to-quantify “tail risks” in the new banking model. Some have built up plump liquidity cushions in case of disaster. But what about the regulators?
The main answer is the Basel 2 banking accord, due to be introduced next year. In terms of banking, it has plainly had a healthy effect: banks have strengthened their risk-management systems and spread their risks—so much so that many should be able to hold less capital against their loans. The danger, however, is that by focusing on the health of banks, the regulators have shunted problems into less supervised realms of the financial system, such as the pensions industry. If pension-fund trustees, with less experience than banks in judging credit risk, have allowed the wrong investments, the consequences would be grave indeed
Risk and reward
May 17th 2007 From The Economist print edition
Worried about credit risk? You should fret more about pension funds than banks
REMEMBER the days when loans were discussed over lunch at the Rotary Club and sealed with a handshake? Pretty soon, the idea of a banker knowing the name of the person he is lending to—let alone inside details of his credit history—could be as quaint a feature of banking's past as bowler hats and Bonnie and Clyde.
Thanks to technological and financial wizardry, loans are now made with little contact between borrower and lender, and are shuffled around the financial system like so many cards at a poker table. Lately, the results of this “arm's length” banking model have looked reassuringly positive. As our survey in this issue describes, international investment banks such as Goldman Sachs and Deutsche Bank have become vast financial-liquidity factories, turning loans into tradable securities, selling them on and earning record profits as a reward. With banks' risk portfolios more diversified and less stodgy than before, banking crises are rare: the closure of a small bank near Pittsburgh in February was the first such institution in America to fold since June 2004.
Yet just because credit risk is more evenly spread does not necessarily mean the system as a whole is safe. Indeed, it may be prone to less frequent, but more violent, shocks, spreading from individual banks throughout the financial system. Thanks to the relentless dealmaking between financial institutions, if (or rather when) liquidity dries up, risks that the banks think they have outsourced to hedge funds, insurance companies and pension funds might cascade back onto their books.
Three forces have enabled the biggest banks to boost the volume and complexity of financial instruments, and the speed at which they are traded. Each has an element of recklessness. The first is the explosion of credit derivatives, which protect buyers from the risk of default. By selling these, banks have brokered insurance contracts to the new holders of risk that in good times produce steady streams of income, but could require huge payouts if markets ever seize up.
The second is the rating agencies, the new arbiters of credit risk. Banks were once the experts on whom they lent to, with inside knowledge on their borrowers. Now that they sell their exposures, they have blithely passed this responsibility on to outsiders, such as Moody's, Standard & Poor's and Fitch Ratings. The agencies have done fabulously well from the stream of new business, but they are further away from borrowers.
Third, the ability of banks to sell their loans may well have led to a lowering of lending standards. Why double-check somebody's books if you are selling on the risk in a matter of days (or even hours)? That became painfully evident this year after American finance companies lent to needy borrowers with poor credit records in the “subprime” mortgage market. Borrowing is also getting easier for private-equity firms, one of which this week threw yet more caution to the wind by proposing to buy Chrysler (see article). Banks have started lending to them with worryingly easy-going covenants, which give lenders scant power to intervene if a loan risks going bad.
Basel: more exciting than you thought
Privately, virtually every investment banker expresses nervousness about the hard-to-quantify “tail risks” in the new banking model. Some have built up plump liquidity cushions in case of disaster. But what about the regulators?
The main answer is the Basel 2 banking accord, due to be introduced next year. In terms of banking, it has plainly had a healthy effect: banks have strengthened their risk-management systems and spread their risks—so much so that many should be able to hold less capital against their loans. The danger, however, is that by focusing on the health of banks, the regulators have shunted problems into less supervised realms of the financial system, such as the pensions industry. If pension-fund trustees, with less experience than banks in judging credit risk, have allowed the wrong investments, the consequences would be grave indeed