How Will the Credit Crisis Affect Treasury Career Prospects?
Financial institutions are holding a large volume of securities of falling and doubtful value, and which imply large losses for them. Further losses are possible from having insured asset values through credit default swaps and other derivative instruments. Trading is not so transparent in the over-the-counter (OTC) markets and there is also massive speculation.
Even if a bank knows that its own balance sheet is intact, it cannot be sure that its counterparty is clear of 'toxic' debt, or in some way exposed to a third party with problems. In this environment of distrust and capital shortage, standard macroeconomic policy instruments can be blunted and a strategy that relies mainly on liquidity provision by central banks, while essential, will not suffice.
What More Must Be Done?
There are five key areas where governments could intervene in ways that would boost economies around the world:
1. As some governments have concluded, the fragility of public confidence has now reached a point that some explicit public guarantee of financial system liabilities is unavoidable. This means not only retail bank deposits, but probably also inter-bank and money market deposits, so that activity may restart in these key markets. Of course, such a step would need to be temporary and include safeguards against the risk-taking that comes with such guarantees, such as heightened supervision and limits on deposit rates offered.
2. The state needs to take out troubled assets and force the recognition of losses. Asset purchases must be done transparently at fair market value. The reasons are not moralistic, though there is such an imperative, but pragmatic. If prices are inflated, then banks will inevitably have to make good the losses that fall on the taxpayer - in the US case, they would have to issue shares to the government, thus diluting other shareholders. But losses deferred to the future prevent new private capital from flowing into banks. If such capital is to be attracted, it is better to pay a lower price now, recognise losses, and give banks an upside if the implied loss turns out to be smaller.
3. Private money is scarce in today's environment and loss recognition alone may not be sufficient to induce fresh injection of private capital. One strategy that has worked in past crises is to match new private capital subscriptions with state capital, which imposes a market test for the use of public funds.
4. A high degree of international co-operation is urgently needed. Unfortunately, recent measures have been taken with national interests in mind, and not enough has been done to prevent unintended consequences that only exacerbate problems for other countries. If one country credibly offers a blanket guarantee (for example, Ireland), investors may move out of countries that do not (for example, the UK). If asset purchase schemes are very different, institutions will go to the most generous buyer. Financial institutions now span many countries and credible rescue plans must be consistent across many jurisdictions. More fundamentally, and looking beyond the immediate crisis, it is clear that the international community needs to work to close the many loopholes in the global regulatory architecture that allowed financial institutions to minimise capital even as they concentrate risk.
5. It is now becoming clear that emerging market countries are likely to be hit hard by the financial turmoil, despite stronger fundamentals and policy frameworks. In case a sudden stop of capital brings their progress to a sudden halt or, worse, brings down their financial systems, some form of large and rapid financing mechanism should be kept ready. There should be no doubt that this fund is prepared to deploy its emergency procedures and flexibility in rapidly approving high access financial programmes, based on streamlined conditionality that focuses on crisis response priorities.
As bleak as the situation now looks, I am convinced that there is a way out of our shared predicament. The trick is to get policymakers around the world to pull in the same direction.
Public Assistance Must Protect the Taxpayer
Government intervention in business usually has unintended consequences. The results of regulation are often disappointing but the scope and scale of the regulation nevertheless expands. Regulation works best when it is narrowly focused on defined objectives. We now regulate airline safety, not the airline business, since prudential supervision of the industry created an elaborate panoply of controls that came to serve only the interests of established operators, and often not even them.
When governments intervene in the banking crisis, their objectives should be equally narrowly focused on what matters to the public, not what matters to the banks. We have no reason to care whether the inter-bank market is functioning well, nor should it be a policy objective to revive the issue of mortgage-backed securities. The inter-bank market was many times larger than needed to secure its economic function, and the residential mortgage-backed securities market should probably never have come into existence: banks will be sounder and their lending decisions wiser if the loans they underwrite are on their own balance sheets.
However, it may feel on Wall Street and Canary Wharf, this is not the worst economic crisis since the Great Depression. Today's problems are not only created by financial markets but also largely confined to them. Compared with the wreckage of Europe's physical infrastructure in the 1940s, or the threats to living standards and social order from oil shortages and accelerating inflation in the 1970s, these perturbations are minor. The greatest threat to the non-financial sector is the effect on business and consumer confidence that comes from apocalyptic headlines.
The travails of the banking system matter less to the public than to bankers, but they do matter. The payments system is an essential utility; companies and individuals must be able to receive cash and pay invoices. The most feared event is a recurrence of March 1933 with customers unable to use their cheque books and locked out of their banks. But the central banks of the world have now flooded the system with liquidity and if your bank cannot pay your bills, it is because it is short of assets, not because it is short of cash.
The next public objective is to reassure those who are rightly uninterested in studying the impenetrable accounts of banks to make sure their savings are safe. The deposit protection measures that are in place - implicit or explicit - are more or less enough to do this. Despite some media sensationalism, the volume of retail deposits that have been withdrawn from big banks are a small percentage of the total.
The largest problem for the real economy, beyond the crisis of confidence, is the difficulty, though not impossibility, that good borrowers find in obtaining credit. This is not because banks do not have sufficient cash, it is partly because they are short of capital. But even better capitalised banks are reluctant lenders. The main cause of the credit shortage is an overdue fit of prudence.
Another lesson from experience of government intervention is that temporary public assistance to get companies over a bad patch is rarely either temporary or effective. When government funding comes in, other funders move out. Things are almost always worse than management admits, or perhaps knows. When the share price or the credit default swap rate has told a different story from the one senior executive tells, the market has generally been a more reliable predictor than the trading statement.
Even large-scale recapitalisation of banks will not ease the pressure on lending much, but it will do so a bit and is certainly the measure most likely to have an effect. All other measures take us down a road whose destination is not clear but certainly distant. Since there are fine ongoing retail and corporate businesses in the banking sector, the idea of separating the good banks from the bad banks makes sense. The scale of necessary recapitalisation may imply a public contribution. But US Treasury Secretary Paulson got it the wrong way round. If taxpayers are called on for cash, they should enjoy the major equity stake in the good bank and leave the value of bad banks behind with the shareholders.
Can Islamic Finance Offer the Answer to Risk Management in Banks?
Important features of risks in Islamic banking
The most common risks are credit risk, market risk, operational risk and liquidity risk. All these risks are also basic principles in Islamic banking:
- Credit risk, conventionally a risk related to lending portfolio, exists in Islamic banking in the same way as in conventional banking. It refers to the non-performance of the counterparty as per the agreed terms. However, the reasons for the origin of the credit risk are different in Islamic banking.
- Market risk, which in conventional banking is based on four factors - interest rates, indices, derivatives and commodities - is based on only three in Islamic banking, which excludes interest rates.
- Operational risk is present in both conventional and Islamic finance, as it relates to systems, processes and people. In Islamic banking, the additional dimension is Shariah risk.
- Liquidity risk exists in Islamic banking in the same way as in conventional banking; however the reasons for this liquidity risk are different.
- Issues related to risk management in Islamic banking
Risks behave differently in Islamic banking when compared to conventional banking. A few points, which should be noted in relation to risks in Islamic banking, are:
- Credit risk is apparently higher in Islamic banking due to the non-availability of legal recourse for defaults, thus increasing the chances of defaults.
- Also, credit risk is higher in Islamic banking due to limited access to credit derivatives.
- Operational risk has another dimension of Shariah risk, which can be treated differently to operational risk.
- Liquidity risk is perceivably higher due to non-availability of money markets, limited recourse to overnight borrowing and higher sensitivity of market and clients.
- Moreover, the additional factors such as deficient legal framework, standards, procedures, qualified manpower and qualified government support increases the risk exposures.
Islamic banking contracts and risk management
The trade policies in the countries with an Islamic finance infrastructure consist of non-recognition of interest in business dealings and non-participation in prohibited activities (usury). Hence Islamic finance contracts are structured with the objective of equitable distribution in mind, avoiding exploitation of the poor and non-recognition of interest as a factor. Trade practices are very similar all over the world in terms of basic trade conditions.
There is also a stress on clarity of the terms of contract to avoid speculation, all goods and services that are not owned by the contracting party cannot be a part of the contract.
A Model Structure?
Several factors have contributed to the growth of Islamic banking, but this phenomenal growth is not without concerns. Islamic banking is fundamentally based on few basic contracts, which can be used to create products as desired. The risk profiles of these products reflect the risk profiles of these basic contracts, and are dynamic and complex.
Islamic banking is fundamentally different from conventional banking and it is suggested that, as Islamic banking does not have interest rates as a variable in the risk equation, it is less risky, since the risks are more dynamic in Islamic banking and they are also generally higher.
