Money, banking & insurance

Credit Where Credit’s Not Due

During a crisis, there is always a rush to blame the perpetrators and protect the victims. In the case of the credit crunch (not alas, a new muesli bar), the industry took two hits: a financial one and a loss of trust. Even the strongest bank cannot overcome a loss of confidence because money it is owed can’t be called in as quickly as the money it owes. While it was Freddie Mac and Fannie Mae, Northern Rock and Bear Stearns that took the headlines, it is the structural flaws in the system that should be addressed: misjudgement of risk, obsession with yield, and loss of oversight.Some claim the way bankers are paid ensures that they will take the risks for which someone else will ultimately pay. In other words, the profits are privatised; the risks are socialised. Or as Martin Wolf comments, there is a “mismatch between public risk and private reward”. In this case, it is tempting to blame the system, and to impose more rules about liquidity, capital management, pay structures, and to stop bailing out the losers. The trouble with that is that the real losers are the taxpayers, the ordinary people taking out the mortgages and car loans. When governments rescue failed lenders, they use public money (which they could have invested by privatising them). As The Economist notes, “if you cannot let firms fail in a bust, then you must contain them in the boom”.

Some transformation in the industry is likely to happen by itself. For example, the next crisis is unlikely to stem from the American housing market, because so many unregulated lenders have disappeared, demand for complex securitised products has fallen, and people again accept that house prices can and do fall. Moreover, banks will have to find a way to lure their investors and their customers back. They might reduce specialist borrowing, like self-certification mortgages in the UK, or home-equity lending in the USA, although less than half of their losses stem from the mortgages themselves. Most losses arise from so-called “amplifiers”, like the use of derivatives, fair-value accounting, and counterparty risk (banks hurting other banks), and overuse of different types of leverage.

Morgan Stanley says that investment banks will suffer more severely in this crisis than in any other period for 20 years. One study found previous banking crises reduced growth by 5% from their peak, and it takes more than three years to regain previous levels. Last, the Monetary Policy Forum claimed that, if American financial institutions lose $US200 billion, credit to households and companies plummets by $US910 billion. The risks are heady indeed. As Martin Wolf argues, when millions of innocent bystanders suffer like this, it must be “politically unacceptable in the long run”. Credit where credit’s not due.

The Trouble with Bubbles

Humans seem destined to create bubbles, even though they inevitably burst.We might call it “contagious optimism” or “irrational exuberance”. They are qualities not necessarily confined to financial risk-takers, but the effects of these bubbles are far-reaching. The dot-com bubble now seems long gone, the housing bubble has just burst, and more bubbles are blowing in this direction: burgeoning Chinese stock exchanges, gold (because of the US current account deficit), rapid growth in grain consumption, and alternative energy demands. The trouble with bubbles is they do not listen to the facts. Enthusiasm is contagious and, as long as more people become enthusiastic, it becomes almost impossible for others to resist.

Even contrarians can’t be heard.For example, a 2005 survey found San Francisco house buyers expected house prices to rise by 14% each year for 10 years. In fact since 2006, housing prices adjusted for inflation have fallen nearly 15%. It would be easy to blame financial institutions for lending money but, at its heart, there is still the pervading belief that we make money out of homes and stocks so we should keep buying them. One way to reduce bubble thinking is to offer subsidised financial advice for low to middle income earners. Real estate futures markets are another way for investors, as they would tend to reduce future housing bubbles. Overall, better and unbiased information would help to reduce the social contagion of unreasonable expectations. It works the other way too. When there is a recession approaching, it is worthwhile remembering the social contagion of negative expectations, as this exacerbates the economy and social problems. Negative bubbles should be popped too.

Mobile Banking, the Mass Affluent, and Other Trends

It was not so long ago that we might have laughed at the idea of Internet banking.Not so anymore, as branches shift basic transactions online and take on a more sales-oriented, advisory role. The next step is mobile banking but various consultancies predict greater use in a few years’ time, not tomorrow. Banks still have to make sure security is watertight, applications are standard, and they have a clear business case. Not only that, they have to convince the rest of us. Consumers expect much more of their financial institutions than before, particularly as they can readily compare their offers and talk to each other via Web 2.0 technologies like social networks or virtual worlds. (Gartner says 75% of financial institutions will be using Web 2.0 by 2012.) Thanks to new technologies, customers have a multitude of ways to pay for goods, including RFID smart cards, mobile payments, biometrics (fingerprints), and online payments. Banks do not always benefit from new methods, such as online payments direct to the seller.

They also have to continue to reduce costs by becoming more efficient, without sacrificing service to the customers they have already attracted. In many cases, inefficiencies result from historical legacy systems, such as inability to share customer information across all touchpoints.Banks are discovering a new niche in the market for the mass affluent who expect differentiated service, convenience, and rewards for their high-value custom – something the Internet is less able to offer. Even so, 30% of mass affluent customers prefer to go online, especially as they tend to travel more frequently. Woori Bank in South Korea offers a website, cleverly called “Two Chairs”, as well as premium physical services. HSBC offers HSBC Premier, Citibank has Citigold. Few banks offer mobile services, where the banker goes to the client, but this could be valuable to customers with little time. In some ways, the trends in banking are quite similar to those in retail, where the market has split into discount and luxury. Those who use the Internet and ATMs are the bottom end; those who visit hotel-style branches for personal advice are the top end.

Look After Your Own

It is no surprise that as nations become more economically dependent on one another, they are becoming more nationalistic. Newsweek calls it the “new mercantilism”. Countries start to look after their own economic and political interests at the expense of others. Examples are Putin’s hold on natural gas in Russia and Hugo Chavez’s hold on oil in Venezuela, China’s artificially devalued currency, and the US-Peru regional trade agreement. The political foundations are weaker than the globalising power of the Internet and large companies. There are two reasons why the idea of free trade was so popular. First, it was thought that protectionism helped to worsen the Great Depression. Second, trade was seen as a way of combating communism, during the Cold War. Today, the world economy depends on each country feeling that it benefits from being part of it. If some countries start to pursue their own interests selfishly, others will follow. In some ways, it mirrors the way shoppers in developing countries exposed to global products eventually start to support their national brands. But the new mercantilism is more far-reaching.

The World’s Biggest (Islamic) Bank

A new Islamic bank, Noor Islamic Bank, plans to spend between $US500 million and $US1 billion on acquisitions in Europe, Asia and North Africa. In this way, it aims to be the largest Islamic bank in five years. It is 25% owned by the Dubai government and 25% by the Emirate’s ruler. The growth in Islamic finance is not lost on the Bank of Japan, which recently joined the Islamic Financial Service Board. Thanks to crude oil prices, growing middle classes, and new financial technologies that create schemes for sharing profits without taking the form of interest, there is healthy demand for Islamic finance. It might also be another manifestation of the trend above, to look after one’s own in a global market.