The global financial industry has come a long way since 1360, when a banker was executed in front of his failed bank in Barcelona, Spain. Since then, the world has witnessed several financial crises with their attendant bank failures. The long-term effects of the near-collapse of the global financial industry triggered off by the sub-optimal mortgage loan crisis in the US and the collapse of Lehman Brothers in 2008, are still reverberating across the world.
When banks fail, it is not just bankers that feel the effect, everyone else suffers. While bankers lose their jobs, millions of their customers lose their savings sometimes their life savings. The financial market that promises prosperity often brings forth untold hardship to everyone instead. Obviously, there are fundamental weaknesses in the functioning of the financial market. The problems of information asymmetries, moral hazards, adverse selection, principal-agency, weakness in corporate governance and standards are well known. But there are other deep-rooted problems that can be linked to the contradictory promises and false premises upon which the industry is built, nurtured, and operated over the years.
The financial services industry from inception is built on the premises that “your money is safe with the bank” and “your money will earn you high returns.” While this might be true in the past, competition has now made simultaneously keeping people’s money safe and making good returns for them harder than ever imagined. The industry’s constant push for more deposits, transactions and profit year in year out have inevitably made bankers more transactional, more clever, short-term minded, selfish and less strategic with the long-term survival of their institutions. More banks are taking huge hits as a result of the greediness and short-sightedness of their operators and operations.
Competition has brought immense pressure on the banks to offer more and charge less. The squeeze on margins is now getting tighter.
According to the Boston Consulting Group, Return on Equity (ROE) of the world’s biggest investment banks have halved to about 10 percent in Europe and 13 percent in America. With the introduction of Basle 3 and a host of other planned new regulations, ROE is likely to further fall to 6-9 percent. Clearly, there is now a trade-off between “your money is safe with the bank” and “your money will earn you high returns.” The era of offering both at the same time is over. Any claim to the contrary is a mirage.
In the financial industry, there is this age-long belief that expert opinion matters. Available facts unfortunately do not support this assertion that has prevailed over the years because of humanity’s quest for certainty. Warren Buffet, the world’s most successful long-term investor, concurs that nobody can reliably forecast short-term outlook of the financial market. Edmund Phelps (Noble prize winner in Economics) states that “the financial market has become too complex to be understood with amazing correctness and its information requirements have gone beyond our ability to gather it.” Yet bankers still believe and act as if they know the unknowable.
Bankers (especially investment banker) have uncommon faith and unlimited price on their skills even when their past profits have little to do with their financial knowledge sophistication.
An empirical study carried out by Steve Levitt and Thomas Miles of Chicago University using tests of persistence in returns to detect whether mutual-fund managers have genuine expertise concluded that “those tests tend to find little evidence of skills in this domain”. Thus, despite the fact that we know with 100 percent certainty that the probability of failure is high in making financial market predictions, the industry still runs on the template that success is down to executive ingenuity but failure is caused by someone else. This is not likely to go away soon, thanks to the increasing availability of more computing power, more complicated theories and more sophisticated financial innovations that baffles the uninitiated.
The fact is that in the financial market, what is safe now may not always be so. Market trends tend to delink from fundamentals from time to time. A case point is Value at Risk (VAR) models often used by financial experts to work out how much capital they need to set aside as insurance against losses on risky assets. This model is based on the assumption that holding two uncorrelated assets is a cushion against losses on both at the same time. Now we know that at times of market stress, assets that normally are uncorrelated can suddenly become highly correlated thereby rendering the buffer implied by VAR unattainable. JP Morgan lost billions on trades in 2012 when VAR predicted very small tail exposures! Unfortunately, neither those who teach these complex financial jargons nor those who practice them are hurt the most when they fail to hold in reality.
Banking operations are standardised. The process of getting loan is virtually the same in all banks. Banks act almost simultaneously and in the same direction all the time. They follow the thriving sector at any point in time. But there is still a place for innovation in the banking industry. However, the industry is one of the very few where product innovations can be harmful to the economy. There is an inverse relationship between innovation and financial stability and by extension economic growth. There are load of academic literature that link financial market liberalisation will increase in bank failures. Increased competition induced by liberalisation simply leads to more risk taking and ultimately the greater chance of bank failures. It is therefore clear that where financial market stability is desired, financial innovation must be slowed down. In the wake of the 2008 financial crisis, evidence from Australia and Canada shows that some restrictions on competition may be a right price to pay in order to achieve financial stability. Getting the trade-off between stability and innovation right in the banking sector is a challenge for regulators all over the world. Its innovations truly have the potentials to inflict greater harm on the society.
The “too big to fail” tag is one of the enviable achievements in the banking industry. Any bank that attains the status of Systematically Important Bank (SIB) is almost assured of government bail-out in its moment of crisis because of the belief that its failure will hurt the economy more. The reality is that SIBs perceived strengths were in fact one of the greatest weakness of the industry. One of the glaring lessons of the recent financial crisis is the astonishing degree to which the safety and soundness of the global banking system is dependent on the business decisions of a few global SIBs. In addition to their contagion risks, the tag of ‘too big to fail’ also creates moral hazard and adverse selection problems in the industry. All these cumulated to create a system that shields bankers from the effects of their negligent mistakes.
Today, the prevailing order is that bankers take most of the profit when the industry is booming and the shareholders/tax payers bear the losses during bust. They seem to conveniently forget that what tends to follow a boom is a bust and the risks that often lead to widespread bank failure are build-up in periods of booms and record profit. No wonder we now have an industry that believe in capitalism when it is making profit but is full of socialists when losses persist. Most times, tax-payers end-up underwriting private risk-taking.
For centuries, the basis for banking operations – lending money at interest – has been under attack. The Bible and the Koran explicitly condemned it. Prophet Muhammed banned usury. The Catholic Church banned it in 1311. The Jews referred to interest payment as ‘neshek’ (a bite). Till date, the antipathy towards the industry and the profession is yet to abate especially in the advanced world where an average worker is still suffering from a squeeze in living standard as a result of the reckless risks the banks took prior to the 2008 crisis. The ‘Occupy Wall Street’ protest in US is an indication of the unprecedented public anger on the industry.
Yet, the global financial market has continued to grow from just $0.1trillion in 1970 to $6.3 trillion in 1990 and to a massive $31.8 trillion in 2007. But according to the World Bank’s Global Findex data base, about 50 percent of adults worldwide do not have an account in a formal financial institution – a bank, credit union, co-operative, post office or micro-finance institution. This represent about 2.5billion unbanked adult. Among the poorest, only 23percent of adults living on less than $2 a day have accounts according to a survey carried out by World Bank and Gallup in 148 countries in 2011.
On the home front, KPMG reported in its 2013 ‘Africa Banking Industry Customer Satisfaction Survey’ that only 20 percent of the Nigerian population is banked and two-third of Nigerians have never “banked at all before.” To further buttress this, NDIC recently disclosed that about 90 percent of deposits in Nigerian financial institutions belong to just 10 percent of the citizens. Thus, whatever benefits that banking industry offers its customers is only being enjoyed by less than 20 percent of the population. It is indeed an industry whose private rewards far outweigh its social benefits.
Banking must have a human face. Government has a responsibility to ensure that the financial industry plays its supposed role as a catalyst for economic growth not only because of the well-being of millions of their citizens but also because any recession caused by financial crisis is more catastrophic and recovery is not only slower but requires more resources. The industry has everything to gain by re-inventing itself otherwise, we run the risk of falling victim to the law of unintended consequences.
Nwolisa is a Lagos-based economic analyst.
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