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Trends and Developments in Banking

Cheryl J. Rathbun

Citigroup

Chief Operating Officer, Institutional Clients Group, Risk Management

U.S. Basel II Implementation Director

Citigroup @all rights reserved November 2008

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Trends and Developments

We are living in one of the most historic times in terms of global banking, finance and economic developments

• The trends over the last decade in many of the developed markets have focused on an extraordinary level of de-regulation, a breaking down of traditional banking and investment bank roles (dismantlement of Glass-Steagall Act in the United States*), financial engineering and innovation in terms of product development, massive “slicing and dicing” of risk, private equity and third party liquidity providers

• These trends led to a massive amount of liquidity in the global system, supported by strong growth globally—both developed and emerging markets, rising global real estate prices, ever increasing business and personal debt levels, a severe loosening of credit and underwriting standards, all maintained by low interest rates (particularly in the United States)…a perfect storm in the making

• These trends have led to the biggest housing bubble and credit bubble in history

*The Glass-Steagall Act was enacted during the Great Depression. It protected bank depositors from the additional risks associated with security transactions. The Act was dismantled in 1999. Consequently, the distinction between commercial banks and brokerage firms has blurred with many banks own brokerage firms and provide investment services.

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Trends and Developments

A year ago, the term “credit crunch” was unknown

• Defined as "a severe shortage of money or credit", the start of the phenomenon has been pinpointed as 9 August 2007 when French bank BNP Paribas told investors they would not be able to take money out of two of its funds because it could not value the assets in them, owing to a "complete evaporation of liquidity" in the market. This triggered a sharp rise in the cost of credit, and made the financial world realise how serious the situation was.

The problems, however, started much earlier.

• GROWING SUB-PRIME PROBLEMS: The crisis began with the bursting of the US housing bubble and and high default rates on “sub-prime" and adjustable rate mortgages (ARM), beginning in approximately 2005–2006. This bursting of the bubble was a direct result of declining lending standards, an increase in loan incentives such as easy initial terms, and a long-term trend of rising housing prices encouraging borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favourable terms.

– However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult.

• Defaults and and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.

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Important Lessons

• Historically major banking crises ultimately solved by massive amounts of government or public funding/money underscored by early and decisive action – either through recapitalising or taking on debt

– two good case studies: • Sweden -- early and decisive action resolved relatively quickly a collapsed banking

system in the early 1990s• Japan – lack of government action caused decade long banking malaise

• Need for important regulatory framework and action -- Banking systems exist within a regulatory framework – they do not exist

• Western finance will be re-regulated -- $55 trillion of credit derivatives brought under regulatory control

• Global Rules on capital may need to revised again and quickly – Basel III?

• Global inter-connectedness of world finance, commerce, financial flows• Globalization is real and it matters. Many countries have been impacted negatively a credit crisis that

originated in the U.S. and/or Britain, even though some national housing and mortgage markets and banking system have been more prudently managed.

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Lessons Learned• Need to reduce leverage in the global system and add transparency of global

flows– In Europe many of the banks are highly leveraged -- the assets of Iceland's (populations

314,000) 3 major banks were about 10 times the island nation's gross domestic product. Martin Wolf, the Financial Times commentator, noted that the combined assets of Britain's Big Five banks are four times the UK’s GDP. The assets of JPMorgan Chase, the largest U.S. bank, is only about 7 percent of America's annual output.

– “What we've discovered is that the real problem is bigger. Large parts of the financial system are too thinly capitalized and too dependent on unreliable short-term debt. Leverage ratios often reached 30 to 1 for investment banks and hedge funds (that is, $30 of debt for every $1 of capital). The presumption was that the MBA types had learned how to "manage risk." That false conceit backfired. Low capital didn't adequately protect against losses. Confidence and trust evaporated, because no one knew which institutions held suspect securities, how much the losses were and who was ultimately safe.” Robert J. Samuelson, 13 October 2008, The Washington Post

– Danger of excess leverage:

• Too many people took on too much debt to get into or move up in the housing market. • Governments and legislators foolishly implemented policies to encourage home ownership among

traditionally non-credit-worthy households. These institutions tend to borrow short, invest long, and have an enormous appetite for leverage.

– Policymakers need to better understand how the "shadow banking system" -- the myriad hedge funds, non-bank mortgage lenders, structured investment vehicles, and private equity funds that have come to play such a large role in the financial system.

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Basel II• Currently, bank regulators across the globe are implementing what is known as Basel II

—an international standard for the amount of capital that banks need to put aside to deal with current and potential financial and operational risks.

• As it stands, Basel II requires banks to set aside more capital for higher-risk exposures. An ongoing review by the Basel Committee could further increase the capital requirements for complex structured products and off-balance-sheet vehicles, which were the main sources of stress in recent months.

• Most of Europe has implemented the new standard and the United States is expected to implemented in 2009-2010….

• But now there are calls to make the rules even tougher. After all, why didn't the rules

soften the fallout from the current market turmoil? And the several-year-old controversy over whether the rules would offer a panacea for financial crises, or instead exacerbate them, is once again front and center.

• The critical question turns out to be: Are the rules too pro-cyclical: that is, are they too lax on capital requirements during the "good times" and too tough during the "hard times," exacerbating boom-bust cycles in the process?