An article written a few years ago by Mr Mathias Schmit on the banking crisis; unfortunately nothing has changed. Sorcerer's apprentices are playing with interest rates, which has the effect of reducing the value of bonds. We regulate, we 'kill the economy' and we don't make the world a better place. Unfortunately.
Article published on LaLibre.be
"Explanation. And improvement. Lesson 1 : profit is not synonymous with value creation. Contrary to popular belief, high profits do not guarantee that a company in general, and a bank in particular, will be able to generate enough cash to meet its obligations and pay its shareholders...". For example, the Icelandic bank Kaupthing made a profit of over 800 million euros in 2007, representing a return on equity of almost 25 %, before going bankrupt a few months later. The value of a company is measured by its ability to generate more money through its investment activities than it spends over its entire lifespan, what managers call "free cash flows".
These free cash flows can be redistributed on a long-term basis by the bank to its creditors (including depositors) on the one hand, and its shareholders on the other. Even before the onset of the crisis, many banks were weakened by the massive use of external funds (deposits and interbank debt) to finance their investments, which could not be financed by cash flow from current operations.
In 2007, for example, Kaupthing offset a free cash flow loss of more than 15 billion euros with debt of the same amount, representing more than 20 % of its balance sheet total. As a result, despite the profits recorded, Kaupthing paid dividends to its shareholders, financed by debt and not by the value generated by its operations.
Lesson 2: capital is not synonymous with marketable value. Since 1988, the standards laid down by the Basel Committee have formed the backbone of international banking regulation. They aim to ensure financial stability and protect depositors, primarily by ensuring that all banks have sufficient capital to absorb losses in the event of a crisis.
However, in the event of an immediate need for liquidity, this capital cannot be mobilised if the assets in which it has been invested cannot be sold quickly. In this respect, it is edifying to note that during the European stress tests in June 2011, Dexia was judged to be one of the most solvent banks in Europe in the event of a major crisis. This did not prevent it from having to be nationalised less than three months later.
Lesson 3: a bank's viability depends on its ability to create value. Ultimately, the Board of Directors is the sole guarantor of the bank's viability and financial stability, and it is therefore up to it to establish, in the light of its objective to create value, an overall estimate of the risk incurred and to acquire a clear understanding of both the various risk factors and their potential impact.
However, board members do not always have the training and skills required for such risk assessment, as the (sometimes political) composition of some boards shows. It is therefore necessary to entrust the design, review and supervision of risk management to qualified and independent members.
Let's be wary of the diktat of more regulation.
Ultimately, the future of prudential regulation will have to be based more on an assessment of the business model, the bank's value creation strategy, governance and risk management, and abandon its excessive reliance on models aimed at calculating capital requirements, giving the false impression of being protected against the effects of a major crisis. As a result, we must be careful to maintain the overriding purpose of regulation, without allowing ourselves to drift into unnecessary and harmful regulatory drift, as has been advocated at recent G20 meetings.
Read this article on this link.
