Article published on LaLibre.be
Lesson 1: profit is not synonymous with value creation.
Contrary to a very widespread idea, large profits do not guarantee a company in general, and a bank in particular, the ability to generate enough “cash” to meet its obligations and pay its shareholders... ”. By way of example, the Icelandic bank Kaupthing had made a profit of more than 800 million euros in 2007, that is, a return on equity of nearly 25%, before going bankrupt a few months later. The value of a company is measured by its capacity to generate, through its investment activities, more money than it spends over the whole of its lifetime, what managers call “free cash flows”.
Indeed, these “free cash flows” can be redistributed sustainably by the bank to its creditors on the one hand (including depositors), and its shareholders on the other. Even before the start of the crisis, many banks weakened themselves through a massive use of external funds (deposits and interbank debts) to finance their investments, which could not be financed by the cash flow coming from current operations.
Thus, for example, in 2007, Kaupthing offset a loss of free cash flows of more than 15 billion euros with borrowing of the same order, that is, an amount representing more than 20% of its total balance sheet. The consequence is that, despite the profits recorded, Kaupthing paid dividends to its shareholders financed by debt and not by value generated on its operations.
Lesson 2: capital is not synonymous with mobilisable value.
Since 1988, the standards laid down by the Basel Committee have formed the backbone of banking regulation at international level. They aim to ensure financial stability and to protect depositors, mainly by ensuring that all banks have enough capital to absorb their losses in the event of a crisis.
However, in the event of an immediate liquidity need, this capital is not mobilisable if the assets in which it has been invested cannot be sold off quickly. In this respect, it is instructive to note that during the European stress tests of 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: the viability of a bank depends on its ability to create value.
Ultimately, the board of directors is the sole guarantor of the viability and financial stability of the bank, and it is therefore up to it to establish, in view of its value-creation objective, an overall estimate of the risk incurred and to acquire a clear understanding, of both the various risk factors and their potential impacts.
However, the members of the board do not always possess the training and skills required for such an assessment of risk, as the (sometimes political) composition of certain boards attests. It is therefore necessary to entrust the design, review and supervision of risk management to qualified and independent members.
Let us beware of the diktat of an increased regulatory burden.
In the end, the future of prudential regulation will need to rely more on an assessment of the business model, of the bank's value-creation strategy, of governance and of risk management, and abandon its excessive dependence on models aimed at calculating equity requirements, giving the false impression of being protected against the effects of a major crisis. Consequently, care must be taken to maintain the higher purpose of regulation, without giving in to a useless and harmful regulatory drift, as may have been advocated at the last G20 meetings.
