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Bank Returns to Fall

Click here to buy - A How To Book of SMSF's by Tony Negline
John Robertson

Capital market reform ultimately means lower investment returns from financial institutions.

The UK government has outlined its program of action to modify the behaviour of financial institutions and reduce their propensity to fail in its white paper ("Reforming financial markets").

The government has identified four problems that left UK financial institutions overextended and, incapable of continuing, in need of a ₤50 billion bailout:

One critical observation made in the white paper is that no model of regulation has been successful in fully insulating a country from the current crisis.

As I discussed last week, it might simply be a matter of luck if financial institutions in one locality seem to have fared relatively well. In part, their performance might have reflected little more than how recently they had last undergone a corporate trauma whose lingering effects had temporarily immunised them against subsequent excess.

This seems to be true of banks in Australia, developing Asia and Japan in the current cycle. Their resilience, while banks elsewhere were failing, might have been due to memories of their own crises constraining their exuberance rather than more virtuous managers or skilful regulators.

The immediate policy response in the UK as elsewhere had been to take emergency action to stabilise the domestic financial system. That having been done, steps were taken to strengthen the regulatory apparatus either by giving regulators more power or shoring up their existing powers.

To some degree, conferring greater power on regulators is a pretence. Failure to exercise pre-existing powers contributed in many cases to the full extent of the credit market shock. Central bank regulators, in particular, had so zealously created a cult of independence that no-one could credibly question their judgements. There is some evidence that a single minded focus on inflation and monetary policy had also drawn attention away from the speculative excesses which eventually took economies to the brink.

In some cases, the gaps between national jurisdictions contributed as companies contrived more ingenious gambits to dodge the gaze of national regulators focussed on domestic activities.

In October 2008, as the full magnitude of the credit crisis dawned on political leaders, the UK government asked the chairman of the Financial Services Authority (FSA) to identify the reforms needed in the future to strengthen the financial system. The key reform put forward by the FSA was to strengthen capital and liquidity requirements.

Overall, more capital will be needed for any banking activities or trading of financial products. Liquidity regulation will also mean that banks will be required to measure how easily they can turn assets into cash. If that is not speedy enough, more capital will be needed. The level of capital required will also be guided by the riskiness of trading activities. The more risk the more capital.

While these are UK initiatives, politicians are campaigning to have similar rules apply elsewhere so that banks are not left with an incentive to escape one jurisdiction for a lighter regulatory touch somewhere else. Ensuring regulators do their job within their own borders while also co-operating internationally is now a policy priority.

However many specific regulatory changes are made, there is little substitute for adequate capital. Regulators second guessing product innovations and the needs of bank customers is not a sustainable solution.

While, with the benefit of hindsight, governments might today have a clear view of the problems they want to counter, such clarity might not persist. In five or ten years, their knowledge base might simply not be adequate for the task as their memories of recent events fade and banks themselves start taking larger risks as the business environment appears more benign.

A hike in capital requirements will be a necessary component of any policy designed to prevent the next inevitable bout of speculative excess.

Banks in the USA and Europe are already rebuilding their capital bases with both government and private money. That is comforting but only up to a point.

Consumers of bank services should benefit as will those lending to them and seeking greater security for their savings. However, the corollary of permanently higher capital requirements for any level of risk must be permanently lower returns for investors.

The 2008 experience has shown that investment returns that had once seemed so attractive to investors were largely unsustainable. Apparently high dividends were being paid from illusory profits.

Even if the banks can reproduce their commitment to expand lending, it will be done on a far larger capital base. Any thought of the returns of the prior ten years being reproduced any time soon is either going to be an error of judgement or a signal of another impending financial disaster because the regulators did not shorten the leash sufficiently.

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