New outlook for banking industry

Sunil Karunanayake

The global banking industry is facing a huge challenge and is now gearing to emerge from the catastrophic crisis that caused extensive losses in 2008 and 09 period. The stakeholders are now busy reassessing the fundamentals.

Excessive deregulation, complex instruments, over confidence of self correction and excessive remuneration packages have been diagnosed as the main causes of the catastrophe that ruined many giant institutions.

In the West so many banks had to be bailed out by the government at a tremendous cost to the public.

Following the crisis over six million jobs have been lost in USA, over 2.5 million in the euro zone and over half a million in the United Kingdom. Few years ago Scotland was home to two of the largest and most respected international banks. Ironically both are now state owned.

In 1826 it was Sir Walter Scott who wrote "not only did the banks dispersed throughout Scotland afford the means of bringing the country to an unexpected and almost marvellous degree of prosperity, but in no considerable instance, save one (the Ayr Bank), have their own over- speculating undertakings as the means of interrupting that prosperity.

Royal Bank of Scotland perhaps needed the largest bailout among European banks in 2008. Switzerland which grew rich as a dominating banking centre in Europe attracting capital flows from all corners of the world is now in the process of downsizing its global operations. They are also enforcing capital requirements on bigger banks with virtual extinction from investment banking.

In Sri Lanka's highly regulated financial sector, exchange controls, capital account restrictions, effective financial stability reviews were a blessing that restricted damage.

In 2006 the Central Bank imposed higher capital requirements for licensed commercial banks with a time frame to achieve such, this move too contributed towards improved financial stability.

The non banking sector and in particular the registered finance companies did run into difficulties following a crash of a leading finance company that belonged to a large conglomerate that was highly inter connected and few unregistered finance companies.

This catastrophe drove many depositors to near bankruptcy and it was reported there were many suicides, even to date settlements have not been completed.

Adverse effects on exports and capital flight caused some panic that reduced the official reserves to a mere one month's imports. Government was successful in negotiating a standby arrangement with IMF that brought some stability.

Following the post crisis recovery period authorities moved further to tighten controls, some of the measures were compulsory listing for registered finance companies and Sri Lankan licensed commercial banks.

This will no doubt provide more muscle to financial stability due to the need for strict adherence to corporate governance rules of both the Central Bank and Securities and Exchange Commission.

"In African and Asian countries that have both private and state owned banks supervisors keep them on a tight leash. There's a positive attitude towards banking regulations in parts of Asia compared to the negative attitude in America.

In Asia they tell you in a positive sense what you could do without telling what you can't do. Before the financial crisis such restrictions were seen as signs of backwardness" (Economist).

Perhaps learning from the lessons of the debacle faced by the financial sector Central Bank moved swiftly to introduce a deposit insurance scheme to protect the interest of small depositors from the failures of the financial institutions and thereby protect the stability of the financial sector. This is expected to be in force from January 01, 2012.

Globally, the deposit insurance scheme (DIS) has evolved to play a major role as a financial safety net instrument for both crisis prevention and crisis management. In the face of global financial integration, financial crises are contagious and are not predictable.

The global experience has shown that a mandatory deposit insurance as a form of safety net is effective in managing individual bank failures as well as systemic failures that lead to financial crisis. At present deposit insurance schemes are available in nearly 100 countries.

Deposit insurance tends to enhance public confidence that contribute towards financial sector stability. Particularly in Sri Lanka such a move would be welcomed in the backdrop of heavy losses incurred by the depositors during 2008-9 periods.

In the event of a crash of a financial institution mostly the burden falls on the government and it's the tax payer's money that will have to be doled out. A DIS in such situations could limit government's involvement. 'DIS apart from bringing confidence to depositors could promote market discipline facilitating Central Bank's regulatory function. It is also argued that DIS could drive the market participants to a state of complacency. Like in any insurance scheme DIS too could more add costs by way of premium thus pushing the lending costs higher.

Globally a host of new banking regulations are being implemented in the midst of efforts to recover; Across Europe bad debts accumulated by the banks are impairing the balance sheets of the respective governments.

Creditworthiness of most of the European banks are being doubted that's causes certain amount of concern in the markets and adding to the borrowing costs.

On the other hand in the emerging markets mostly in the South Asia issues are different with rapid economic growth and associated development in the rural areas.

This is clearly visible in Sri Lanka with even the once war ravaged North and East showing remarkable growth.

Government initiatives to boost the agricultural economy and promote food security has provided opportunities for banks who mostly concentrated on the western province to activate themselves in rural pockets, happily this scenario is now taking place. Food packaging, transportation and storage are crying needs.

Availability of telecom and IT facilities even in the deep pockets of the country could spur opportunities for Bankers. Many catastrophic losses , closures, lay offs have now given the regulators confidence to take the whip hand and discipline the industry.

Banking institutions usually operate on low equity with a large deposit base, deposit holders interests as well as governments burden on potential bail outs are critical, making regulator's role more stringent.

"If sustainable capital flows provided the fuel and an inadequately designed regulatory system ignited the fuel, the past two years have shown how dangerous it is to let bankers play with fire.

This is not a question of blame- the majority in the industry are good men and women. It is a matter of incentives they face.

To protect our genuinely successful financial centers, reform of banking is essential. With that I am confident that we will have attended to our terrible warning and our varied internationally competitive financial industry will thrive - Mervyn King Governor of the Bank of England"