Banks - A Necessary Evil

Posted in Finance Articles, Total Reads: 2890 , Published on June 27, 2013

This article won Second Prize in Article Contest June 2013

These are tough times for the banking industry - brickbats from all sides, totally blamed for the current state of the world and highly threatened by regulators. The 2008 financial crisis led to the systemic risk spreading across all parts of the world, hitting all industries, small and big, and bringing growth to a total standstill. The recession that started then is still in motion and by the looks of it, it is nowhere close to the end. In such a depressed state, people all over the world have squarely put the blame on the banking industry for this mess and made it their aim to kill this so called “disease” off this planet. Based on my experience of the banking industry (having worked in the balance sheet, funding and collateral management desk for the Equities business of a large European bank for the past three years), the blame is not justified. In this piece I will try to assess this blame game, try to provide some color on the underlying reasons and suggest a few broad corrective steps to take in the years to come. These are purely my views based on my experience and must be taken with a pinch of salt (The Treasury in the US to the FSA in the UK are working full-time to solve this issue and have not been able to solve the riddle yet, so no harm trying).

The root cause for the banking blame game is the accusations of insatiable greed and the big bucks associated with bankers. Attached to these are the revelations of total disregard for client interests and malpractices in the fixing of critical rates such as LIBOR. All this has attracted a lot of negative flake and outbursts of anger amongst the public. Let us broadly reason out the possible underlying reasons behind this behavior.

A million dollars a year for a salaried employee is a lot of money.  But it's not fair to review the scenario this way. The banking industry is very entrepreneurial in nature - each person runs his/her book and is responsible for the associated profit and loss. Many times, various desks in the same bank are competing for a piece of business. So the correct way to view bankers is to evaluate them in the same frame as businessmen - ambitious, risk taking, innovative intertwined with hints of greed, profit and a high risk high reward kind of mentality. So many large and medium banks offer the same product at costs which differ only by one basis point (which is one-hundredth of a percent) – that is how competitive the industry is.

The existence of one’s job itself is totally performance based. Most people are from the top of their class from their business schools and the undergrad colleges from across the world and have never finished second in their entire life. They have such huge education loans on their heads that the only way to sustain and shape a good life ahead is to sell more and do more business. In this scenario, everyone does what it takes to survive. These are the natural instincts of survival and the fittest stays while the rest perish.

Also, from my background in the industry, I see drastic changes in the way banks are doing business with clients’ post 2008 - the focus has shifted from increasing revenues to increasing profitability in a sustainable and reduced risk manner. This is very important for the industry.

Another aspect to understand is the importance of the banking industry in the functioning of global businesses. Banks ensure free flow of money. What differentiates the banking industry from other businesses is that banks function using the concept of leverage. In simple terms, leverage allows banks to multiply their risk rewards equation - one can crank up the possible profits but that also means the risk of a loss also multiply. The importance of leverage is that it provides a profitable way for the free flow of money, which is then used to create useful products, pay for services, invent and innovate to make life easier. This nature of banking makes it prone to both high upside and downside risk - making the tolerance for error very low. So when the time is bad, it takes a lot of weight down along with it. This is exactly the situation we are in today. The need of the hour now is not to stifle the money circulation system but to create stable environments to ensure that money flows freely and faith is restored.

Now having seen the underlying scenarios in which bankers work, we must also look at what can be done next. The current scenario has a few positives - it presents us with a chance to correct the cyclic nature of banking. This can be achieved by taking affirmative action in three spheres - regulations, education and technology. Regulations are necessary to institutionalize discipline and uniformity. But what is required is clarity in the rules. Basel 3, Dodd Frank and the likes are volumes of texts framed without taking appropriate views from the actual implementers - bankers and product specialists. Including their opinions is very important and needs to be done first up. Secondly, it is important that basic financial education is included in the school curriculum for everyone. This will ensure that the future users of these products understand the importance of risk associated with such products and take intelligent decisions. Thirdly, technology will help improve risk controls. Currently, banks invest in systems only if it allows for expansion and greater profits. A possible solution is the one suggested by Deutsche Bank co-CEO Anshu Jain. He suggested that all banks invest in a common set of technologies and platforms to allow for uniformity and optimization. That is definitely a good solution, if it can be chalked out. Regulators have now made central clearing of OTC products mandatory in the US. Moves like these will help institutionalize honorable practices in the industry and will ensure appropriate checks and balances.

The way ahead now is to let bygones be bygones and look at the future course of action to make the environment more stable and industry friendly. Only that will ensure that innovation and growth continues.  The captains of the ships such as Jamie Dimon, Anshu Jain feel that the stormy nights will pass and they will emerge stronger - only time will tell if they are correct. Until then, we must keep our hopes alive. Remember, hope is always a good thing.

The article has been authored by Pradeep Krishnakumar, IIM Ahmedabad

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