For centuries, banks have performed two critical functions. One is supporting trade through lending to support supply chains. The second is funding of first war and then infrastructure building - initially through a central banking activity and eventually through private enterprise. As cross border trade expanded, the role of banks grew to cover the foreign exchange business and financing of cross border trade. With the increasing footprint of private enterprises and the reducing role of the state, banks supported the expansion of capitalism through investment banking activities.
At every stage of growth in private enterprise, globalization and growth in capital markets, the role of banks has become inseparable from the underlying economic activity. At every stage of evolution in business and trade, banks have continued to evolve and sometimes collapse as they supported economic expansion. The role of banks in this growth has been largely unquestioned and the protections or quasi-protections afforded to them for supporting both fiscal and monetary policy was largely unaffected.
The implicit and sometimes explicit protection afforded to banks against failure including the perception of them being too big to fail has kept banking stable and generally profitable.
Banks have been the earliest adopters and consumers of technology for many decades largely with the intent of improving speed and efficacy of their operations. The large capital investments traditionally needed in technology have kept banks ahead of the curve. All in all, until the turn of the 21st century, banks were under no threat both in terms of business models and margins. The threat to the existence arose mainly from poor underwriting and inability to tide over economic cycles.
The need for changing the business model in the 21st century
By the turn of the 21st century, two important changes were on the horizon that would pose a business model challenge if not an existential challenge to banks. High-cost technology which was only affordable to banks was getting increasingly cheaper and more importantly democratized. With wider general availability of technology, banks would no longer keep the technology edge or stay ahead of the curve. Ironically, the early adopters of technology would be straddled by legacy systems and technology that would make the transition to new age technologies burdensome. To this date, maintaining legacy technology continues to attract a higher budgetary allocation of banks than investments in new-age technology that are relatively more efficient.
Another major change was on the horizon by the turn of the 21st century. Competition in banking by new players and more nimble players was starting to surface. While these players were not supported by the legacy and perceived stability that came with vintage, they were able to make up for perception of safety with better customer service. Traditional banks, many state-owned, who were quite secure primarily earning a well-controlled net interest margin were now under threat from peers who offered better customer service and were more willing to drive down net interest margins for market share.
Balance sheet management in the early days
Up until the turn of the century, balance sheet management for banks was relatively simple. Money raised through deposits was to be marked up and lent onwards. The markup covered cost of operations, absorption of credit underwriting losses and a net margin for shareholders. The concept of fractional reserve banking i.e. leaving a small portion of money obtained through deposits in reserve and lending the remaining allowed banks to lend without worrying too much about liquidity mismatches.
It was assumed that since all depositors are unlikely to claim their deposits including demand deposits at the same time, fractional reserve banking allowed for asset liability mismatches to be run and not necessarily factored into the pricing of loans. Prudential asset liability management limits and balance sheet ratios could safely be assumed to surrogate risk-based pricing caused by ALM mismatches. In the unlikely event of a run on the bank, reserves were expected to allay any immediate demand on the bank’s resources.
More importantly, liquidity support from central banks and other forms of backstop virtually ensured that banks could continue to price on a cost-plus basis while not being overly concerned about balance sheet risk. Credit risk continued to be the major focus of all risk management activities of the bank.
The need for extending the balance sheet in the 21st century
As technology evolved and new entrants kept chipping away at the market share and/ or net interest margins of banks, banks felt the need to extend themselves and more importantly their balance sheet. Extending the balance sheet could be achieved by leveraging it further. Lower net interest margins coupled with higher leverage would still preserve and in many cases enhance shareholder returns.
With the implicit understanding that liquidity will be backstopped by central banks, banks continued to leverage without pricing in the cost or risk of leverage into their lending practices. Prudential balance sheet ratios and mismatch limits between asset and liability positions were considered passe. The age-old bank would fight back both incumbents and new-age technology with the perceived strength of its balance sheet. Strength that could be multiplied simply by leveraging the balance sheet.
The constraints experienced from capital adequacy norms
The primary hindrance to unlimited leveraging were capital adequacy norms. Capital adequacy norms were a remnant of past financial crisis requiring banks to maintain a certain amount of capital for assets on their balance sheet.
Banks innovated around this issue by moving assets off their balance sheet by using special purpose vehicles (SPV) while effectively retaining both risk and ownership interest in such securitized assets. With the capital adequacy norms made redundant through SPVs, balance sheets were free to grow unfettered by the need for effective balance sheet management or balance sheet risk management.
At this time, most governments and fiscal authorities inexplicably and sometimes unwittingly supported banking expansionism through loose monetary policies aimed at bolstering or expanding the real economy. With liquidity backstopped and fiscal support firmly in place, virtually nothing should have impacted return on equity as banks had access to virtually unlimited leverage.
By this stage, balance sheet management was reduced to two things:
- Fund transfer pricing based on cost plus methods, which primarily focused on return on equity and not necessarily return on assets or net interest margins
- Managing prudential limits and capital adequacy ratios through innovation in financial instruments rather than any innovation in the underlying business model
With the ability to write virtually unlimited credit, only one thing could go wrong. Credit underwriting practices that were at the core of risk management for banks for centuries were about to be compromised. Credit evaluation was traditionally built on understanding the underlying business of the borrower i.e. the cash flow profile and the ability to provide encashable security as collateral. While credit availability expanded virtually infinitely, what did not expand was the need for credit. The only way to support growth of return on equity for banks was to loosen credit underwriting standards.
Credit underwriting over the years had been reduced to a rating or a score. A rating still largely driven by the underlying business of borrowers, their cash flow profile and encashable value of security. Credit rating and scoring was about to shift its basis entirely to one thing and one thing alone – market value of security provided as collateral. Market value that was theoretical, rarely encashable, and almost entirely propped up by monetary expansion and unlimited supply of credit.
With the credit underwriting hurdle out of the way, balance sheets could now be expanded with mock abandon. By this time, balance sheet management had almost been entirely reduced to structuring ways around regulatory and prudential limits. Risk management had left the building.
- End of Part 1
Click here to continue reading Part 2 of this blog which focuses on how banks had to fundamentally change their balance for efficiency, for innovation and for catering to the influx of new regulatory changes since the Glass-Steagal Act
Visit the Antares page to know more about using technology to bring in efficiency in balance sheet management