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					Crunch Sheet
An introductory note on the credit crunch

16 October 2008

 The speed and agility with which public policy makers and private financial
institutions respond to the continuing pressures in a rapidly evolving
environment will determine how quickly and how smoothly market conditions
return to normal—and how rapidly the risks to the economic outlook are
mitigated. (Timothy Geithner, President and Chief Executive Officer, Federal
Reserve Bank of New York)

It was last year that the credit crunch emerged as a discussion topic, mainly
because of the sub-prime mortgage crisis developing in the US. Traditionally,
banks financed mortgages through the deposits received from their customers.
They lent money to customers after rigorous investigation of their credentials
and retained the risk of default, known as ‘credit risk’. In the last few years, a
new mortgage model called the sub-prime mortgage model has developed.

Unlike the traditional model, under the sub-prime model banks can now sell
rights to the mortgage payments and related credit risk to the bond market
investors, through a process called securitisation. This sub-prime mortgage
model made it easier for banks to fund additional borrowing, as it involved
selling the mortgages to bond markets. This also meant that banks no longer
had the incentive to check carefully the credentials of those to whom they
issued mortgages loans. This resulted in sub-prime lending to borrowers with
poor credit histories.

The sub-prime mortgage market grew significantly in size during the early years
of the present century. The crashing of sub-prime lending market in 2007
resulted in banking losses, sharp falls in property prices, and scarcity of credit.

Analysts warned there would be a credit crunch: a critical situation where,
owing to depleting liquid reserves and high default rates leading to fears of
bankruptcies or further defaults, banks would become reluctant to lend money,
resulting in higher costs of borrowing, i.e. higher interest rates. Hence,
businesses would no longer have access to easily available credit. The
beginning of this credit crunch last year therefore signalled the beginning of a
global slowdown. Today, as we witness economies around the world struggling,
stock markets crumbling and financial institutions falling, there is a genuine
interest in discovering the reasons for the credit crunch.

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Crunch Sheet
An introductory note on the credit crunch
Crunch impacts

Owing to the credit crunch, Cadburys Schweppes has put on hold a planned
$16,000 million sale of its US drinks arm, and a possible $23,000 million sale
of Virgin Media is likely to be delayed. A multi-billion-dollar deal by US car
maker Chrysler has also been affected. The plans of McDonald's Corp. to
introduce coffee bars in its 14,000 restaurants in April 2009 have also been
affected as the company is unable to obtain financing for the construction from
its bank, Bank of America.

ACCA’s policy paper, ‘Climbing Out of the Credit Crunch’, identifies a failure of
corporate governance at banks, which encouraged excessive short-term thinking
and a blindness to risk, as the principle source of the credit crunch. Regulators
have reacted to the collapse of financial institutions in the past (BCCI, Barings
bank, the crisis in certain Asian economies in the 1990s) by amending
corporate governance regulations, making them more ‘stringent’. Despite these
regulations, collapses have continued mainly because, for effective corporate
governance, a fundamental requirement is a performing, empowered and
efficient board of directors that accepts the responsibility of providing strategic
oversight and direction, to ensure a strong control environment and to challenge
the executive.

No amount of regulatory intervention can fully institutionalize corporate
governance unless Boards and senior management of banks appreciate the
value addition of corporate governance to their productivity and
competitiveness. Dr Shamshad Akhtar, Governor, State Bank of Pakistan,

The ACCA/SECP/IFC/PICG Survey of Corporate Governance Practices in
Pakistan 20071 demonstrated the commitment of Pakistan’s financial
institutions to implement the Code of Corporate Governance: all the surveyed
companies complied with the Code of Corporate Governance. Those interviewed
for the survey nevertheless expressed reservations about the implementation of
the code in its true spirit, stressing the need for greater appreciation of the role
of the board of directors in achieving successful adoption of corporate
governance frameworks. One of the key observations made in the survey was
that effective, efficient, successful and focused boards are critical to the success
of any corporate governance framework, because they will provide strategic
direction, management oversight and the creation of an effective control and
risk management framework.


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Crunch Sheet
An introductory note on the credit crunch
As well as corporate governance, the Policy Paper suggests that even though
banks have developed highly sophisticated risk management functions, the
events of the last year have nonetheless exposed weaknesses in their risk
management systems, demonstrating that risk management departments in
banks did not have sufficient influence, status or power. Banks since the late
eighties have undergone a metamorphosis. Traditionally, banks and insurance
companies used to strengthen their balance sheets by having a combination of
assets, such as land and buildings, investments in blue chip companies,
combined with a secured loan portfolio lent to creditworthy clients, and all this
was supported by a highly professional and ethical management team. With the
rise of investment banking, banking systems changed. The financial markets’
transformation also had role to play in the change in banking systems.
Financial markets have evolved from the traditional stock and bond markets to
complex securities markets offering highly sophisticated but poorly understood
securities such as derivatives. Banks started investing in these securities.
Derivative traders are different from traditional retail bankers and the chief
executives and risk management departments of banks may have lacked the
necessary training in securities such as derivatives, and so were unable to
understand the risks associated with investing in them.

As banks’ investment in securities such as derivatives increased, there was a
gradual deterioration of the banking system, as more and more complex
transactions took place, where the underlying asset or security was not
ascertainable and was extremely difficult to value. Over time the balance sheets
of financial institutions became burdened by such items whose value declined
as the credit crunch deepened, resulting in liquidity crises.

In the recent past, mainly because of regulatory pressures, banks in Pakistan
have invested tremendously in risk management systems. The recent Crescent
Bank and Punjab Bank fiascos did, however, raise questions about the
effectiveness of risk management systems in the country’s financial institutions.
Banks are the custodians of public money; a collapse of a bank is a collapse of
public trust. Thus there is a need to assess the effectiveness of the risk
management departments of the financial institutions as well as to determine
whether they have the skills and the experience to understand and manage
contemporary risks.

The Policy Paper states that there needs to be a link between risk management
and remuneration and incentive systems. The remuneration and incentive
schemes of banks have encouraged short-term thinking. Instead, executive
payments could be linked to operational cash flows rather than to paper profits.
Concerns have also been expressed about the rationale for payment of excessive
remuneration to bank executives and directors as well as the perks enjoyed by

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Crunch Sheet
An introductory note on the credit crunch
them. Suggestions have concerned the urgent need to design transparent and
fair remuneration and executive packages. These suggestions are not new. In
the late 1990s, in the wake of Polly Peck, BCCI and Maxwell, similar
suggestions had been made. OECD Principles of Corporate Governance, and
codes of corporate governance over the world, have stressed the need to have
remuneration systems that are aligned with the interests of shareholders. The
question that arises is whether the best practices relating to remuneration and
incentives are being followed, or is there a need to improve current practices? It
is also possible that just as the success of corporate governance depends on the
board of directors, remuneration systems cannot be improved by regulations
and legislation but by a board that works in the interest of shareholders.

In Pakistan, as elsewhere, the salaries being drawn by bank executives have
been considered excessive2. The ACCA/SECP/IFC/PICG Survey of Corporate
Governance has argued that remuneration packages need to be reviewed
making them aligned to the interests of the shareholders. There may be a case
for SECP to develop guidelines on remuneration and incentive packages for
executives and directors.

The Policy Paper specifies poorly drafted regulations as another reason for the
credit crunch. Depositors need to be protected not by overabundant regulations
but by clearer regulations and the development of financial literacy. After Enron,
a number of regulations, including the most famous, the Sarbanes–Oxley Act,
were enacted. As collapses and bailouts become the order of the day, there is a
case for assessing why regulations have not been a barrier to such collapses.
Regulations are required to protect the public interest but their success depends
upon individuals with conscience and ethics, implementing these regulations in
their true spirit. Can regulations be a barrier to individual/corporate greed?

The resilience of Pakistan’s banking sector will enable it to absorb market
shocks and adverse macro-economic conditions. This has been achieved
through continuous financial reforms and regulations. There should not be any
cause for concern about the stability of the banking system in the coming
days. State Bank Governor Dr Shamshad Akhtar.

Amid reports of Rs. 161 billion being withdrawn from depositors’ accounts in
commercial banks from 1 July to 20 September, last week the State Bank of
Pakistan injected Rs 31 billion into the banking system and reduced the Cash
Reserve Requirement (CRR) by one per cent, enabling banks to meet their
liquidity shortage.

 ‘Widening gap in bank employees’ salaries’,DAWN, Business; August 06, 2007

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Crunch Sheet
An introductory note on the credit crunch
The financial crisis in the US and European countries will also hit the local
bank industry, but its intensity will be much less than some other countries.
Banks in Pakistan are on sound footing since the exposure of Pakistani banks
is not as high as in United States and other European countries. Pakistan
Banks Association

Banking experts, however, remained optimistic about the resilience of the
banking sector of Pakistan, in view of its being highly regulated, with a huge
interest spread, a robust capital base and conservative lending policies. There
are, however, concerns about the liquidity position of the banks, owing to the
flight of capital. In an environment of rising inflation, where the cost of business
is going up, banks may not be willing to provide credit to businesses, thus
putting additional pressure on firms’ ability to remain in business. There have
been suggestions for mergers and acquisitions in the banking sector to enhance
the financial health of this sector in Pakistan. As banks around the world
struggle for survival and the takeover of banks by governments becomes
frequent, the coming days and weeks are crucial for determining the future of
the banking sector of Pakistan.

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