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LETTER FROM EUROPE

Crisis in the banking sector

It is unbelievable that the current crisis started with something as simple as giving loans to homebuyers without checking their solvency status.
WRITING on the ongoing economic crisis which started in the United States in 2008 and later engulfed most of the Western world with devastating consequences, New York Times columnist Joe Nocera commented: "What is killing the economy is lack of credit. In the aftermath of an asset bubble, invariably the result of too-loose credit, banks don't just tighten their standards; they practically shut down." How did the banking crisis start and more importantiy how to fix it?
In the olden days, banks used to take deposits and promote economic activities by giving loans to businesses which, when successful, created jobs and increased production and consumption. Their activities were completely transparent. But over the years, as their activities became more and more complex, they became increasingly opaque.
It is unbelievable that the current crisis started with something as simple as giving loans to home-buyers without checking their solvency status. The lenders loosened the standards to such a level that loans were given to people with no income, no job or no other collateral except the house on which the mortgage was given. Everything hinged on the false assumption that house prices would never fall. So if the worst came to the worst, the bank would simply take possession of the house through foreclosure and eventually recoup the loan by selling it.
This was not a prudent way to run a banking business, but under this system banks could at least keep track of individual loans, repayments made, outstanding balances and defaults.
But the process became far more complicated when taking advantage of the slack regulatory system, the ever-innovative financiers, the so-called investment bankers who were adept at financial engineering, found a way to trade these sub-prime mortgages as complex derivatives to investors across the world. The mortgages were sliced, diced and packaged into bundles of Collateralised Debt Obligations (CDO) or Mortgage Backed Securities (MBS), making it impossible to know their real value at any given point of time.
As Robert G. Wilmers, the CEO of M&T Bank, one of the most successfill commercial banks of the United States, put it: "Mortgages were originated by one firm,
packaged by another, sold by a third and serviced by yet another, but none of them worried about whether mortgages would be repaid, because they did not hold them in their books." Yet banks, hedge funds and insurance companies, with the blessing of the rating agencies, merrily used them to swap loans and risks with one another without bothering to update their real values. Again quoting Wilmers: "This growing market for synthetic mortgage-backed securities inundated the country with credit that combined with historically low interest rates, exotic new mortgage products, fuelled the housing bubble, turned our financial markets into a virtual casino. In the collapse that followed, billions of dollars' worth of mortgaged-
backed securities were written off."
As the rating agencies belatedly downgraded the CDOs, the turmoil spread to other parts of the securities market, creating a huge liquidity crisis because financial institutions became reluctant to lend money not only to outsiders but also to each other. In spite of the fact that central banks pumped billions of dollars into the market to avoid a total collapse, a collective loss of faith in the financial system still persists. What can be done to restore this confidence so that credit can start flowing again?
One sure way of rebuilding confidence would be to ban the activities of this "shadow banking industry" which basically engage in trading and speculation. But time has shown that this shadow industry is so powerful that it is impossible to ban its activities. Moreover, today, even though the commercial activities of most of the large traditional banks are better regulated, many of them have also developed trading activities and now earn more money from these activities than from traditional banking. Therefore, under the circumstances, for the sake of better transparency, the regulators should separate the commercial and trading activities in separate companies and control their debt, leverage, capital and reserves separately.
As Wilmers pointed out: "The depres-
sion era Glass-Steagall Act that separated commercial and investment banks should never have been abolished, and the derivatives need to be brought under control." The recendy passed Dodd-Frank Act and the FASB's revised accounting rules relating to sales of financial assets will go a long way in meeting Wilmer’s demands. These measures, when implemented, together with the Fed's monetary policy of quantitative easing will hopefully restore confidence in the American financial system which, in turn, will allow it to extend credits to its clients.
Unfortunately, the banking situation in Europe is even worse. Whatever happens to Europe's banks will affect the American banking system as well. (Unfortunately, the huge market in credit default swaps, which affect banking on both sides of the Adantic remains unregulated and still operates in the shadows.) No one could describe the European situadon better than Gordon Brown, the former British prime minister. He wrote: "European Banks were, in fact, more vulnerable than American banks, they were far more highly leveraged and far more dependent on short-term wholesale funding. In fact, half of America's toxic sub-prime assets had been bought by reckless institutions in Europe." Reading the financial statements, it is difficult to ascertain whether adequate provision has been made by the institutions for potential losses on these assets. Therefore, it is imperative that once and for all they make full disclosure of these risks.
Second, Europe's sovereign debt crisis is posing an even greater threat to the stability of the European banking system and the Euro. Although most of Europe's large banks seemed to pass the recent stress tests with flying colours, the tests among other things did not measure the banks' ability to manage through a possible Greek default, no matter whether it is controlled or uncontrolled. Moody's has downgraded the creditworthiness of two of France's largest banks because of their exposure to Greek sovereign debt.
There is no doubt that in order to feel secure enough to issue credits most of Europe's banks need massive recapitalisation. A huge stabilisation fund is also needed to save the Euro.
The prospects for the future do not look bright. An urgent and concerted effort by the EU, the US, China and the IMF can still save the economy from a total disaster.