The Hindu Business Line : Global banking — The convergence scenario

With the convergence of commercial banking, securities trading and insurance streams, banking has indeed undergone a metamorphosis. In this background, banks operating in niche markets and focussed on ‘relationship banking’ will probably have to change the rules of the game.

Smaller banks operating in niche areas need to be supported in the interest of ‘equitable growth’ of the economy.

Katuri Nageswara Rao

Banking, the principal intermediation agency, has a vital role to play in the realm of financial globalisation. Its importance however, differs from country to country. Generally speaking, in developing nations the pure form of commercial banking has a primacy of place, but not so in developed nations.

With the convergence of commercial banking, securities trading and insurance streams, banking has indeed undergone a metamorphosis. Banking, on a global plane, faces many challenges.

Does size matter?

While universal banks are fast emerging following the convergence model, fierce competition is forcing these mega banks to go global and offer many other diversified financial services. What will happen to small and medium sized banks? Do they have prospects for survival? Will they be taken over by big banks, or will they exit gradually under the pressure of competition?

China has small banks, about 100 in number, catering to the SME sector, accounting for over 5 per cent of total assets with a 0.6 per cent return on assets. Japan also has the presence of small banks, in the form of regional banks (64 in number) and city banks (12); both, when combined, command a significant market share. In the US, there are community banks, accounting for 15 per cent of assets. In India, there are old generation private banks, accounting for 4.5 per cent of assets.

All these banks operate in niche markets, confining to narrow geographic regions, serving the middle-class segment, by adopting the strategy of ‘relationship banking’. The regulators need to support them in the interest of the ‘equitable growth’ of the economy.

Operational risk has acquired centre-stage with banks and financial institutions suffering huge losses due to frauds perpetuated by employees.

Operational risks

Barings Bank collapsed because of a rogue trader Nick Leeson, whose indiscretions resulted in a loss of $ 1.4 billion.

A copper trader, Yasuo Hamanaka, was responsible for a loss of $ 2.6 billion to Sumitomo Corp through fraudulent deeds. Both these frauds occurred in 1990. In the year 2006, a hedge fund called Amaranth collapsed, after sustaining a loss of $6 billion, following fraudulent transactions by a trader Brian Hunter, and his team.

Recently, French bank Societe Generale sustained a huge loss of $7.1 billion because of a fraud by a single trader. This bank, the second biggest listed one in France, says that it plans to raise about $8 billion of additional capital to strengthen the balance-sheet.

This bank, incidentally, plans to write down about $3 billion relating to the recent global credit crunch, following the sub-prime crisis in the US.

The series of frauds discussed highlights the disastrous consequences that could follow on account of operational risk. It questions the risk management practices of banks and the diligence of the rating agencies as well Basel II norms.

Technology management

To quote from the recent RBI report, “IT capability can no longer be a black box. Owing to limited technology experience and IT complexity, key decisions in the traditional handling of IT management by board-level executives are deferred to IT professionals.” Perhaps in the future, bank CEOs need to be significantly tech-savvy to be in command of things, as technology will be a critical element of success.

From the consumers’ perspective, slow technology diffusion is a great challenge, especially in the emerging economies such as India, with low R&D expenditure, poor level of basic education, unsatisfactory logistics and very poor rural infrastructure. Proponents of inclusive banking and financial services need to draw the right lessons from this digital divide.

Sub-prime lessons

The US sub-prime crisis teaches many lessons for banks: Loan pricing and risk management standards should not be relaxed in an environment of low interest rates as the eventual rise in interest rates could result in the pile-up of NPAs.

Likewise, excess liquidity should not force banks to dilute credit standards. More important, the very practice of securitisation where the investors blindly sink huge sums without a real-time analysis of the quality of the underlying assets needs a critical examination.

So is the credit transfer mechanism, where such counter-parties as insurance firms, pension funds and hedge funds acquire liabilities without much knowledge about the quality and supervision of the credit portfolio.

While ‘the originate-and-distribute’ strategy of banks under credit risk-transfer mitigates their risks, the counter parties are innocently embracing unknown risks, which is not in the best interests of the economy, though it could be good for the banks.

Global imbalances

Global imbalance in finance result from the massive investments made by emerging economies, besides Japan, and Gulf nations in the US treasuries, home mortgages, and other private funds; these investments are generated either though trade account surplus or capital account borrowings, as a part of external sector management.

With the US, the wealthiest nation, turning into the biggest borrower through profligate consumption and with minimal savings, global imbalances keep rising. The key currency status of the greenback aids this process.

The US, as a consequence, generated twin deficits, namely current account and fiscal to unacceptable heights. The results are obvious: falling dollar and a possible slowdown in the US, which could be contagious.

Banks the world over have to be extra cautious in managing the risks out of these imbalances, like currency risk, interest rate risk and liquidity risks. Emerging economies have a potential to grow fast through the ‘credit led growth route’ if they follow nominative lending polices with a well-diversified portfolio. Higher percentages of bank assets positively correlate with higher GDP growth rates.

Enhance credit

While this ratio is high for the banking systems in Canada, the US, the UK and Japan, it is low, at about 93 per cent, in India. There is a good case, therefore, for further credit expansion in percentage terms.

A recent IBM report forecasts that the rules of the banking game will be redefined by customers, and an intensified regulatory burden. It recommends focus on core strengths; optimising the potential of each customer relationship and harnessing the strength of the workforce through effective performance management.

Global banking is in for exciting times.

(The author is Associate Dean, ICFAI School of Financial Studies, Hyderabad, and consulting Editor, ‘Professional Banker’.)