What banks can learn from this credit crisis - from FT

--There has been an increasing disconnection between the real and financial economies in the past few years. The real economy has grown at a brisk pace but nothing like that of the financial economy, which grew even more rapidly – until it imploded. --Formidable financial expansion was a response in part to the dynamism of economic activity and in part to a prolonged period of low interest rates. But there has also been the rise in securitisation and the development of structured investment vehicles, conduits, hedge funds, private equity, leverage loans and the like. These were probably the biggest stimulus to the credit multiplier. --The process has been driven by agents that have grown up (and made big profits) in unregulated areas without taking into account the basic principles of prudence and risk management. Some have been non-bank intermediaries. Others have been banks that have used different off-balance sheet vehicles to duck and dive through the regulations in order to join the party. --A clear underestimation of risk and huge flows of finance have been the results. In turn these have fed an unsustainable level of leveraging and asset inflation. The financial community ought to draw conclusions from all this in order to re-establish the normal functioning of the markets. --Regulators and supervisors need to get closer to the activities of unregulated agents that may have a strong bearing both on markets and on regulated firms. --The main question, however, is how to make sure that the activities of high-risk-taking agents do not contaminate the balance sheets of the traditional banking sector. Because the banking sector has a fundamental role in the payments system, there is a considerable amplification of systemic risks when it is hit. Negative knock-on soon filters through to affect the flows of credit and savings of businesses and individuals. --Moreover, it is the banks that have direct access to the liquidity supplied by the central banks and act as a transmission mechanism for changes in monetary policy. --It is clear that we are not up against a problem of lack of regulation. Any overreaction in this direction would be not only futile but also counterproductive. The real challenge is to apply regulation in the right way. And that means looking again at the use of judgment, procedures and incentives in applying the rules. --Various approaches to this challenge should be examined. --First, dealing with the risks of liquidity and funding. It is obvious that in the short term central banks will need to continue supplying ample liquidity to alleviate tensions in interbank and wholesale credit markets. --But beyond that it is clear that supervisors, auditors, rating agencies and, above all, companies themselves will have to pay a lot more attention to getting liquidity management right. This must include, among other things, the use of rigorous stress-testing scenarios. --Second, the mis-pricing of risk. Risk valuation models have improved enormously in the run-up to the incoming Basel II capital adequacy rules. This crisis, however, has revealed that they have their limitations and that it is the markets that provide the final measure of value. It is a reminder that transparency and prudence in decision-making procedures are just as important as the most sophisticated model. --The third approach that should be examined is making sure the incentives of agents are in line with some basic principles of prudent finance. For example, the crisis in the securitised assets markets suggests that origin­ators should be obliged to retain a significant part of the risk on their own balance sheets. --A further area that needs to be revisited is that of executive compensation schemes, to ensure that in future they adequately reflect performance in the medium and long term. --Fourth, it is necessary to enhance the transparency of the exposures of banks. The Basel pillar III, which deals with market discipline, is a good starting point. --But there are big differences in the internal models used by both banks and supervisors and a great deal of harmonisation is required. Harmonisation of models needs to be part of a much broader process. The nature of the global crisis demonstrates the need for greater co-ordination of what are currently national frameworks of regulation and supervision. Greater dialogue and contact among regulators, supervisors and the industry will be essential if they are to be effective in the future. --Finally, and most importantly, the crisis illustrates once again the relevance and usefulness of principles over and above even the most precise rules. All financial intermediaries’ decisions and actions must be morally and socially acceptable, not just legally enforceable, and should withstand any amount of public scrutiny. --We face a complex set of problems. But the good news is that the crisis has exploded during a phase of robust global economic growth and before it could produce long-lasting damage. If we all apply what we have learnt, our markets and firms have the resources to overcome the current crisis – as we have overcome others before. This will allow us to move forward towards a stronger financial environment, taking advantage of the new opportunities offered by globalisation and technological advance.