From the Executive Director August 2009

After the crisis: rediscovering old wisdoms

Almost a year after the world faced the real possibility of the international financial system’s collapse, we are still only beginning to get a sense of how that system will be different in the future. In this issue of IBN we feature several articles giving important perspectives on the crisis and its aftermath. There are still plenty of unanswered questions, but let’s focus first on where consensus has clearly emerged.

Banks that strayed from old wisdoms are rediscovering the essence of their business as one of pricing and assessing risk, rather than of growing their balance sheets. They will focus far more on managing down leverage, on the loan/deposit ratio in particular, putting a cap on the extent to which their lending can exceed their deposits, and on their capital ratio. A case like The Royal Bank of Scotland, whose assets exceeded its core capital by 50 times – making a mere two per cent drop in its assets fundamentally endangering – should never be seen again. Over-reliance on wholesale funding, as has been dramatically demonstrated, is no protection in a crisis.

Banks will also hold – indeed they will be required by regulators to hold – more capital against many types of assets. There is also talk of regulators requiring a build-up of excess capital in the good times, to be drawn upon in bad times. The Basel rules on Tier 2 capital have been shown to be inadequate in the accurate weighting of risk. More than that, the crisis arguably even called into question the validity of Tier 2 capital as currently devised. When it all came down to the wire in late 2008, the investment markets put their trust only in pure equity capital to place a value on banks: it was the extent of this in many cases which determined whether or not a bank was going to be allowed to survive. Greater proportions of equity capital will be fundamental to the future of financial institutions.

The need to retain much higher amounts of capital in bank reserves will of course reduce the amount available to be deployed in lending and other asset-growing activities. Within the banks themselves, this will cause some changes to the shape of the business, probably requiring more mergers, and putting more emphasis on income streams which are less capital-intensive. But its greatest impact will be beyond the banks, creating changes that are likely to affect the wider economy, with consequences for all of us, and for our firms.

We can already see a huge reduction of credit. The non-bank lending sector in particular had been fed for years by the banks’ policy of balance sheet growth, leading to a vast market in securitised and packaged bank loans. Those days are over. The necessary and reassuring link between an asset and the owner of title to that asset, which Hernando de Soto talked about so memorably at our Annual Conference in Buenos Aires, will reassert itself.

The reduction in the sector, coupled with the decline or decrease of some of the complex financial products which accompany it, will certainly mean less finance work for law firms. But this is only a small part of the story. In the new more tightly regulated arena of bank capital, capital is likely to become much more difficult to commit across jurisdictions. As a consequence, we might expect trade finance and project finance to become more difficult, and arguably then, globalisation of trade, with all its benefits for the growth of economies, to become more difficult. Countries which are net importers of finance – ie, most countries in the world – might suffer a decline in potential investment levels. These are big issues for our working day as cross-border lawyers, of course, but beyond that, for the economic potential of ordinary lives, none more so tha for the world’s growing numbers of people in poverty, whose chances of escaping that condition may be materially reduced. That, surely, is the most sobering of all perspectives on the new world of the next decade.