MOORAD CHOUDRY<br /><strong>HEAD OF TREASURY, EUROPE ARAB BANK</strong><br /><br />THE financial crash of 2007-2008 was caused by the interaction of several different factors, some of which had been building for years. Since then markets have entered a period of restructuring that reflects the realities of the crash: key to this is an awareness that much of the previous business model no longer applies. Banks must recognise the changing dynamic in finance, and adapt their strategy and approach accordingly. Heavier regulation is inevitable.<br /><br />It is not universally agreed that the financial crisis has caused a paradigm shift in the way the banking business model is structured. Time will tell. However, banks will still need to modify their strategies in response. Stronger financial regulation is to be expected. Ideally, regulators in the US and EU will coordinate policies, so banks do not concentrate operations in the jurisdiction with the least restrictive regime. <br /><br />In the first instance the market needs to avoid the build up of another &ldquo;Shadow Banking&rdquo; system. The Basel II rules alone will not prevent a resurgence of shadow banking. Therefore it is important to incorporate a regime that regulates all institutions which engage in leveraged investment business, irrespective of whether they are a &ldquo;bank&rdquo;. The systemic risk is too great to allow any large financial institution to operate without supervision. <br /><br />Regarding lending practices, regulators must enforce minimum acceptable origination standards. For instance, rules might be set on minimum loan-to-value ratios in retail mortgage lending. In Germany, banks have been conservative in their mortgage lending, which explains why their real estate market did not reach levels observed in Spain, Ireland or the UK. A 25 per cent deposit ratio would be a healthy indicator.<br /><br />Banks and regulators, recognising that a business cycle is an inherent part of the economic system, must implement &ldquo;counter-cyclical&rdquo; capital and supervision regimes. Capital should be built up during a bull market, when it is easier to raise, to cover for the impact of a bear market. One approach would be to raise &ldquo;contingent capital&rdquo;, for example debt that can be converted to equity when required. Regulators must also stress supervisory oversight during a bull market, when it tends to be relaxed.<br /><br /><strong>FURTHER STEPS</strong><br />Banks will need to move to a strategy that is sustainable over the business cycle. This will mean lower return on capital targets. A long-run average of 10-12 per cent is more realistic than the recent 18-25 per cent targeted by some banks. <br /><br />The liquidity crisis of 2007-08 has shown that banks must manage liquidity risk better. Measures that should be implemented include:<br /><br />&9679; the leverage ratio: bank boards should not run up leverage ratios approaching 20, 30 or 40 times the capital base. This is unsustainable once the market turns bearish;<br /><br />&9679; liquidity risk management: liquidity is the lifeblood of banking, so banks must approach liquidity risk with greater rigour. This will involve (i) a more diversified funding base, with limits on funds from one source (ii) a longer average tenor of liabilities, to reduce the asset-liability gap and (iii) a liquidity reserve of instantly-realisable assets;<br /><br />&9679; lending policies: revised origination standards that are no longer cyclical and remain robust throughout the business cycle;<br /><br />&9679; knowing one's risk: this also means know one's counterparty risk. Its principal significance is that it implies a return to a bank's core business.<br /><br />The final issue remains the &ldquo;too big to fail&rdquo; bank. A bank that relies on a &ldquo;lender of last resort&rdquo; cannot be allowed to hold a country hostage to its own fortune. To prevent any significant future impact, governments must limit the size of banks whose balance sheet value begins to approach the GDP of its home country. While this is against the culture of free markets, it is important because it recognises that banks are part of society: as such they must not be allowed to endanger societal well-being, which they do when they fail. A bank that is bigger than its own country represents significant risk to society, which is why, if a bank becomes too big to fail, a government should make it smaller.<br /><br /><strong>Moorad Choudhry and Gino Landuyt are in the Treasury team at Europe Arab Bank plc. Moorad is author of Bank Asset and Liability Management (Wiley 2007). </strong><br /><br />Professor Moorad Choudhry is a panellist at the Europe Arab Bank Financial Forum on bank regulation at the London Stock Exchange on 1st July 2009. Lord Lawson of Blaby is the keynote speaker and City AM will feature highlights from the debate on 3 July.