How to Rebuild Banking?

The financial sector has been one of the main causes and victims of the global economy crisis.

Many once-revered names are no longer with us and many others have only survived because of government bailouts. The Gulf region, by and large, has fared much better but especially markets such as Dubai and Kuwait have experienced their share of turbulence.

Also here, the authorities have intervened aggressively, applying a range of measures to support the normal operations of the financial sector. However, the action has tended to be more pre-emptive and less an emergency response dictated by sheer necessity. Nonetheless, the goal of ensuring the normal operations of the sector has been met only with very partial success.

Moreover, in many countries, the more established banking regulators have done better than their counterparts in the non-banking area.

The reputation of the financial sector now lies in tatters. In the West, the battle over bonuses has turned into one of the worst PR disasters of our time as the one-time masterminds of finance have become some of the most hated villains of our time. The situation in the Gulf is less serious and confrontational.

This is partly because financial sector regulation was much more conservative but also because the regional financial sector was far less developed and sophisticated. This meant that many risky products and techniques were not available but also that the growth of many products had not yet reached the risky frontiers revealed for instance by the US sub-prime crisis.

Nonetheless, markets participants have been sharply hit by the equity market correction and the real estate crisis. Credit has become scarce. Some banks have struggled to meet regulatory requirements in the face of plummeting asset values but a lack of confidence has arguably been an even greater problem. The Saudi banking sector has remained profitably but engaged in essentially no new lending in the course of 2009.

Arguably the main victim of this crisis has been the end-user of financial services, the customer. As banks turned on themselves and their own problems, they inevitably paid less attention to their clients. However, if this has been a stressful time for banks, it has all the more difficult for investors and borrowers. They have seen their expectations and assumptions invalidated by dramatic volatility in their savings, changes in the terms of their loans and adverse shocks to the broader economic circumstances facing them.

To date, relatively little has been done to properly address these problems, with most people content to await a cyclical recovery. Moreover, after the onset of the credit crunch, market players and government authorities have been staging a relatively incoherent, uncoordinated retreat.

Firefighting, however, is not conducive to strategic planning. The public debate has focused disproportionately on bonuses and risky transactions rather than a holistic approach to systemic challenges. An additional complication is the practical difficulty of reform with a largely national focus when most of the leading financial service companies continue to have an international footprint.

It is clear, however, that the crisis will pave the way for more, as well as more conservative regulations. One example are the efforts to create a new capital market law in Kuwait. In the US, the so-called Vocker Rule highlights the widespread aspiration to prevent banks from engaging in high-risk activities. A number of countries are talking about reshaping and restructuring their regulators.

The problem with all these endeavors is that they require time and focused attention when everyone is in a hurry. The political imperative of appearing to do something is often greater than the commitment to truly fixing a problem. Yet a bad reform is worse than no reform at all! Moreover, there is a risk of complacency: one set of regulations replaces another and policymakers turn their attention elsewhere as markets continue to evolve.

Ultimately, however, regulators cannot restore confidence on behalf of the regulated entities. While they create the infrastructure and set the rules and principles, individual banks are responsible for regaining the trust of their clients.

For the GCC banks, this represents an attractive opportunity to become more client-focused and better at fulfilling their inherent role as financial intermediaries. The potential for innovation and growth is considerable indeed in a number of areas:

Product development. A very limited range of investment opportunities has been a source of considerable risk and volatility for Gulf investors. Banks have a chance, emulating their peers elsewhere, to develop a range of products and services that is not specific to particular phases of the business cycle and that offer alternatives as circumstances change.

To manage risks, clients need well-diversified portfolios and the ability to easily alter the proportions of their investments. This is just as important on the loan side where new techniques are needed to ensure that credit can be kept flowing in a prudent way and the customers can deal with situations of distress, not with impunity but without excessive disruptions.

More effective communication. Banks will have to become better at and more focused on talking to their clients. Financial institutions have a responsibility and opportunity to educate, particularly in emerging markets where many products and practices are new. Especially during turbulent times, banks can perform an important service by explaining what is going on and what it means.

A lack of trust is often caused by a lack of understanding and information. By apprising their clients of the risks as well as the opportunities linked to particular products, banks can help inculcate a sense of responsibility. Both product development and communication can in turn be used to help clients embrace a longer investment horizon, something that is still sorely missing, partly because of the excessive reliance on bank finance for credit and on individual equities for investment purposes.

Transparency. Banks must understand not only the broader economic environment they operate in but also the nature and risks of their products and counterparties.

Transparency, or the lack of it, has been much talked about during this crisis and the repudiation of many outdated practices – name lending among them – has created an uncomfortable vacuum as a new regulatory and policy paradigm has yet to take shape. When the old rules no longer apply and new ones are yet to be written, market players tend to err on the side of caution.

More generally, a great deal more has to be invested in systematically assessing customer behavior and risk. The fantastic opportunities of boom times can quickly turn into enormous risks as the economic environment changes.

Both banks and their clients must become better at understanding and managing their risks, an area where regulators can help drive change in a way that does not negate the responsibility of the regulated entities.

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