Leadership requires that banks show they are not fixated on short-term shareholder value, writes Ray Kinsella
MORE THAN a year after the onset of the international credit crisis, the International Monetary Fund (IMF), in its most recent financial stability report, has warned that "global financial markets continue to be fragile, and indicators of systemic risk remain elevated". It is not only the IMF. In June, the European Central Bank (ECB) warned that "the risks to the euro area financial stability system had, on balance, increased compared with the previous six months".
This, it argued, pointed to "a protracted adjustment period within the financial system as banks seek to increase their liquidity and capital positions". They are having a hard time doing both. This unprecedented financial crisis is not going away.
There is a persuasive argument, based partly on levels of volatility, that behind the facade of "Business as Usual", the system is increasingly vulnerable to tectonic shocks with unknowable consequences for the real economy of jobs, trade and living standards.
As recently as two weeks ago, the two titans of the mortgage markets in the US - Fannie Mae and Freddie Mac - which between them hold some $6 trillion (€3.89 trillion) in mortgages, and already enjoyed privileged access to the capital markets, teetered on the brink of failure.
Had the US authorities not stepped in to provide additional guarantees, they would have effectively failed. They are not out of the water yet. In the UK, the Alliance & Leicester Building Society has been acquired by Banco Santander, as the UK mortgage sector goes deeper into crisis.
With each new collapse and/or "near miss", the credibility of the authorities is being further eroded. The next time round - and there will be a next time - neither investors nor the public may trust in the markets or the regulators to contain the implosion.
Recent data from the US on the acceleration of foreclosures on mortgages - the epicentre of the initial crisis - together with the fact that an increasing number of people are simply walking away from mortgages mired in negative equity, is a pathogen within the system that has the capacity to bring about its collapse. All of this highlights the case for a global central bank, as argued some months ago in these pages ( The Irish Times, "Global central bank is needed", January 23rd, 2008).
These developments raise important issues for Irish publicly quoted banks: AIB, Anglo-Irish, Bank of Ireland and Irish Life & Permanent and, by extension, the wider economy. The recent recovery in share prices is well-founded. Such was the extent of the decline in share prices over the last 12 months or so that, prior to the recent recovery, share prices had fallen - on average - by some 70 per cent compared to the previous 12 months. Such declines are not justified by reference to balance-sheets or recent performance, as AIB's recent results demonstrate. It is an axiom of financial theory that markets are efficient and rational. But the operation of markets over the last decade has been subverted by a business model that is flawed, rooted in greed and excess.
It is not functioning effectively. It is a rogue market, spawned by the malign sub-prime debacle to which it gave birth and the parallel universe of "structured finance". It is now beset by uncertainty and fear. The credibility of policy has dissipated.
The US and other world central banks have injected hundreds of billions of euro into global credit markets - effectively exchanging publicly funded equity for the toxic debt acquired by banks in their pursuit of short-term shareholder value. Even this hasn't succeeded in regenerating trust on the part of the financial markets.
The Irish economy is structurally stronger than it was in the 1980s. Equally, the banks, while exposed to prospective write-offs, have balance sheets fully compliant with regulatory requirements. The Financial Regulator imposes limits on the extent of exposures by banks to specific sectors. Importantly, unlike their European peers, the liquidity position of Irish banks was presciently "stress-tested" before the onset of the crisis. They also have access to liquidity from the European Central Bank (ECB).
However, higher write-offs and the fall in the demand for mortgages and loans, as well as a lack of market confidence and difficulties on the funding side experienced by all banks, have impacted on their share prices. This has been reinforced by the fact that Ireland is no longer "flavour of the month" with international institutional investors. The Celtic Tiger was always a niche play for them and, in any event, there is no longer any incentive to acquire Irish bank shares to gain indirect exposure to the Irish economy.
In the present savage bear market in global equities, financial stocks have been hammered and Irish banks shares have been a casualty. Domestic investors lack the stomach for "value investing" in institutions that would appear to be undervalued, while international investors have simply lost interest. Against this background, the recent modest strengthening is encouraging.
The four listed banks - each with a very different business model - have an importance to the Irish economy that would be difficult to overstate. It's not alone the jobs, and the quality of these jobs. It's the knowledge-base encompassed within the banks' branch network. It's also about the sensitivity of domestically-owned and headquartered banks to the pulse of the Irish economy and their informal role as a conduit for public policy directed towards the common good. The IFSC, to take one example, would never have happened in the absence of a commitment by Irish banks.
Compared with 12 months ago, and taking a short- to medium-term view, the market value of Irish banks has contracted. Smaller banks generally find it more difficult and/or expensive to raise capital. The issue here is not that the banks need to raise capital from a regulatory perspective; rather, the market reserves to itself the right to decide on what it regards as a sufficiently robust capital base.
There are a number of options for the banks. They could seek to "sit out" the recession, on the basis of the economy's latent strength, the quality of their recent performance and, also, their balance sheets. The markets, it is reasonable to assume, have factored all of this into the existing share-levels.
This option of sitting it out, however, may leave individual banks vulnerable to take-over. It is quite certain that more than one potential predator has run the slide-rule over them - and they will almost certainly have redone their homework in recent times. An attempted takeover could, in principle, be friendly or hostile. One point is clear: the implications would be very far-reaching indeed.
Another option would be for one, or more, of the banks to initiate merger talks. This would require the consent of the Financial Regulator and the Competition Authority. The fact that the Irish banking system is now an integral part of the EU Internal Market, together with the ease of entry through new technology-based platforms, means that the implications for competition would be very different compared to the past. A merger would reduce the absolute number of competitors, particularly in retail, business and mortgage finance. But the Irish banking market would remain contestable - any attempt to exploit market dominance would attract new entrants.
The Irish financial system has been enormously enriched, in terms of consumer choice, alternative business models and competition, by the entry of overseas-based banks. This is what the EU internal market is all about. Nonetheless, if one or more of the listed banks were to be taken over, particularly through a hostile takeover, there would be a serious and lasting loss of welfare for the Irish economy.
A newly merged bank would be less vulnerable to a takeover. It would almost certainly find it easier and cheaper to raise additional capital, should this be necessary. In the mid and late 1960s Dr Ken Whitaker, the economic architect of modern Ireland, impelled the then eight Irish clearing banks to merge in order to form four larger and stronger banks, capable of competing with an influx of overseas banks. The same logic - albeit in different circumstances - applies in today's environment.
A merger would inevitably lead to job losses and the closure of some branches. It is the staff that creates value in any bank. In order for a merger to succeed, it would be imperative that management, staff and the IBOA engage in dialogue, in an environment of trust and respect. A post-merger rationalisation process has to be set against the possible consequences of an overseas acquisition of one of the core banks, at the heart of the Irish financial system. This would involve not alone job losses, but also the migration of key management, operational and technical functions abroad.
There is another perspective that needs to be factored into any attempt to understand, let alone resolve, this crisis. It began within the banking system. It was transmitted across the banking sector and credit markets. The sheer scale of the fallout from what has been a monumental failure in leadership within the global banking system is simply incalculable. The banks continue to be insulated from consequences of their actions at two different levels. Firstly, by shareholders (including pension funds - the irony!), whose investment in the banks has been diluted by capital-raising to mitigate disastrous strategic and operational decisions. Secondly, the banks have been bailed out by governments and global central banks. The business model within which banks operate needs to change. "Business as usual" is no longer an option - not after what has happened and its cost in human terms.
It is important that banks be proactive, whichever of the options above is pursued. Leadership requires that they demonstrate they are not fixated on maximising short-term shareholder value. They have other stakeholders, whose commitment and loyalty has helped to generate shareholder value. Households are now struggling with mortgages, including those of 100 per cent on a 40-year term, on properties that have fallen sharply in value - mortgages that banks were marketing aggressively as recently as last year. Businesses are confronted with an economy at the cusp of recession while, at the same time, being subject to much stricter conditions and requirements in relation to funding.
The Irish listed banks prospered during the years of the Celtic Tiger. It is in their strategic interest, and that of the country, that they demonstrate an understanding of this reality: sustainability and profitability are built on real relationships and public trust, rather than on a fixation with shareholder value through the pursuit of a metric/targets-driven culture imposed on staff. It is in the hard times that the sincerity of such "relationships" are truly tested.
• Professor Ray Kinsella is author of the forthcoming book Regulation Corporate Governance and Ethics in Financial Services