There is no such thing as risk-free lending - as the world's bankers keep finding out

Citation

Merrell, C. (2001), "There is no such thing as risk-free lending - as the world's bankers keep finding out", Balance Sheet, Vol. 9 No. 1. https://doi.org/10.1108/bs.2001.26509aab.002

There is no such thing as risk-free lending - as the world's bankers keep finding out

The problems of risk and bank lending were graphically illustrated at the beginning of January by what has become known as the Californian power situation. The state, where inhabitants are among the richest in the world, has through a series of regulatory blunders managed to push two of its utilities to the very brink of bankruptcy. The situation, which appears to be threatening the stability of the USA's capital markets, has shown that there is no such thing as risk-free lending.

Utilities, after all, with their juicy predictable streams of cash and their continuing virtual monopolies must be among the safest companies in the world to which to lend money – usually their bonds attract a triple A rating from the credit rating agencies. However, even capital markets sometimes misjudge the eccentricity of governments and their attitude to deregulation of what were previously State controlled monopolies. A recent 10 per cent lift in the prices the Californian cash-strapped utilities can charge their customers has done little to alleviate the crisis. Some of the more pessimistic commentators believe that, if the companies were allowed to fall into bankruptcy, as well as plunging parts of California into darkness, the resulting debt write-offs would be enough to trigger a banking crisis in the USA which could spill over into Europe. Already, Bank of America, a bank that has for years wrestled with a higher than average bad debt record has been forced to admit that it could be hit by the situation – so jittery were investors that the bank itself had to suspend its own shares to prevent mass selling, as rumours of even bigger write-offs circulated.

Even as the power companies struggled to stave off the dreaded Chapter 11, and the banks, including Barclays, prepare for the worst, a group of bankers, regulators and legislators released a new version of the Basel capital accord, a series of global banking standards aimed at guarding against such capital catastrophes. The proposals, which try to encompass banks' increasingly global perspective, should in future provide a cushion against the biggest capital disasters. Both operational and credit risk will for the first time play key roles in determining capital ratios of nearly all the world's banks. Investors in a bank in Sa¬o Paulo should feel as secure as investors who put their money into a bank in a more developed area of the world.

However, the reality of the new rules may be some time in coming, as they will not be enforced for another four years, giving the world plenty of time to be plunged into some kind of capital chaos, as a result of a hedge fund crisis or debt default. The revised capital accord also has another unusual dimension, as responsibility for policing capital levels will fall to the banks themselves rather than any of the world's regulators – it is a system that accountants and perhaps the unscrupulous could easily exploit. Banks have not often been the most adept guardians of their creditworthiness.

However, the Basel capital accord will at least reduce systemic risk – under the old rules, hastily cobbled together in the wake of the third-world debt crisis, loans were weighted up to a maximum 8 per cent limit. The one-rule-for-all system worked reasonably well – although loans to Microsoft, for example, were deemed to be less risky than loans to Indonesia. The old regime increased liquidity in capital markets globally, but has in more recent times been viewed as too much of a strait-jacket for markets where products have become more and more sophisticated. The previous capital accord was also revealed to be totally lacking when faced with an unexpected shock, such as the Russian Government's default on its own debt – a type of lending that did not require the maximum capital to be set aside. The Russian default, bad as it was, nearly triggered another crisis of global capital, as it, together with the devaluations of currencies in the Far East, was responsible for pushing Long-Term Capital Management, the hedge fund, to the very edge of insolvency. The old Basel rules gave no clue to the seriousness of the situation, until it was nearly too late. Many of the world's biggest banks were forced to bale out the hedge fund, in the interests of market stability, and many investors were astonished to discover that their high street bank had considerable exposure to a fund, the workings of which no one seemed to understand.

The new rules will more finely calibrate risk, and require greater disclosure for shareholders and regulators alike. They will also give a bigger role to the credit-rating agencies, as they are expected to provide advice to the smaller banks, which do not have the fire-power to set up their own internal credit-scoring systems. The use of credit agencies has some particular flaws, as they have not always spotted the highest risk situations.

Banks will also have to set aside capital for the first time to cover the risks of IT failure, and fraud, both very difficult to quantify. The level of capital needed to cover these particular risks has been set at around 20 per cent. Greater disclosure on loan portfolios in the information circulated between banks and to investors will also be another safeguard against global shocks.

All-in-all the new rules are expected to release more capital into the world's banking system. The biggest banks are expected to be those that are in a position to slim down their existing capital level, freeing up cash for more expansion. The New York Federal Reserve Bank president William McDonough, who is also chairman of the Basel Committee for Banking Supervision, summed up the new accord, saying: "The work that we have been doing is meant to strengthen banking systems and banking supervisory systems everywhere. It will make for a safer and sounder banking system, and a shock-absorber for the whole economy." Only time will tell whether the one-inch thick document is enough to prevent another global shock.

Caroline Merrell is banking correspondent with The Times in London.