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David Ely

Expert Insights: Banking industry

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David Ely is a professor of finance and director of Graduate Business Programs for the College of Business Administration at San Diego State University.

How has the financial crisis reshaped the banking industry? What are the new requirements for successful banking leadership?

Until 2007, the banking industry had been on a trend of regulatory liberalization. Over the past 20 years, a range of geographical and product regulatory restrictions have been relaxed. This culminated with the passage of the Financial Services Modernization Act in 1999 that allowed for the creation of large financial organizations that engage in commercial banking, securities and insurance activities. The proposals put forward by the Obama administration in response to the financial crisis represent a reversal of this trend. If implemented, financial institutions will become more regulated in a number of ways, especially the financial institutions that are judged to be "too-big-to-fail" or too "interconnected."

One proposed change receiving broad support concerns bank capital. In the future, financial institutions will need to be better capitalized to withstand losses arising from lending, off-balance-sheet and other activities in areas that have now been revealed to be sources of underappreciated risks. Risk management techniques employed by banks must also be adjusted so that they are more robust. The popular value-at-risk techniques based upon historical information cannot accurately measure risk when the current economic environment is very different from the past. Greater emphasis will need to be placed on risk assessment methods simulating economic scenarios that are more extreme than recent historical experience. The financial crisis has also changed banks' thinking about liquidity. Bank managers need to develop contingency plans in case common sources of liquidity evaporate.

David Ely

Another key feature of the administration's proposal is to assign identifying emerging systematic risk to a newly created Financial Services Oversight Council. Since actions by regulators may be influenced by perceptions of heightened systematic risk, financial institutions may also want to monitor systematic risk to anticipate changes in the regulatory environment.

What do you see banks doing/continuing to do to maintain profitability and manage costs during the downturn?

Now more than ever, banking organizations need to project an image of strength and stability. A key component of such a strategy is for a bank to convince investors, the public and regulators that its capital is more than sufficient to absorb losses even in an unstable economic environment. This may involve promoting the institution as one with relatively few problem loans and a portfolio of low-risk assets. Those institutions that avoided subprime mortgages and securities backed by them, and that operate in markets where home prices have not declined precipitously, are in the best position to credibly make this claim.

Demonstrating that a bank can conduct business without government assistance can also signal strength. For example, 10 banks sent such a signal after receiving permission to repay TARP funds in early June. Banks perceived as strong and stable are more likely to be successful in raising capital from private sources. And, banks that have been able to raise capital can argue that the process provided certification of their strength and stability by investors.

While almost all banks have experienced a depletion of capital during this economic downturn, some banks have experienced greater losses than others. Moreover, some banks were less well capitalized at the start of the financial crisis. A bank that finds itself close to or below the regulatory minimum standards may have little choice but to shrink the institution in order to raise its capital ratio. Stronger rivals may therefore be well positioned to capture market share at the expense of these retrenching institutions. The competitive positions of many institutions will change as a result of these relative capital conditions.

All banks are now benefitting from the historically low deposit rates. These are low not only because of the general level of interest rates across the economy, but also because of greater deposit inflows arising from the perceived safety of traditional bank accounts. For a while in spring, banks were also benefiting from non-interest income generated from the business of refinancing mortgages.

What other trends do you see emerging in the banking industry? Is there anything in particular that consumers should keep an eye on?

Consumers may want to follow the debate over the Obama administration's proposal to create a new regulatory body, the Consumer Financial Protection Agency (CFPA), to protect consumers and investors from unfair, deceptive and abusive practices. Given the evidence of abuses in the selling of subprime and other mortgage products, some additional oversight is needed.

The goal of promoting fairness and simplicity in consumer financial markets is commendable. However, care must be exercised to avoid creating a regulator that is overly bureaucratic. Consumers have a great deal at stake in seeing that the CFPA ends up encouraging fairness and efficiencies in retail financial markets without stifling innovation.

The low mortgage rates that existed in April and May of this year generated a high volume of refinancing. This activity slowed in June as mortgage rates increased. However, with so much uncertainty over the direction of the economy, it is difficult to predict the direction of mortgage rates with any confidence. Homeowners who missed out on the opportunities to refinance earlier this year may want to follow mortgage rates throughout the summer and fall to spot new opportunities. Long-term interest rates will rise with any sign that an economic recovery is under way or that inflation is getting out of hand.

Regulatory reforms in the credit-card industry will be implemented next year. However, credit card issuers are re-evaluating their products in the context of the new rules. Consequently, the terms of credit-card products may be changed over the next few months. Consumers will want to carefully review any communication from their credit-card companies so that they are aware of any changes in the terms of their agreements.

At the start of the financial crisis, the deposit insurance coverage at banks and credit unions was temporarily raised from $100,000 to $250,000. The higher limit was to revert back to $100,000 at the end of 2009. However, in May Congress extended the higher limit through 2013.

-- Compiled by Rebecca Go

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