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Spring Thaw?

CFOs are hoping government intervention will soon melt frozen credit markets. Not likely.
Vincent Ryan, CFO Europe Magazine
March 2, 2009

Every spring, the thawing of the Yellow River threatens lives and property across Inner Mongolia. Ice blocks break free and then pile up further downstream, causing floods and dam bursts. The Chinese army often has to shoot cannonballs at the ice to restore the river's normal flow.

Governments around the world have taken a similar approach to freeing up the frozen banking system: blast away at blockages in liquidity so that banks can resume channeling funds to businesses. But it looks to be a long winter, as many lenders simply aren't ready — or willing — to see their capital dislodged. As much as they may profess to care about corporate customers, commercial banks have made their own survival priority number one.

"A couple of years ago, banking was all about leveraging capital and growing [earnings per share]," says Michael Reinhard, CFO of National Penn Bancshares, a Pennsylvania-based community bank with $9 billion (€7 billion) in assets. "Now it's about generating capital and preserving it."

What do banks have to do before they feel comfortable making loans again? Plenty. For one thing, raising capital is still a struggle, despite the bailout largesse. Also, risk management, both credit and otherwise, has to be retooled, especially with regulators, shareholders and lawyers breathing down bankers' necks. Then there is the problem of disclosure: almost everyone is clamoring for banks to come clean about the quality of their balance sheets, many of which — particularly in the US and the UK — are still riddled with toxic mortgage-related assets.

But the first order of business for banks is shoring up capital. Officials on both sides of the Atlantic contend that banks infused with government funds will have no choice but to lend the bailout funds or use them to absorb loan write-downs and restructurings.

By far the largest bailout, the US government's Troubled Asset Relief Program (TARP), which evolved into the Capital Purchase Program (CPP) for injecting preferred capital into healthy financial institutions, had released $194 billion to 317 financial institutions by late January. In return for taxpayers' money, the government took preferred shares that pay a 5% dividend, which rises to 9% after five years. "If a bank doesn't put the new capital to work earning a profit or reducing a loss, its returns for its shareholders will suffer," said the US Treasury's interim assistant secretary for financial stability and TARP overseer Neel Kashkari in January.

Have programmes such as TARP freed up the flow of funds? At some banks, yes. For example, Independent Bank of Michigan, with $3 billion in assets, wrote $72.4m in new lending — equal to the total amount it received from TARP — during the one month it had the funds in its possession, says CFO Robert Shuster. National Penn Bancshares, which received $150m from TARP, has written several loans, including two totalling $19m — one to an outpatient medical facility whose lender wanted to exit the relationship and one to a retailer to finance holiday season inventory. "We don't usually get involved in large business loans, but TARP made it a whole lot easier," says CFO Reinhard.

Overall, however, only a fraction of the funding has made it from banks' vaults to companies' coffers, despite some banks sitting on the capital since last October. Commercial and industrial loans on the books of US banks dropped by $358 billion from November 2008 to mid-January, according to the Federal Reserve. And research by The Financial Times in February found that only about £12m (€13.4m) has been lent to companies under the UK government's £1 billion loan guarantee programme for small businesses. (The bailout package for UK banks, including RBS, Lloyds TSB and HBOS, has thus far totaled £37 billion.)

Clearly, some larger banks are hoarding capital, but is it fair to tar all the institutions with the same feather? Many continental European banks certainly don't believe so. "Is there an assumption that we are not lending any more?" asks Bertrand Badré, CFO of Crédit Agricole, France's largest bank, which raised €3 billion last year by issuing hybrid securities that were bought by the French government, under the first of its two €10.5 billion rescue plans. (The loans to the country's six biggest financial institutions carry a hefty 8% interest.) While Badré concedes that French banks are less capitalised than they were, say, 18 months ago, their situation isn't comparable to their counterparts in the US and the UK. "Growth in credit in France is more than 7% year on year on average, compared with less than 6% in the rest of  Europe."

Uncharted Territory
Badré is among the bank CFOs who believe the bailout programmes have been unjustly criticised. "It is very difficult to judge the various programmes that were initially announced," he says.  "At that time you had no markets were lending anywhere in the world and measures were needed to ensure sufficient capital to run the economy. That was the rationale."

Patrick Butler, CFO of Raiffeisen Zentralbank (RZB), a privately held Austrian institution that's 88% owned by eight of the country's landesbanks, also goes easy on governments and policy makers. "We — and that includes market participants, regulators, governments, indeed everybody who has some responsibility to carry out the world's financial system — are now operating in uncharted territory," he says. "We don't have a script for what is  occurring. So it's not surprising that there have been some policy proposals and actions that have not been optimal, either in the way that they've been announced or in the way that they've been executed."


As of mid-February, the bank was still undecided whether it would participate in the Austrian government's recapitalisation programme, announced in October, comprising €100 billion of loan guarantees and direct aid. At the end of 2008, RZB had core capital of around €8 billion and a core capital ratio of over 7% (the minimum requirement is 4% in Austria). Total capital exceeded 9%. While the bank does not need the state's capital injection, CEO Walter Rothensteiner has noted on several occasions that the bank would be at a competitive disadvantage if it didn't tap the programme. All of Austria's banks, in any case, are keeping options open as they watch economies sink in central and eastern Europe, to which they are highly exposed.

Slumping economies desperately need commercial lending for their revival. But a recent analysis of UK lending by consultants at Oliver Wyman found that the profit banks achieve from residential mortgage is double that from commercial lending. Yet as Mark Weil, head of EMEA financial services at Oliver Wyman, explains, while banks tend to favour residential mortgage lending from a profit point of view, the country's GDP benefits four times more per pound of commercial lending than retail lending. "This argues strongly for intervention to stimulate commercial lending whether through guarantees, quotas or direct intervention through state sources," he concludes. "Without this, commercial credit will dry up, affecting in particular SMEs, which lack the ability to access capital markets directly and so depend heavily on bank credit."

Aside from stimulating economies, the government programmes will continue to slap a seal of approval on healthy banks to attract private capital. But sovereign wealth funds and private equity are shunning the opportunity to buy entire institutions. Ridding banks' books of toxic assets, guaranteeing future losses on such assets or some combination of the two could pique the interest of private investors.

Consider RZB, which has been increasing its capital cushion over the past few years, says Butler, with a three-part €475m rights-issue programme — the final one raising  €166m and was 100% subscribed last autumn. Though "the days are over for now for RZB of raising five-year money at 12 basis points over Euribor — which we did two and a half years ago on a regular basis — we're still able to raise money competitively," says Butler. "[Last month] we raised five-year money — €1.5 billion — at Euribor at 68 basis points with a government guarantee on the issue."

Comme çi, Comme ça
Banks are also tackling their all-too-obvious risk management failures, notably by tightening lending standards and managing problem credits. But not all banks are good at handling decomposing loan portfolios and working out problem loans, says Richard Speer, CEO of Speer & Associates, a banking consultancy. "Half of banks are pretty good at this, but it's a tough experience for the other half," he adds. One reason is antiquated information-technology systems. "CFOs are very much at the mercy of what the IT environment is," says Speer. "Some banks are still doing this [credit risk management] with Excel spreadsheets and rudimentary databases." And that's not likely to change much any time soon — researchers from Celent predict that this year financial services will spend $5 billion less on IT this year than in 2008.

Regardless of any belt-tightening, however, banks will have to improve stress-testing practices — subjecting assets and liabilities to drastically different assumptions about interest-rate, credit-quality and operational risk. "What would my balance sheet look like if interest rates suddenly rose two times, four times, six times?" asks Don Ogilvie, chairman of the Deloitte Center for Banking Solutions. "Everybody does stress testing, but the questions [banks should be asking] are, Did we stress test properly? Did we anticipate that whole markets would stop? Did we understand the relationships between market A and market B?'"

Finally, banks need to develop risk-exposure frameworks that span the enterprise and aggregate exposures in a timely manner, say consultants. "Risk concentrations are not attributable to any particular category of risk," comment Allan Grody and Peter Hughes of ARC Best Practices in a recent paper. "Indeed, the unmeasured and unreported risk exposures that contributed to the current financial crisis were a cocktail of all the principal categories of risk."

Even if banks do bolster capital and buttress risk management, they will have to shed more light on their balance sheets if they want to regain the confidence of borrowers, investors and other banks. Openness is not something banks are very good at. As CFO Europe's banking survey found, corporate finance chiefs are still looking for assurances about financial strength and stability of their banks. Yet they often have to pay third-party firms for assessments of the safety and soundness of individual lenders.

In general, banks' financial reports are just too complex, says John Millman, CEO and president of Sterling National Bank, part of New York-based Sterling Bancorp, which has $2.1 billion of assets and received $42m of TARP funds in December. "When you talk about money-centre banks with multiple lines of businesses and all kinds of hedging and swap products, I can't pick up the financial statement and understand what's going on," he says. "I hope the regulators can."


According to Richard Herring, a finance professor at the University of Pennsylvania's Wharton School, regulators have been part of the problem, permitting banking complexity to run amok. The top 16 financial institutions have 2.5 times as many majority-owned subsidiaries as the top 16 non-financial companies have, he notes. Such complexity can have serious systemic ramifications if a financial firm goes under, as demonstrated by last September's bankruptcy of Lehman Brothers. One solution Herring recommends: require every bank to have a live bankruptcy plan that gets updated quarterly, to ensure an orderly unwinding if a bank fails.

The Return of Banking
What, ultimately is going to revive financial institutions, assuming they survive the economic meltdown? New regulations can reduce risk by stemming excesses. Previous programmes that purported to manage systemic risk simply didn't work, says Roel Campos, a partner at Cooley Godward Kronish and former commissioner at the SEC. "The markets didn't handle this very well by themselves — you need a diligent referee to enforce legitimate, smart rules," he says. "And you need new software, new models and people who understand them."

RZB's Butler agrees that new regulations are needed. He blames the current ones  for hampering banks' agility to respond to changing business conditions. Basle 2 prevents "banks from building capital in the good times, and requires additional capital in the bad, when it is difficult or impossible to obtain," he says. "The system should encourage banks to 'repair the roof' when the sun is shining. It does the opposite."

But perhaps it would be best if governments didn't burrow too deeply into the fabric of banking, suggest some observers who fret over possible governmental control of capital allocation. Consultant Speer says bank CFOs can't rely on the emergence of a revolutionary product to reignite profits. Instead, small improvements in the economic outlook and the mathematics of banking will have to do, at least for "spread lending" institutions that don't dabble in exotic financial instruments.

Banks are probably hoping that the combination of a low government funds rate and the power to increase pricing continues. For that to happen over a long period, credit would have to remain scarce. But lower benchmark interest rates also spur refinancing by other kinds of borrowers, says Nick Caplanson, CFO of Connecticut-based Dime Bank. "We're going to see accelerated prepayments on loans; that will flood us with cash that we're going to have to put to work."

That raises the problem at the heart of commercial banking: how to keep credit quality high while generating greater loan volume. "Are there going to be enough good credits out there?" asks Caplanson. If not, banks will be happy to stay in a semi-frozen state, and the winter of customers' discontent may drag on for many seasons to come.

Vincent Ryan is a senior editor at CFO. Additional reporting by Janet Kersnar.




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