Banking Banana Skins 2010

After the ‘quake

The CSFI survey of bank risk
In association with In association with

Centre for the Study of Financial Innovation

CSFI

C S F I / New York CSFI
The Centre for the Study of Financial Innovation is a non-profit think-tank, established in 1993 to look at future developments in the international financial field – particularly from the point of view of practitioners. Its goals include identifying new areas of business, flagging areas of danger and provoking a debate about key financial issues. The Centre has no ideological brief, beyond a belief in open and efficient markets. Trustees Minos Zombanakis (Chairman) David Lascelles Sir David Bell Robin Monro-Davies Sir Brian Pearse Staff Director – Andrew Hilton Co-Director – Jane Fuller Senior Fellow – David Lascelles Programme Coordinator – Lisa Moyle Governing Council Sir Brian Pearse (Chairman) Sir David Bell Geoffrey Bell Robert Bench Rudi Bogni Peter Cooke Bill Dalton Sir David Davies Prof Charles Goodhart John Heimann John Hitchins Rene Karsenti Henry Kaufman Angela Knight Sir Andrew Large David Lascelles Philip Martin-Brown Robin Monro-Davies Rick Murray John Plender David Potter Mark Robson David Rule Sir Brian Williamson Peter Wilson-Smith Minos Zombanakis

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C S F I / New York CSFI
NUMBER NINETY TWO

C S F I / New York CSFI
FEBRUARY 2010

Preface Prefaceproducing its Banking Banana Skins survey almost annually since 1994, The CSFI has been
latterly with generous support from PricewaterhouseCoopers. The CSFI has been producing its Banking Banana Skins survey almost annually since 1994, The intention has always been to identify those concerns latterly with generous support from PricewaterhouseCoopers.that people in the financial services sector – as well as those who watch, regulate and succour them – believe are the next “banana skins” on which the industry is likely to slip. those concerns that people in the financial not what The intention has always been to identify Note, therefore, that it is not predictive. It is services the CSFIas or theas those Davidwatch, regulate and succour them – believe are the next “banana sector – – well author, who Lascelles – believes is going to happen. It is a distillation of what others on which the industry is likely to slip. what is going that the not predictive. It is not what skins” (most of whom are extremely close toNote, therefore,on at it is financial coalface) expect to happen, or or the author, David Lascelles – believes is going to happen. It is a distillation of what the CSFI – fear may happen. others (most of whom are extremely close to what is going on at the financial coalface) expect to So, don’t blamemay happen. surveys didn’t always get it right. In particular, don’t blame us that, happen, or fear us that earlier in 2005 and 2006, pride of place at the top of the Banana Skins list went to “too much regulation”. That was what us industry felt – though one can get it right. In a case that what the us that, So, don’t blame the that earlier surveys didn’t alwayscertainly make particular, don’t blameindustry really needed was pride more regulation or, better still, smarter regulation. in 2005 and 2006, either of place at the top of the Banana Skins list went to “too much regulation”. That was what the industry felt – though one can certainly make a case that what the industry That said, looking at the list regulation or, better still, Banana Skins since 1996 (page ??), it is really needed was either more of the most important smarter regulation. significant just how close to the top credit risk, derivatives and risk management have been. It sometimes seems at the list of the most (who are well-represented in 1996 (page 10), like That said, lookingas though senior bankersimportant Banana Skins since our survey) were it is compulsive shoplifters, almost begging to risk, derivatives be risk management have been. It significant just how close to the top credit be caught and to and put out of their (peer pressureinduced) misery. as though senior bankers (who are well-represented in our survey) were like sometimes seems compulsive shoplifters, almost begging to be caught and to be put out of their (peer pressureBut those are conclusions for you, the reader, to make. induced) misery. What we are conclusions for you, the reader, of multi-year data on what keeps senior City types But those offer is an increasingly valuable setto make. awake at night – besides the size of their bonuses, of course. Over the next few months, we hope to work the raw data that we have accumulated multi-year data on what sciencesenior City types What we offer is an increasingly valuable set of a bit harder, since the keeps of statistics has advanced in the besides the size of their bonuses, of course. Over the more fascinating we hope awake at night – last decade – and that may well generate some even next few months, findings. But, in the raw data that we have accumulated a put “political interference” at the top of has to workthe meantime, no surprise that bankers todaybit harder, since the science of statisticstheir Banana Skins list; at decadeI – and that maybetter generate some even more fascinating findings. advanced in the last least, suppose that’s well than the threat of ritual disembowelling which seemed the the cards only surprise that bankers today put “political interference” at the top of their But, in on meantime, no a few months ago. Banana Skins list; at least, I suppose that’s better than the threat of ritual disembowelling which Andrew Hilton seemed on the cards only a few months ago. Director CSFI Andrew Hilton Director CSFI

This report was written by David Lascelles Cover by Joe Cummings This report was written by David Lascelles Cover by Joe Cummings

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Foreword
PricewaterhouseCoopers is delighted to sponsor another year of Banking Banana Skins. It has been an extraordinary eighteen months for the banking industry since the last Banana Skins was published in May 2008. Back then, few thought we would see so many banks either collapse or require rescue; events since then make for a fascinating survey. This is the first economic crisis that has drawn out long enough to have two Banana Skins published (let us hope it doesn’t continue for a third!). Once again a brand new banana skin – political interference – heads the list. Respondents are also beginning to focus on what comes after the crisis, although many retain fears that the worst is not yet over, hence credit risk retains its number two spot. A worrying theme is the question of whether the crisis has taken the industry’s future out of its own hands. With political interference as the top risk and too much regulation at number three there is clear sense that change may be forced onto the industry from outside. Many respondents make the point of how deeply unpopular the banks have become among the populace at large. The need to rebuild trust that the last survey highlighted has become even more acute. It is always interesting to look back at the previous survey to see which of the top banana skins were slipped on subsequently. Liquidity was the top risk last time and came closer in the autumn of 2008 to bringing the entire system down than any previous banana skin. The survey does get it right sometimes and so this year’s survey could be a well timed warning for politicians not to overreact. As ever there is a richness of perceptive comment threaded through the survey which repays a careful read. John Hitchins UK Banking Leader PricewaterhouseCoopers (UK)

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About this survey
This survey describes the risks currently facing the global banking industry, as seen by a wide range of bankers, banking regulators and close observers of the banking scene around the world. The survey was carried out in November and December 2009, and received 443 responses from individuals in 49 countries. The questionnaire (reproduced in the Appendix) was in three parts. In the first, respondents were asked to describe, in their own words, their main concerns about the financial system over the next 2-3 years. In the second, they were asked to rate a list of potential risks, or Banana Skins, selected by a CSFI/PwC panel, both by severity and whether they were rising, steady or falling. In the third, they were asked to rate the preparedness of financial institutions to handle the risks they identified. Replies were confidential, but respondents could choose to be named. The breakdown of respondent by type was:
Regulators 6% Observers 32% Bankers 62%

The responses by country were as follows:
Australia Austria Bahrain Belgium Bermuda Brazil Canada Cayman Is. Croatia Czech Rep. Denmark Finland France GCC Germany Gibraltar 11 5 1 3 2 1 16 1 1 9 1 10 1 1 17 1 Greece Guernsey Hong Kong Hungary India Ireland Italy Japan Jersey Kazakhstan Kenya Luxembourg Malta Mauritius Multinational Netherlands New Zealand 8 2 2 3 12 4 2 4 6 5 1 9 1 1 4 7 4 Philippines Poland Qatar Romania Russia Serbia Singapore Slovakia South Africa Spain Sweden Switzerland Thailand UK Ukraine US 2 7 1 13 31 1 6 1 6 2 13 17 1 156 1 29

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Summary Summary
This report describes the the risk outlook This report describes risk outlook for for the banking industrythe the turn of the banking industry at at turn of the the year 2010 – a time of year 2010 – a time of unprecedented stress in the the financial unprecedented stress in financial markets. TheThe findings are based on markets. findings are based on responses from more than 400400 responses from more than bankers, bankers, regulators regulators andand close close observers of the the banking scene 49 49 observers of banking scene in in countries. countries.

Banking Banana Skins 2010 Banking Banana Skins 2010
(2008 ranking in brackets) (2008 ranking in brackets)
Political interference (-) (-) 1 Political interference 2 Credit (2) Credit risk risk (2) TooToo much regulation (8) 3 much regulation (8) Macro-economic trends (5) (5) 4 Macro-economic trends Liquidity (1) (1) 5 Liquidity Capital availability (-) (-) 6 Capital availability Derivatives (4) (4) 7 Derivatives Risk management quality (6) (6) 8 Risk management quality Credit spreads (3) (3) 9 Credit spreads Equities (7) 10 Equities (7) Currencies (13) 11 Currencies (13) Corporate governance (16) 12 Corporate governance (16) Commodities (12) 13 Commodities (12) Interest rates (9) 14 Interest rates (9) Fraud (11) 15 Fraud (11) Management incentives (17) 16 Management incentives (17) Emerging markets (18) 17 Emerging markets (18) High dependence on on technology 18 High dependence technology (15)(15) Hedge funds (10) 19 Hedge funds (10) Rogue trader (14) 20 Rogue trader (14) Business continuation (23) 21 Business continuation (23) Retail sales practices (20) 22 Retail sales practices (20) Conflicts of interest (21) 23 Conflicts of interest (21) Back office (19) 24 Back office (19) Environmental risk (25) 25 Environmental risk (25) Payment systems (27) 26 Payment systems (27) Money laundering (24) 27 Money laundering (24) Merger mania (28) 28 Merger mania (28) Too little regulation (29) 29 Too little regulation (29) Competition from new entrants (30) 30 Competition from new entrants (30)

The biggest The biggest Banana Skin is is Banana Skin political political interference interference

Pessimism about Pessimism about the global the global economic economic outlook outlook

1 2 3 4 5 6 TheThe dash by governments rescue dash by governments to to rescue 7 their banks from the the financial crisis their banks from financial crisis may have staved off off a collapsethe the 8 may have staved a collapse of of system, but but has has left the banking 9 system, it it left the banking industry industry deeply deeply politicised, politicised, a a 10 development which respondents to to 11 development which respondents thisthis survey find be be the greatest 12 survey find to to the greatest source of riskrisk now facing the banking 13 source of now facing the banking sector. sector. 14 15 As As risk, political interference a a risk, political interference 16 (making its its first appearance as a (making first appearance as a Banana Skin thisthis year) has many 17 Banana Skin year) has many angles: it itdistorts commercial angles: distorts commercial 18 judgment, it creates moral hazard, andand 19 judgment, it creates moral hazard, it raises uncertainty about how andand 20 it raises uncertainty about how when financial support willwill be 21 when financial support be removed. Closely linked is the the risk of 22 removed. Closely linked is risk of too too much regulation (No.from an an 23 much regulation (No. 3) 3) from over-reaction to the the crisis. over-reaction to crisis. 24 25 What is striking about these Banana What is striking about these Banana Skins is thatthat they are common all all 26 Skins is they are common to to major banking regions, andand are shared 27 major banking regions, are shared 28 by bankers andand non-bankers alike. by bankers non-bankers alike. 29 TheThe dominant factor shaping risk 30 dominant factor shaping risk

perceptions is the the state the the world perceptions is state of of world economy. Respondents’ comments about macro-economic trends (No. 4) were economy. Respondents’ comments about macro-economic trends (No. 4) were broadly pessimistic, viewing the the recent signsrecovery as fragile andand vulnerable to broadly pessimistic, viewing recent signs of of recovery as fragile vulnerable to further shocks. This accounts for for the high position occupied credit risk (No. 2) 2) further shocks. This accounts the high position occupied by by credit risk (No. where the the outlookseen to be for for further losses the the true cost the the crisis is where outlook is is seen to be further losses as as true cost of of crisis is counted, andand the lagging effectthe the recession takestoll toll borrowers. counted, the lagging effect of of recession takes its its on on borrowers. Although liquidity risk (No. 5) has has slipped from the top position it occupiedthe the Although liquidity risk (No. 5) slipped from the top position it occupied in in last last surveymid-2008, it remains a high level concern. Tension in other financial survey in in mid-2008, it remains a high level concern. Tension in other financial markets, however, is seen to be easing, notably in derivatives (No. 7), 7), credit markets, however, is seen to be easing, notably in derivatives (No. credit spreads (No. 9) andand equities (No. 10). One market where risk is seenbe rising is is spreads (No. 9) equities (No. 10). One market where risk is seen to to be rising currency (up (up from No. to No.No. 11) with attention focusing particularly the the currency from No. 13 13 to 11) with attention focusing particularly on on prospects for for the US dollar. Concern has also eased about the outlook for interest prospects the US dollar. Concern has also eased about the outlook for interest rates (down from No.No. 9No.No. 14): although a sharp riserates may be imminent rates (down from 9 to to 14): although a sharp rise in in rates may be imminent in an environment of dramatic monetary easing, it isitalsoalso very predictable. Another in an environment of dramatic monetary easing, is very predictable. Another notable decline is the the risk associated with hedge funds (down from No. to No.No. notable decline is risk associated with hedge funds (down from No. 10 10 to

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19) withwith a falling in theirtheir aggressive activity, also alsoappreciation that that they 19) a falling off off in aggressive activity, but but an an appreciation they may may be less threatening to financial stability thanbanks themselves. be less threatening to financial stability than the the banks themselves. Making its first first appearance in Banana Skins series, the availability of capital Making its appearance in the the Banana Skins series, the availability of capital (No.(No. 6) is seen asarea area of high risk as banks to rebuild theirtheir balance sheets. 6) is seen as an an of high risk as banks try try to rebuild balance sheets. Although there havehave been a number of large recapitalisations in crisis, investor Although there been a number of large recapitalisations in the the crisis, investor appetite could weaken; there will will alsoselling pressure as governments seekseek to appetite could weaken; there also be be selling pressure as governments to offload theirtheir stakes inmedium term. offload stakes in the the medium term.

The availability The availability of capital is is of capital a big worry a big worry

Political interference: distorts commercial judgment, creates moral hazard. Political interference: distorts commercial judgment, creates moral hazard. Too much regulation: over-reaction to the crisis. Too much regulation: over-reaction to the crisis. Capital availability: hugehuge demands, weakening investor appetite. Capital availability: demands, weakening investor appetite. Corporate governance: will banks learn lessons fromfromcrisis? Corporate governance: will banks learn lessons the the crisis? Currencies: worries about US dollar volatility. Currencies: worries about US dollar volatility. Liquidity: not the problem it was a year year ago. Liquidity: not the problem it was a ago. Credit spreads, derivatives, equities, interest rates: markets getting backback to Credit spreads, derivatives, equities, interest rates: markets getting to normal. normal. Hedge funds: off the radar screen so far as risk is concerned. Hedge funds: off the radar screen so far as risk is concerned. BackBack office: stood up well in the crisis. office: has has stood up well in the crisis. Fraud and rogue trader: fewer incidents thanthan might be expected crisis period. Fraud and rogue trader: fewer incidents might be expected in a in a crisis period.

RISING RISKS RISING RISKS

BigBig movers movers

FALLING RISKS FALLING RISKS

Some of the risksrisks facing banks seenseenbe self-generated. Concern about the the Some of the facing banks are are to to be self-generated. Concern about quality of risk risk management (No.remains highhigh following disastrous losses quality of management (No. 8) 8) remains following the the disastrous losses suffered in the last last two years. The riskpoorpoor corporate governance risenrisen suffered in the two years. The risk of of corporate governance has has sharply (from No. No.to No. No. 12), and management incentives (No. remain a a sharply (from 16 16 to 12), and management incentives (No. 16) 16) remain preoccupation, though opinion is divided between bankers whowho consider risk risk to preoccupation, though opinion is divided between bankers consider the the to be outside interference and and non-bankers who see bad incentives encouraging be outside interference non-bankers who see bad incentives encouraging excessive risk-taking. Concern about conflicts of interest within financial excessive risk-taking. Concern about conflicts of interest within financial institutions seems to be easing (down fromfrom No. to No. No. 23). Many the the institutions seems to be easing (down No. 21 21 to 23). Many of of responses in the governance area area were tinged with worry that that banks have not responses in the governance were tinged with the the worry banks have not learnt lessons from the crisis and are too eager to get backback to business as usual. learnt lessons from the crisis and are too eager to get to business as usual.

‘Green risks’ ‘Green risks’ are seen to be be are seen to small despite small despite climate change climate change

On the operational risk risk front, there was a notable decline in concern about fraud On the operational front, there was a notable decline in concern about fraud (down fromfrom No.to No. No. and the rogue trader (down from No. No.to No. No. 20) (down No. 11 11 to 15) 15) and the rogue trader (down from 14 14 to 20) despite experience which sayssays that both risks risea in a recession. However the despite experience which that both risks rise in recession. However the ranking of these risksrisks is closely linked to number of recent incidents, of which ranking of these is closely linked to the the number of recent incidents, of which there havehave been few (Madoff being strictly a bankbank fraud). Concerns about risks there been few (Madoff not not being strictly a fraud). Concerns about risks in the back office, payment systems and business continuation – all– all of which once in the back office, payment systems and business continuation of which once featured highhigh as Banana Skins – have eased considerably. There also also been a fall featured as Banana Skins – have eased considerably. There has has been a fall in the ranking of money laundering (down from No. No.to No. No. which is nownow in the ranking of money laundering (down from 24 24 to 27) 27) which is viewed as a as a reputational rather than financial risk. The perception of environmental viewed reputational rather than financial risk. The perception of environmental risk risk (No. was was unchanged despiteheat heat generated byCopenhagen Summit. (No. 25) 25) unchanged despite the the generated by the the Copenhagen Summit. Although competition from newnew entrants (No. was was seen tothe leastleast of the Although competition from entrants (No. 30) 30) seen to be be the of the risksrisks facing industry, it generated much comment from respondents about the the facing the the industry, it generated much comment from respondents about dangers of weakened bankbank competition greater complacency due to government dangers of weakened competition and and greater complacency due to government bail-outs and higher regulatory entry barriers. The The prospectsstructural change, as as bail-outs and higher regulatory entry barriers. prospects for for structural change, measured by the risk risk of merger mania (No. 28), were seen to be small. measured by the of merger mania (No. 28), were seen to be small.

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A break-down of responses shows an unusually highhigh levelagreement among A break-down of responses shows an unusually level of of agreement among bankers and non-bankers about the main Banana Skins. Insofar as there are nuances, bankers and non-bankers about the main Banana Skins. Insofar as there are nuances, bankers are mainly concerned withwith political and and regulatory fall-out from the bankers are mainly concerned the the political regulatory fall-out from the crisis, and and non-bankers worried that that banks will to reform themselves, and and crisis, non-bankers are are worried banks will fail fail to reform themselves, merely headhead straight into a new crisis. Regulators focusedthe quality of balance merely straight into a new crisis. Regulators focused on on the quality of balance sheets and risk risk management. Geographically, concerns were also strikingly similar sheets and management. Geographically, concerns were also strikingly similar in the three regions surveyed: North America, Europe and and Asia-Pacific: all all in the three regions surveyed: North America, Europe the the Asia-Pacific: considered political interference, regulatory overkill and credit risk risk to be among the considered political interference, regulatory overkill and credit to be among the biggest dangers facing the industry. biggest dangers facing the industry. Preparedness. We asked respondents howhow well prepared they thought industry Preparedness. We asked respondents well prepared they thought the the industry was was to handle risksrisks they identified. Only 9 per cent cent answered “well” 11 11 to handle the the they had had identified. Only 9 per answered “well” and and per cent cent answered “poorly”. The remainder gave a “mixed” reply. This is a more per answered “poorly”. The remainder gave a “mixed” reply. This is a more negative result thanthan timetime whenper cent cent said “well” onlyonly 4 cent cent said negative result last last when 24 24 per said “well” and and 4 per per said “poorly”. “poorly”.

Only 9% of of Only 9% respondents think respondents think banks are well banks are well prepared prepared to handle risk to handle risk

The Banana Skins Index The Banana Skins Index
5 5
Equity Equity mkts mkts Credit Credit risk risk Liquidity Liquidity Too much Too much Political Political regulation regulation interference interference Derivatives Derivatives

4.5 4.5 Score Score 4 4

3.5 3.5Poor Poor 3 3

risk mgt mgt risk

2.5 2.5 2 2

The Banana Skins The Banana Skins Index is at an an Index is at all-time high all-time high

The The Banana Skins Index tracks responses over time and be readread asindicator Banana Skins Index tracks responses over time and can can be as an an indicator of anxiety levels on a on a scale of 1-5. The line line showsaverage score given to the the of anxiety levels scale of 1-5. The top top shows the the average score given to top risk risk over last last years, and and bottom line line average of all the risks. top over the the 12 12 years, the the bottom the the average of all the risks. Although the top risk risk has fallen off, All-risk index is atis atall-time high, an an Although the top has fallen off, the the All-risk index an an all-time high, indication of the exceptional level of anxiety currently gripping the market. indication of the exceptional level of anxiety currently gripping the market. The The course of index overover last decade shows the finance sector emerging in a in a course of the the index the the last decade shows the finance sector emerging bullish mood from the late 1990s but running into intofrenzy of the dot comcom crash in bullish mood from the late 1990s but running the the frenzy of the dot crash in the early 2000s. Although the top risk risk peaked2000, the overall anxiety levellevel the early 2000s. Although the top peaked in in 2000, the overall anxiety continued to rise risetwo two years in messy aftermath. The The risk level then subsided continued to for for years in the the messy aftermath. risk level then subsided as stability returned to the markets. However the first first indications of anxiety about as stability returned to the markets. However the indications of anxiety about the soundness of the bull bull appeared in the 2006 survey withwith a sharp rise in the the soundness of the run run appeared in the 2006 survey a sharp rise in the All-risk index, which has continued withwithpresent poll.poll. All-risk index, which has continued the the present

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19 98 19 19 98 99 19 20 99 00 20 20 00 01 20 20 0 01 2 20 20 02 03 20 20 03 04 20 20 04 05 20 20 0 06 5 20 20 06 07 20 20 07 08 20 20 08 10 20 10
Top risk risk Top Avg.Avg. of all risks of all risks

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Who said what Who said what
A breakdown of the top ten responses by type type shows different levels of concern. A breakdown of the top ten responses by shows different levels of concern.

Bankers – practitioners of commercial andand investment banking Bankers – practitioners of commercial investment banking
1 2 3 4 5 6 7 8 9 10 Political interference 1 Political interference Too Too much regulation 2 much regulation Credit risk risk 3 Credit Liquidity 4 Liquidity Derivatives 5 Derivatives Macro-economic trends 6 Macro-economic trends Capital availability 7 Capital availability RiskRisk management quality 8 management quality Credit spreads 9 Credit spreads Equities 10 Equities

Bankers put political interference at the top of of Bankers put political interference at the top theirtheir risk because of the pressure it creates risk list list because of the pressure it creates to override commercial judgment, e.g. e.g. by to override commercial judgment, by forcing them to lendlenda in a recession. Concern forcing them to in recession. Concern about a regulatory over-reaction to to the about a regulatory over-reaction the financial crisis is closely linked. Bankers’ financial crisis is closely linked. Bankers’ worries also also include a worsening credit outlook worries include a worsening credit outlook as bad bad debts continue pile pile up, and the as debts continue to to up, and the availability of new new capital. Their concern with availability of capital. Their concern with liquidity risk risk and the derivatives market, liquidity and the derivatives market, particularly credit default swaps, remains high. particularly credit default swaps, remains high.

Bankers, Bankers, observers and observers and regulators agree regulators agree onon the big risks, the big risks, but differ onon the but differ the detail detail

Observers – non-bankers, analysts, consultants, academics Observers – non-bankers, analysts, consultants, academics
1 2 3 4 5 6 7 8 9 10 Political interference 1 Political interference Macro-economic trends 2 Macro-economic trends Credit risk risk 3 Credit Too Too much regulation 4 much regulation Capital availability 5 Capital availability RiskRisk management quality 6 management quality Liquidity 7 Liquidity Credit spreads 8 Credit spreads Currencies 9 Currencies Equities 10 Equities

Non-banker respondents share the the bankers’ Non-banker respondents share bankers’ concerns about political interference, though concerns about political interference, though for different reasons: theythey worried about for different reasons: are are worried about the moral hazard created by bankbank rescues and the moral hazard created by rescues and wonder whether bankers havehave learnt lessons wonder whether bankers learnt lessons from the crisis. They also also suspect that banks from the crisis. They suspect that banks havehave got to the bottom of theirtheir bad loans, not not got to the bottom of bad loans, and and skimping on theirtheir risk management. are are skimping on risk management. Non-bankers are the mostmost pessimisticthe the Non-bankers are the pessimistic of of major respondent groups about the economic major respondent groups about the economic prospects, fearing a ‘double dip’ dip’ recession. prospects, fearing a ‘double recession.

Regulators – supervisors, government officials Regulators – supervisors, government officials
1 2 3 4 5 6 7 8 9 10 Credit risk risk 1 Credit Political interference 2 Political interference Liquidity 3 Liquidity Currencies 4 Currencies Macro-economic trends 5 Macro-economic trends Credit spreads 6 Credit spreads Corporate governance 7 Corporate governance Commodities 8 Commodities RiskRisk management quality 9 management quality Capital availability 10 Capital availability

The The prospect another wave of bad bad debts prospect of of another wave of debts heads the concerns of regulators as recession heads the concerns of regulators as recession takes its toll on borrowers – and and uncertainties takes its toll on borrowers – uncertainties still still cloud the financial markets. Liquidity, cloud the financial markets. Liquidity, currency, credit spreads and and commodity risk currency, credit spreads commodity risk are all highhigh on their Regulators also also worry are all on their list. list. Regulators worry about political interference, in theirtheir case about political interference, in case because of the the uncertainty about how and because of uncertainty about how and when governments will will withdraw their when governments withdraw their support. The The weaknesses in bank governance support. weaknesses in bank governance exposed by the crisis are another concern. exposed by the crisis are another concern.

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North America North America
1 2 3 4 5 6 7 8 9 10 Political interference 1 Political interference Credit risk risk 2 Credit Too Too much regulation 3 much regulation Liquidity 4 Liquidity Macro-economic trends 5 Macro-economic trends RiskRisk management quality 6 management quality Corporate governance 7 Corporate governance Derivatives 8 Derivatives Credit spreads 9 Credit spreads Capital availability 10 Capital availability

Government intrusion into intobanking system Government intrusion the the banking system through bail-outs and and official support heads through bail-outs official support heads the list of risksrisks in North America, notably in the list of in North America, notably in the US. US. Canadian banks more concerned the Canadian banks are are more concerned about the threat of regulatory over-reaction. about the threat of regulatory over-reaction. The The immediate concerns in both countries are immediate concerns in both countries are veryvery much with crisis fall-out: credit and much with crisis fall-out: credit and liquidity risk,risk, and the shaky prospects for liquidity and the shaky prospects for economic recovery. There was was less concern economic recovery. There less concern about the the availability capital thanthan in about availability of of capital in Europe. Europe.

Risks are Risks are similar across similar across the major the major regions regions

Europe Europe
1 2 3 4 5 6 7 8 9 10 Political interference 1 Political interference Credit risk risk 2 Credit Macro-economic trends 3 Macro-economic trends Too Too much regulation 4 much regulation Capital availability 5 Capital availability Liquidity 6 Liquidity RiskRisk management quality 7 management quality Credit spreads 8 Credit spreads Derivatives 9 Derivatives Equities 10 Equities

Europe is also also deeply concerned about the Europe is deeply concerned about the consequences of government involvement consequences of government involvement withwith banks, notably inUK where there is a is a banks, notably in the the UK where there lot of it, and and where many respondents were lot of it, where many respondents were located. Linked to this this is fear of a regulatory located. Linked to is fear of a regulatory over-reaction, particularly by Brussels. Other over-reaction, particularly by Brussels. Other top top concerns focus crisis-related issues: concerns focus on on crisis-related issues: credit risk,risk, capital, liquidity, and credit credit capital, liquidity, and the the credit derivative markets. The The economic mood is derivative markets. economic mood is pessimistic, withwith many respondents worried pessimistic, many respondents worried that the recovery will will be long difficult. that the recovery be long and and difficult.

Asia Pacific Asia Pacific
1 2 3 4 5 6 7 8 9 10 Too Too much regulation 1 much regulation Macro-economic trends 2 Macro-economic trends Credit risk risk 3 Credit Political interference 4 Political interference Currencies 5 Currencies Commodities 6 Commodities Liquidity 7 Liquidity HighHigh dependence on tech. 8 dependence on tech. Derivatives 9 Derivatives Fraud 10 Fraud

Respondents from this this region included Japan, Respondents from region included Japan, Australasia, South EastEast Asia and India – a Australasia, South Asia and India – a broad group exposed to a to a variety of risks. The broad group exposed variety of risks. The response is notable for the strength of concern response is notable for the strength of concern about regulatory over-reaction to the the crisis, about regulatory over-reaction to crisis, particularly in Australia, and pessimism about particularly in Australia, and pessimism about the economic outlook, mainly because of fearsfears the economic outlook, mainly because of of aof a ‘bubble’ the tigertiger economies and a ‘bubble’ in in the economies and a collapse of the credit markets. The The region also collapse of the credit markets. region also focused on the risksrisks of fraud and banking focused on the of fraud and the the banking system’s highhigh technological dependence. system’s technological dependence.

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C S F I / New York CSFI
Industrial countries Industrial countries
1 2 3 4 5 6 7 8 9 10 Political interference 1 Political interference Too Too much regulation 2 much regulation Liquidity 3 Liquidity Credit risk risk 4 Credit Macro-economic trends 5 Macro-economic trends Capital availability 6 Capital availability RiskRisk management quality 7 management quality Credit spreads 8 Credit spreads Corporate governance 9 Corporate governance Derivatives 10 Derivatives

Industrial and Industrial and emerging emerging economies have economies have different concerns different concerns

The The concerns of industrial countries centre on concerns of industrial countries centre on the the political fall-out from the crisis: the political fall-out from the crisis: the impact of government ownership and support, impact of government ownership and support, and and ensuing regulatory crackdown, which the the ensuing regulatory crackdown, which is widely seenseen as potentially damaging to the is widely as potentially damaging to the banking system. The The most pressing risks for banking system. most pressing risks for the banks remain on the credit front, withwith the the banks remain on the credit front, the possibility of another wave of bad bad debts, and possibility of another wave of debts, and continuing liquidity difficulties, despite recent continuing liquidity difficulties, despite recent improvements. Recapitalisation could be abe a improvements. Recapitalisation could problem. There is caution about the economic problem. There is caution about the economic outlook. outlook.

Emerging economies Emerging economies
1 2 3 4 5 6 7 8 9 10 Credit risk risk 1 Credit Credit spreads 2 Credit spreads Macro-economic trends 3 Macro-economic trends Currencies 4 Currencies RiskRisk management quality 5 management quality Fraud 6 Fraud Political interference 7 Political interference Equities 8 Equities Too Too much regulation 9 much regulation Capital availability 10 Capital availability

The The concerns in the emerging world are are top top concerns in the emerging world all linked to financial pressures arising from all linked to financial pressures arising from the crisis: bad loans and difficult markets. The The the crisis: bad loans and difficult markets. risksrisks in macro-economic outlook are seenseen in the the macro-economic outlook are to be particularly high, for example in Russia to be particularly high, for example in Russia where the economy is fragile, and and in Far Far where the economy is fragile, in the the EastEast where ‘bubbles’ feared to be building where ‘bubbles’ are are feared to be building up. On the other hand, concern about political up. On the other hand, concern about political and and regulatory pressures lower thanthan in regulatory pressures is is lower in industrial countries. The The high place taken by industrial countries. high place taken by fraud is notable, again possibly driven by the the fraud is notable, again possibly driven by economic downturn. economic downturn.

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Banana Skins: The Top Ten 1996-2010
1 2 3 4 5 6 7 8 9 10 Poor management EMU turbulence Rogue trader Excessive competition Bad lending Emerging markets Fraud Derivatives New products Technology foul-up

1996

1 2 3 4 5 6 7 8 9 10

Poor risk management Y2K Poor strategy EMU turbulence Regulation Emerging markets New entrants Cross-border competition Product mis-pricing Grasp of technology

1998

1 2 3 4 5 6 7 8 9 10

Equity market crash E-commerce Asset quality Grasp of new technology High dependence on tech. Banking market o’-capacity Merger mania Economy overheating Comp from new entrants Complex fin. instruments

2000

1 2 3 4 5 6 7 8 9 10

Credit risk Macro-economy Equity markets Complex financial instruments Business continuation Domestic regulation Insurance Emerging markets Banking market over-capacity International regulation

2002

1 2 3 4 5 6 7 8 9 10

Complex financial instruments Credit risk Macro economy Insurance Business continuation International regulation Equity markets Corporate governance Interest rates Political shocks

2003

1 2 3 4 5 6 7 8 9 10

Too much regulation Credit risk Corporate governance Derivatives Hedge funds Fraud Currencies High dependence on tech. Risk management Macro-economic trends

2005

1 2 3 4 5 6 7 8 9 10

Too much regulation Credit risk Derivatives Commodities Interest rates High dependence on tech. Hedge funds Corporate governance Emerging markets Risk management

2006

1 2 3 4 5 6 7 8 9 10

Liquidity Credit risk Credit spreads Derivatives Macro-economic trends Risk management Equities Too much regulation Interest rates Hedge funds

2008

1 2 3 4 5 6 7 8 9 10

Political interference Credit risk Too much regulation Macro-economic trends Liquidity Capital availability Derivatives Risk management quality Credit spreads Equities

2010

Some Banana Skins come and go, some are hardy perennials. The Top Ten since 1996 show how concerns have changed over more than a decade. The 1990s were dominated by strategic issues: new types of competition and technologies, dramatic developments such as EMU, the Internet and Y2K. Many of these faded, to be replaced by economic and political risks and particularly by concern over the growth of regulation. The period after 2000 also saw the rise of newfangled risks such as derivatives and hedge funds, the latter making their first appearance in 2005. The 2008 survey, conducted at the height of the crisis, brought the focus sharply onto credit and market risks, and propelled two new entrants to the top of the charts: liquidity and credit spreads. This year’s survey shows a preoccupation with the crash aftermath: lingering debt and funding problems, but also looming questions about the state of the world economy and the intrusion of government into the banking sector.

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1. 1. Political interference (-) Political interference (-)
The The dashgovernments to rescue theirtheir banks from disaster may have stavedaoff a dash by by governments to rescue banks from disaster may have staved off collapse of the system, but it has has left banking industry deeply politicised, a a collapse of the system, but it left the the banking industry deeply politicised, development which is seenseenour respondents to be the greatest risk risk now facing the development which is by by our respondents to be the greatest now facing the finance sector. finance sector. Political interference on this this scale being rare, it never before appeared in 15 15 Political interference on scale being rare, it has has never before appeared in years of Banana Skins surveys (though “political shocks” suchsuchrevolutions and and years of Banana Skins surveys (though “political shocks” as as revolutions warswars have). concern about it is strong and widespread, and it includes bankers as as have). But But concern about it is strong and widespread, and it includes bankers well well non-bankers, eveneven regulators. Geographically, it came top the list in in as as non-bankers, regulators. Geographically, it came top of of the list Europe and North America, and No. 4 in 4 inAsiaAsia Pacific region. Europe and North America, and No. the the Pacific region.

Political meddling Political meddling in banking is is in banking invariably invariably ‘negative’ ‘negative’

Concern falls falls into three areas. Concern into three areas. One One ismoral hazard created by bankbank rescues. The managing director of risk at a is the the moral hazard created by rescues. The managing director of risk at a large US bankbank said that it had already begun to breed complacent attitudes: “We'll large US said that it had already begun to breed complacent attitudes: “We'll always be bailed out”. Ros Ros Altmann, a policy adviserthe London School of of always be bailed out”. Altmann, a policy adviser at at the London School Economics, said said that banks now assumed that they cannot “which distorts theirtheir Economics, that banks now assumed that they cannot fail fail “which distorts operational decisions and and permits different behaviour than would otherwisethe the operational decisions permits different behaviour than would otherwise be be case. They also also know that governments need bank share pricesstay stay strong in case. They know that governments need bank share prices to to strong in order to offload taxpayer stakes in future which, again, gives them the one-way order to offload taxpayer stakes in future which, again, gives them the one-way option of reaping the rewards of risk-taking, but but not suffering penalties of of option of reaping the rewards of risk-taking, not suffering the the penalties failure”. failure”. The The second the the politicisation lending. Having bailed the the banks out, second is is politicisation of of lending. Having bailed banks out, governments are pushing them to keepkeep lending through recession, against theirtheir governments are pushing them to lending through the the recession, against better judgment. A director at a at a large UK bank said that “political meddling in the better judgment. A director large UK bank said that “political meddling in the financial sector is almost universally contradictory and and negative. One can't lend financial sector is almost universally contradictory negative. One can't lend more to support the economy and build up capital bases at the same time”. A credit more to support the economy and build up capital bases at the same time”. A credit analyst at a large Japanese bank said said that “political interference in both banking and analyst at a large Japanese bank that “political interference in both banking and regulation is likely to lead leada to a mis-allocationresources, which will will probably regulation is likely to to mis-allocation of of resources, which probably increase, not decrease, the risk profile of the system”. increase, not decrease, the risk profile of the system”. The The third concernhowhow governments will withdraw their support without third concern is is governments will withdraw their support without upsetting the banking system and and jeopardising recovery. A respondent from upsetting the banking system jeopardising the the recovery. A respondent from Ireland, where the government is deeply involved, said:said: “Currently system is is Ireland, where the government is deeply involved, “Currently the the system extensively supported by individual states. The The ability of individual banks, and the extensively supported by individual states. ability of individual banks, and the system in general, to extricate itself fromfrom such support and raise capitalaon a standsystem in general, to extricate itself such support and raise capital on standalone basis is an issue”. The The chief risk officer of a large South African bank said: alone basis is an issue”. chief risk officer of a large South African bank said: “The main immediate concerns havehave been alleviated through government “The main immediate concerns been alleviated through government intervention. The The remaining concern is mostly around disengagement process of of intervention. remaining concern is mostly around the the disengagement process governments from theirtheir intervention, and whether this would occuran orderly governments from intervention, and whether this would occur in in an orderly way”. way”. The The future of government intervention is also a crucial question regulators, one one future of government intervention is also a crucial question for for regulators, of whom said said that “premature withdrawal government support could leave of whom that “premature withdrawal of of government support could leave weaker banks unable to finance theirtheir assetsaon a sustainable basis given their high weaker banks unable to finance assets on sustainable basis given their high leverage”. Several respondents raised the additional worry that that there wasmoney leverage”. Several respondents raised the additional worry there was no no money left to bail bail banks of a of a new round of failures. A senior risk officer at a large US left to banks out out new round of failures. A senior risk officer at a large US bankbank said that “should ‘green shoots’ prove false, and and these countries have said that “should the the ‘green shoots’ prove false, these countries have exhausted theirtheir resources, no company will be ‘too to fail’ fail’ - which could create a exhausted resources, no company will be ‘too big big to - which could create a crisis deeper thanthan of us havehave seen”. crisis deeper any any of us seen”.

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There is ais a reason, course, for for the politicisation banking: the the need rescue There reason, of of course, the politicisation of of banking: need to to rescue banks in the the first place. This will leave a political legacy matter how the the crisis banks in first place. This will leave a political legacy no no matter how crisis runs its its course. Many respondents said that banks would have repair their runs course. Many respondents said that banks would have to to repair their relations with governments andand the public if they wantedexpunge political risk. relations with governments the public if they wanted to to expunge political risk. Here is a is a selectioncomments on thisthis theme. Here selection of of comments on theme. “Banks justjust don’t get how unpopular they are and how much has to “Banks don’t get how unpopular they are and how much has to change.” – Former regulator. change.” – Former regulator. “The banks stillstill failrealise the the depthpublic anger against them. As a a “The banks fail to to realise depth of of public anger against them. As result, their behaviour seems to have changed not notall. all. The result is likely result, their behaviour seems to have changed at at The result is likely to be a period of tension between banks andand regulators, which means that to be a period of tension between banks regulators, which means that banks concentrate on politics to the the detriment their ordinary banking banks concentrate on politics to detriment of of their ordinary banking business.” – City lawyer. business.” – City lawyer. “The financial sector as aas a lobby groupnot not aligned with the interests of “The financial sector lobby group is is aligned with the interests of the the real economythe the taxpayer.” – City trader. real economy or or taxpayer.” – City trader. “We need to get get backbusiness without government support.” – UK UK bank “We need to back to to business without government support.” – bank chairman. chairman.

A legacy of of A legacy mistrust mistrust

2.2. Credit risk (2) Credit risk (2)
TheThe risklarge credit losses remains a top-level Banana Skin because of fears thatthat risk of of large credit losses remains a top-level Banana Skin because of fears thatthat banks have not gotthe the bottomtheir existing their badbad debts, and because banks have not got to to bottom of of their existing their debts, and because loan problems always lag lag the recovery and could still increase. This was the No. 1 loan problems always the recovery and could still increase. This was the No. 1 riskrisk for regulators. Bankers and observers put itNo.No. Geographically, the the risk for regulators. Bankers and observers put it at at 3. 3. Geographically, risk waswas seenbe most severe in the the Asia Pacific region becauseasset bubbles. seen to to be most severe in Asia Pacific region because of of asset bubbles.

The worst yet The worst yet to to come come onon credit? credit?

Many respondents felt felt that the worst was yetcome. US US bank analyst Ray Soifer Many respondents that the worst was yet to to come. bank analyst Ray Soifer said: “The economy is not not yet out the the woods, and credit losses arelagging said: “The economy is yet out of of woods, and credit losses are a a lagging indicator. I do not not believe that they have peaked.” Chris Pettit, head strategy at at indicator. I do believe that they have peaked.” Chris Pettit, head of of strategy the the Royal Bank Scotland, saidsaid that “the economic outlook still looks miserable; Royal Bank of of Scotland, that “the economic outlook still looks miserable; credit riskrisk remains high,” while from Ireland, a respondent wrote: “A real concern credit remains high,” while from Ireland, a respondent wrote: “A real concern would be the the impact bank balance sheets of aof a ‘double dip’the the euro/worldwide would be impact on on bank balance sheets ‘double dip’ in in euro/worldwide economies.” economies.” Concerns focused particularly on real estate, commercial as well as domestic. A A Concerns focused particularly on real estate, commercial as well as domestic. respondent from the the US said that rising unemployment was harbinger of of respondent from US said that rising unemployment was a a harbinger potentially huge losses on property lending. A Nordic regulator saidsaid that “companies potentially huge losses on property lending. A Nordic regulator that “companies are are only surviving due lowlow interest rates”. On the home loan front, several only surviving due to to interest rates”. On the home loan front, several respondents could see see banks facingdilemma as borrowers defaulted on on their respondents could banks facing a a dilemma as borrowers defaulted their mortgages, but but the political climate made hard for for them foreclose. Adrian mortgages, the political climate made it it hard them to to foreclose. Adrian Coles, director-general of the the UK’s Building Societies Association, saw a squeeze Coles, director-general of UK’s Building Societies Association, saw a squeeze between “rising unemployment in 2010, andanddiminishing ability on the the part of between “rising unemployment in 2010, a a diminishing ability on part of mortgage lenders to exercise significant forbearance policies”. mortgage lenders to exercise significant forbearance policies”. Another area of concern is consumer credit – credit cards andand car loans – where Another area of concern is consumer credit – credit cards car loans – where bankers saidsaid that bad debts “had not bottomed out yet”. There is also the question of bankers that bad debts “had not bottomed out yet”. There is also the question of leverage: pastpast deals built large amounts of debt which investors cannot now leverage: deals built on on large amounts of debt which investors cannot now service. A UKUK regulator saw “continuing economic weakness affecting highly service. A regulator saw “continuing economic weakness affecting highly leveraged borrowers, particularly commercial property lending andand leveraged buyleveraged borrowers, particularly commercial property lending leveraged buyouts”. outs”.

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TheThe other major area concern is is other major area of of concern asset valuation: are are banks on top of A subtle beast asset valuation: banks on top of A subtle beast their exposures, andand have they valued their exposures, have they valued them realistically? Many respondents them realistically? Many respondents Credit risk risk is a complex and subtle Credit is a complex and subtle beast. Even if the upturn continues felt felt the answer both questions waswas beast. Even if the upturn continues the answer to to both questions it will manifest itself number of no. no. Richard Farrant, chairman the the it will manifest itself in a in a number of Richard Farrant, chairman of of different ways. audit committee of Daiwa Securities, audit committee of Daiwa Securities, different ways. Europe, saidsaid that “while mark-toEurope, that “while mark-toUK banking consultant market means thatthat banks' trading UK banking consultant market means banks' trading portfolios are are probably reasonably portfolios probably reasonably realistically valued, I am am much more sceptical that their loan books are, and that realistically valued, I much more sceptical that their loan books are, and that could well become a source of pressure if the the rateeconomic recovery diminishes could well become a source of pressure if rate of of economic recovery diminishes or stalls”. Peter Moffatt of the the Guernsey Financial Services Commission was or stalls”. Peter Moffatt of Guernsey Financial Services Commission was concerned about “unexpected lossloss duemispricing/misunderstanding of assets on on concerned about “unexpected due to to mispricing/misunderstanding of assets banks’ balance sheets (or clients’ balance sheets)”. banks’ balance sheets (or clients’ balance sheets)”. Geographically, a respondent from a major banking trade association saidsaid this was a Geographically, a respondent from a major banking trade association this was a particular issue in the the eurozone where, unlike the US and the UK, banks tenduse use particular issue in eurozone where, unlike the US and the UK, banks tend to to lessless markmarket accounting. “Failure to admit the the extentthe the write-downs that mark to to market accounting. “Failure to admit extent of of write-downs that are are necessary will prolong the periodinstability in both the the system and for some necessary will prolong the period of of instability in both system and for some individual eurozone banks”. A respondent from a Middle East bank saidsaid that individual eurozone banks”. A respondent from a Middle East bank that “European banks, Middle Eastern banks andandparticular Dubai banks are aredenial “European banks, Middle Eastern banks in in particular Dubai banks in in denial about their exposures, which could very well set back Europe andand the Middle East about their exposures, which could very well set back Europe the Middle East for about fivefive years”. for about years”.

3.3. Too much regulation (8) Too much regulation (8)
TheThe torrentnew regulation being proposed in the the wakethe the crisis, however well torrent of of new regulation being proposed in wake of of crisis, however well intentioned, is seen as potentially weakening the the banking industry rather than intentioned, is seen as potentially weakening banking industry rather than strengthening it. Many respondents described it as aas a dangerous over-reaction which strengthening it. Many respondents described it dangerous over-reaction which could endend damaging not not just the banks but the wider economy. could up up damaging just the banks but the wider economy.

Excessive Excessive regulation may regulation may weaken rather weaken rather than strengthen than strengthen the banks the banks

This concern waswas particularly strong among bankers, who ranked it No.but but also This concern particularly strong among bankers, who ranked it No. 2, 2, also among observers of the the banking industry who putat No.No. Regulators took a a among observers of banking industry who put it it at 4. 4. Regulators took different view: they thought the the problem was too little rather than too much different view: they thought problem was too little rather than too much regulation. All All geographical regions gave this Banana Skin a high score: it came top regulation. geographical regions gave this Banana Skin a high score: it came top in Asia Pacific. in Asia Pacific. Respondents gave many reasons for for their concerns about regulation. Chief among Respondents gave many reasons their concerns about regulation. Chief among them waswas that the regulatory crackdown was politically driven and therefore likely them that the regulatory crackdown was politically driven and therefore likely to be be overdone. The chairman a large UKUK bank was said his worry was to overdone. The chairman of of a large bank was said his worry was “overbearing regulation which is not not proportionate of a level playing field “overbearing regulation which is proportionate or or of a level playing field character”. Many respondents made the the point that the risk lay politicians andand character”. Many respondents made point that the risk lay in in politicians regulators going for for quantity rather than quality. The chief auditor a large regulators going quantity rather than quality. The chief auditor of of a large Canadian bank saidsaid regulators took the view that “more work equals more control, Canadian bank regulators took the view that “more work equals more control, when they need intelligent risk-based regulation”. A particular concern for European when they need intelligent risk-based regulation”. A particular concern for European respondents waswas the EU’s response, which was likely be particularly heavyrespondents the EU’s response, which was likely to to be particularly heavyhanded andand politically driven. Sonja Lohse, headgroup compliance at Nordea in in handed politically driven. Sonja Lohse, head of of group compliance at Nordea Sweden, saidsaid that the EU’s new regulatory proposals had not been properly Sweden, that the EU’s new regulatory proposals had not been properly evaluated, andand could “squeeze out flexibility from the markets” and damage the few evaluated, could “squeeze out flexibility from the markets” and damage the few banks which hadhad managedmake it through the the crisis unscathed. banks which managed to to make it through crisis unscathed.

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There waswas also the fear that regulation would stifle the recovery loading the the There also the fear that regulation would stifle the recovery by by loading banks with expensive capital andand liquidity rules. John Hitchins, UK banking leader banks with expensive capital liquidity rules. John Hitchins, UK banking leader at PricewaterhouseCoopers, saidsaid that “the cumulative effect all the the regulatory at PricewaterhouseCoopers, that “the cumulative effect of of all regulatory initiatives could have an inadvertent permanently damaging effect on the the industry’s initiatives could have an inadvertent permanently damaging effect on industry’s profitability”. TheThe chief risk officer aof a large German bank warned that pressure profitability”. chief risk officer of large German bank warned that pressure from politicians andand regulators “could lead overregulation of banks. This may from politicians regulators “could lead to to overregulation of banks. This may reduce banks’ willingness to take further risks, andand could lead turnturn ato a further reduce banks’ willingness to take further risks, could lead in in to further contraction of the the economy”. contraction of economy”. TheThe sheer volumenew regulation waswas also a concern, from the pointview of of sheer volume of of new regulation also a concern, from the point of of view costcost and management distraction. Michael McKee, a partnerlawlaw firm DLA Piper and management distraction. Michael McKee, a partner at at firm DLA Piper saidsaid that “there has be a limit to how much change a financial institution can can that “there has to to be a limit to how much change a financial institution safely take on board at oneone time”. Tougher regulation may also have unintended safely take on board at time”. Tougher regulation may also have unintended consequences. TheThe higher costs will havebe passed on to consumers, which willwill consequences. higher costs will have to to be passed on to consumers, which be unpopular. TheThe impact profitability could alsoalso spur bankstake more riskrisk or be unpopular. impact on on profitability could spur banks to to take more or abscond to more lightly regulated centres. abscond to more lightly regulated centres. TheThe riskexcessive regulation waswas No. 1the the Asia Pacific region.Australia, risk of of excessive regulation No. 1 in in Asia Pacific region. In In Australia, Gary Dingley, chief operational riskrisk officer the the Commonwealth Bank, saw the Gary Dingley, chief operational officer of of Commonwealth Bank, saw the riskrisk a regulatory overreaction “without the the necessary review, consultation and of of a regulatory overreaction “without necessary review, consultation and analysis of overall impact on the the individual banksthe the financial sectors”. A banker analysis of overall impact on individual banks or or financial sectors”. A banker from India commented: “The current crisis has has ledall types of banks failing, large from India commented: “The current crisis led to to all types of banks failing, large small, investment, retail, the the works. Largely the common denominator poor small, investment, retail, works. Largely the common denominator is is poor liquidity management. As we come out outthisthis crisis the main threatsafety willwill be liquidity management. As we come of of crisis the main threat to to safety be over-reaction from regulators which leads to ato a too costly system and unsustainable over-reaction from regulators which leads too costly system and unsustainable business models.” business models.” Regulators were not,not, however, blind these dangers. Michael Lesser, managing Regulators were however, blind to to these dangers. Michael Lesser, managing director of supervision andand authorisationQatar, wrote: “Regulators (and I am am one) director of supervision authorisation in in Qatar, wrote: “Regulators (and I one) need to be careful about how new rules are are written,avoid either overly restricting need to be careful about how new rules written, to to avoid either overly restricting the the ability of banks to do business or by restricting some business lines, ability of banks to do business or by restricting some business lines, inadvertently encouraging firms to get get involvedother, lessless restricted, but riskier inadvertently encouraging firms to involved in in other, restricted, but riskier business.” business.”

Too much Too much regulation regulation could stifle the could stifle the recovery recovery

4.4. Macro-economic trends (5) Macro-economic trends (5)
Fears of of a Fears a ‘double dip’ ‘double dip’ recession recession
TheThe economic outlook remains extremely uncertain, pushing this Banana Skin a a economic outlook remains extremely uncertain, pushing this Banana Skin up up notch. Most of our our respondents sounded very pessimistic. For many, the danger is notch. Most of respondents sounded very pessimistic. For many, the danger is not not simply that there will a “double dip” recession, but but that bankers will be simply that there will be be a “double dip” recession, that bankers will be unprepared for it. it. unprepared for Broadly, non-bankers seem to be more pessimistic than bankers (No. 2 versus No.No. Broadly, non-bankers seem to be more pessimistic than bankers (No. 2 versus 6), andand Asia Pacific (No. more pessimistic than either Europe (No. 3) or North 6), Asia Pacific (No. 2) 2) more pessimistic than either Europe (No. 3) or North America (No. 5). If there is a is a consensus, it is that the current recovery is very weak, America (No. 5). If there consensus, it is that the current recovery is very weak, sustained only by lowlow interest rates and massive fiscal and monetary support.isIt is sustained only by interest rates and massive fiscal and monetary support. It alsoalso vulnerableato a reversal caused fresh problems on the the banking front: a surge vulnerable to reversal caused by by fresh problems on banking front: a surge in badbad debts,continuing shortage of credit, mounting pressures on government in debts, a a continuing shortage of credit, mounting pressures on government resources, andand wavering investor confidence. The question whether the the global resources, wavering investor confidence. The question is is whether global economy willwill somehow struggle on, suffer a setback,even collapse intointo deflation. economy somehow struggle on, suffer a setback, or or even collapse deflation. TheThe chief investment officer aat a large UK investment group said: believe the the chief investment officer at large UK investment group said: “I “I believe actions of the the authorities guarantee depositors have significantly reduced the the actions of authorities to to guarantee depositors have significantly reduced likelihood of aof a systemic wide collapse. However, the possibility aof a ‘W’ path for likelihood systemic wide collapse. However, the possibility of ‘W’ path for the the economy with a further leg down 2010 remains significant. While not not our economy with a further leg down in in 2010 remains significant. While our

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C S F I / New York CSFI
central scenario, suchsuchoutcome could put severe further pressure on assetasset prices central scenario, an an outcome could put severe further pressure on prices and would clearly lead lead to a higher level of defaults”. Elbert Pattijn, chief risk officer and would clearly to a higher level of defaults”. Elbert Pattijn, chief risk officer at DBSDBS BankSingapore, saw saw main risksrisks“double dip in terms of global at Bank in in Singapore, the the main as as “double dip in terms of global GDP, leading to highhigh inflation and interest rates that would impact property values GDP, leading to inflation and interest rates that would impact property values and and ability of property owners to service theirtheir floating rate loans”. A London the the ability of property owners to service floating rate loans”. A London economist wondered whether governments would be able able fine fine tune policy economist wondered whether governments would be to to tune policy sufficiently to navigate between “the “the Scyllainflation and and Charybdis of aof a sufficiently to navigate between Scylla of of inflation the the Charybdis double dip recession”. Russian respondents werewere specially gloomy. A senior bank double dip recession”. Russian respondents specially gloomy. A senior bank economist said said that “significant credit risksgenerated by the overall instability in in economist that “significant credit risks are are generated by the overall instability the economy, and a worsening of the business climate”. the economy, and a worsening of the business climate”.

A new ‘asset A new ‘asset bubble’ onon the bubble’ the way? way?

Many respondents felt that that government actions to pump liquidity into markets Many respondents felt government actions to pump liquidity into the the markets had merely inflated an “asset bubble” which would eventually burst withwith damaging had merely inflated an “asset bubble” which would eventually burst damaging consequences, as itas it in 2007. ThisThis concern underlay highhigh risk that Asian consequences, did did in 2007. concern underlay the the risk that Asian respondents placed on the economic outlook. The The chief executive of a Eastern respondents placed on the economic outlook. chief executive of a Far Far Eastern bankbank said that liquidity being poured mostly into into 'financial assets' such as said that liquidity “is “is being poured mostly 'financial assets' such as equities and and real estate, thus creating a bubble economy. More needs todonedone to equities real estate, thus creating a bubble economy. More needs to be be to create jobs jobs and boost credits and investment flows into productive industries”. The create and boost credits and investment flows into productive industries”. The chief economist at a at a large hedge fund said thatmain concern “is that thatget yet yet chief economist large hedge fund said that his his main concern “is we we get another assetasset bubble developing and bursting…The excess liquidity markets another bubble developing and bursting…The excess liquidity in in markets means that that many asset pricesalready starting to looklook frothy”. means many asset prices are are already starting to frothy”. There was was also a concern that rallyrally had created a false sensesecurity, and and There also a concern that the the had created a false sense of of security, brought a return of complacency, eveneven recklessness tofinancial markets (see (see box brought a return of complacency, recklessness to the the financial markets box below). A respondent fromfrom a large bankbank said that “risk is inadequately calibrated below). A respondent a large US US said that “risk is inadequately calibrated against an uncertain economic recovery”. against an uncertain economic recovery”.

The C word The C word
Complacency may may bebiggest Banana Skin Skin ofMany of our respondents werewere Complacency be the the biggest Banana of all. all. Many of our respondents alarmed by the “business as usual” attitude of banks despite the hugehuge amount of alarmed by the “business as usual” attitude of banks despite the amount of workwork was still needed to clearclear upmess and stabilise economies. A UKA UK that that was still needed to up the the mess and stabilise economies. investment manager saw “the “the return of hubris/over-confidence the old short investment manager saw return of hubris/over-confidence and and the old short termterm habits among investment banks, notably Wall Street ones.” habits among investment banks, notably Wall Street ones.” Apart fromfrom exposing banks torisk of a double dip recession, these attitudes Apart exposing banks to the the risk of a double dip recession, these attitudes also also bode ill forfuture. TheyThey imply the lessons of the crisis may maybe be bode ill for the the future. imply that that the lessons of the crisis not not learnt. A regulator wondered whether “changes in behaviour will result, or whether learnt. A regulator wondered whether “changes in behaviour will result, or whether there will be a be a return topractices that led to the problems, or toor to new,just just there will return to the the practices that led to the problems, new, but but as risky, behaviour.” UK consultant economist David KernKern “inadequate as risky, behaviour.” UK consultant economist David saw saw “inadequate changes in culture and mentality within the financial system; an inability or or changes in culture and mentality within the financial system; an inability unwillingness to learn fromfromcrisis,” and a Swiss banker observed that “product unwillingness to learn the the crisis,” and a Swiss banker observed that “product development goesgoes ahead almost before”. development ahead almost like like before”. A respondent fromfrom an Australian bank said “parts of Asia Asiaimproving rapidly A respondent an Australian bank said that that “parts of are are improving rapidly and some of the issues are again emerging. Pricing for risk is being eroded, the the and some of the issues are again emerging. Pricing for risk is being eroded, cost cost of human resources is movingThe governance framework is more of human resources is moving up. up. The governance framework is more bureaucratic thanthan addressing risk”. bureaucratic addressing risk”. A belief that the crisis is over over may also the political will to reform the financial A belief that the crisis is may also sap sap the political will to reform the financial system. The director of a USa US project on financial reform said: mainmain worry is that system. The director of project on financial reform said: “My “My worry is that a goodgood crisishavehave been wasted. On Wall Street, are backback doing business as a crisis will will been wasted. On Wall Street, folk folk are doing business as normal. On MainMain Street, loans aren't getting made a bunch more smaller normal. On Street, loans aren't getting made and and a bunch more smaller banks havehaveto goto go belly which they they And on Capitol Hill, there is a real real banks yet yet belly up - up - which will. will. And on Capitol Hill, there is a danger we will get some symbolic moving of deckdeck chairs nothing, nada, in the the danger we will get some symbolic moving of chairs and and nothing, nada, in way of steps to reduce the chances of another $15tr dip in economic activity.” way of steps to reduce the chances of another $15tr dip in economic activity.”

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5. 5. Liquidity (1) Liquidity (1)
A critical shortage of liquidity triggered the credit crunch two two years ago, which is A critical shortage of liquidity triggered the credit crunch years ago, which is why why this Banana Skin shot to top of our survey last time. It remains high, not not this Banana Skin shot to the the top of our survey last time. It remains high, because liquidity is still still such an urgent problem, because new new liquidity beenbeen because liquidity is such an urgent problem, but but because liquidity has has artificially created by central bankbank actions such as Quantitative Easing (QE) which artificially created by central actions such as Quantitative Easing (QE) which mustmust come to an at some point. Then what? come to an end end at some point. Then what? Liquidity was was a high level concern all respondent categories. A Eurozone Liquidity a high level concern for for all respondent categories. A Eurozone regulator said:said: “The current optimismfinancial markets is probably overstated. regulator “The current optimism on on financial markets is probably overstated. Banks' liquidity and and solvency position appearsbe less less critical the moment, Banks' liquidity solvency position appears to to be critical for for the moment, but…liquidity risk risk is still very much an issue. The reopening of short longlong term but…liquidity is still very much an issue. The reopening of short and and term funding markets is fragile and and some firms still still overly wholesale and short term funding markets is fragile some firms are are overly wholesale and short term funded.” Another respondent said said “QE“QE creates an illusion which will burst”. funded.” Another respondent that that creates an illusion which will burst”.

What happens What happens after after Quantitative Quantitative Easing? Easing?

The The questionwhen and and how central banks wind down their programmes is is question of of when how central banks wind down their QE QE programmes crucial. The The finance director aof a major international banking group saw banks crucial. finance director of major international banking group saw banks suffering fromfrom excessive reliance on the hugehuge liquidity boost that central banks suffering “an “an excessive reliance on the liquidity boost that central banks havehave injected”. A City of London economist said he feared that “QE will before injected”. A City of London economist said he feared that “QE will end end before banks havehave been forced to refinance”. banks been forced to refinance”. NewNew regulations will require banks to keep higher levels of liquidity which would regulations will require banks to keep higher levels of liquidity which would reduce the scale of this this risk, though some respondents feared this would add to reduce the scale of risk, though some respondents feared this would add to banks’ funding costs, and therefore the cost cost of credit. banks’ funding costs, and therefore the of credit. Many respondents also also made point that,that, until credit crunch at least, liquidity Many respondents made the the point until the the credit crunch at least, liquidity was was viewed as a as a high risk area. Now, things different, and one one of issues not not viewed high risk area. Now, things are are different, and of the the issues is whether lessons havehave been learnt. A German bank adviser said thatwe havehave is whether lessons been learnt. A German bank adviser said that “if “if we learnt something from the crisis, it is it is that liquidity risk needs toin the minds of of learnt something from the crisis, that liquidity risk needs to be be in the minds authorities, boards and and senior management”. UK UK bank chairman described authorities, boards senior management”. A A bank chairman described liquidity as “the “the next problem to solve, post-central bank withdrawal”. liquidity as next problem to solve, post-central bank withdrawal”.

6. 6. Capital availability (-) Capital availability (-)
Banks havehave been able to raise impressive amounts of new capital in wake of the the Banks been able to raise impressive amounts of new capital in the the wake of crisis. But But can this continue? Will banks able able meetmeet the tougher capital crisis. can this continue? Will banks be be to to the tougher capital requirements that thaton the way,way, will will they be able to service them? requirements are are on the and and they be able to service them? ThisThis new new Banana Skin: shortages of capitalthe banking industry werewere never is a is a Banana Skin: shortages of capital for for the banking industry never a problem in the boom times. But But they couldnow, particularly if hardhard economic a problem in the boom times. they could be be now, particularly if economic conditions persist, and the ability/willingness of governments to support them begins conditions persist, and the ability/willingness of governments to support them begins to fade. ThisThis concern was strongest in Europe. to fade. concern was strongest in Europe. Many respondents werewere sceptical about adequacy of bank capital, eveneven after the Many respondents sceptical about the the adequacy of bank capital, after the recent round of capital-raising. A City City of London economist said: “Banks have too recent round of capital-raising. A of London economist said: “Banks have too littlelittle equity and bankers (even bankers!) know this. Until they forced to raiseraise equity and bankers (even bankers!) know this. Until they are are forced to large amounts, they they willlend.” large amounts, will not not lend.” And And compulsion is onway.way. New rules will oblige banks to hold more capital and compulsion is on the the New rules will oblige banks to hold more capital and contingency funding, and force them to salt earnings away in the good times to helphelp contingency funding, and force them to salt earnings away in the good times to pay for the bad. bad. The head of a European banking association said: “The demands of pay for the The head of a European banking association said: “The demands of the new new Basel/EU requirements in excess of some banks’ ability to raiseraise the the Basel/EU requirements are are in excess of some banks’ ability to the necessary capital. ThisThis will mean more of them having to seek government support, necessary capital. will mean more of them having to seek government support,

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eg eg some Japanese banks, some eurozone banks, the mutual sector the the UK, some Japanese banks, some eurozone banks, the mutual sector in in UK, Landesbanks in Germany, the the mutualsFrance andand Spain.” Landesbanks in Germany, mutuals in in France Spain.” Higher capital requirements willwill also mean higher costs for banks, which will put a Higher capital requirements also mean higher costs for banks, which will put a strain on on profitability, and possibly create incentives take on on new risks. The strain profitability, and possibly create incentives to to take new risks. The director of group riskriskaat a UK merchant bank said that “higher capital requirements director of group at UK merchant bank said that “higher capital requirements andand lower returns increase the relative attractions trading activities…” while a a lower returns increase the relative attractions of of trading activities…” while respondent from a Japanese bank saidsaid that “as memories fade, there will be respondent from a Japanese bank that “as memories fade, there will be significant pressure from shareholders to boost returns, which willwill lead banks significant pressure from shareholders to boost returns, which lead to to banks taking unacceptable risks again”. One banker summed up the the paradox: “Regulation taking unacceptable risks again”. One banker summed up paradox: “Regulation willwill increase demand for capital, whereas decreased bank profitability will reduce increase demand for capital, whereas decreased bank profitability will reduce the the supplycapital.” supply of of capital.” Some banking respondents felt felt that higher capital requirements were unwarranted, Some banking respondents that higher capital requirements were unwarranted, given the the work that banks were doing clean up up their balance sheets and degiven work that banks were doing to to clean their balance sheets and deleverage. TheThe head government relations at aat a large international banking group leverage. head of of government relations large international banking group saidsaid this waskeykey issue, but driven political andand misinformed agendas”. this was “a “a issue, but driven by by political misinformed agendas”.

Higher capital Higher capital requirements requirements may push banks may push banks to to take take greater risks greater risks

It’s not all all bad It’s not bad
A number of respondents saidsaid there was much pessimism around, andand that we A number of respondents there was too too much pessimism around, that we were in danger of talking ourselves intointo another crisis. The chief executive of a were in danger of talking ourselves another crisis. The chief executive of a London-based bank saidsaid emphatically: “I think global banking system andand all London-based bank emphatically: “I think the the global banking system all major national banking markets are are sound. Therefore I haveconcerns about major national banking markets sound. Therefore I have no no concerns about ongoing systemic risk.” ongoing systemic risk.” Another respondent saidsaid thatoverly pessimistic outlook would result in in Another respondent that an an overly pessimistic outlook would result “regulators setting too much store by stress tests which turnturn to be too severe. “regulators setting too much store by stress tests which out out to be too severe. ThisThis constrains growth, and forces failures or consolidation which need have constrains growth, and forces failures or consolidation which need not not have happened… It alsoalso leads to pessimism amongst rating agencies who adoptultra happened… It leads to pessimism amongst rating agencies who adopt an an ultra cautious approach which restricts access to wholesale funding.” cautious approach which restricts access to wholesale funding.” Susan Rice, managing director of Lloyds Banking Group Scotland, saidsaid that while Susan Rice, managing director of Lloyds Banking Group Scotland, that while there were still still risks, “financial institutions and the financial systemaas a whole are there were risks, “financial institutions and the financial system as whole are far safer than a yearyear ago. This is due to lessons learned, public and regulatory far safer than a ago. This is due to lessons learned, public and regulatory scrutiny, regulatory reformation, economic factors, the newnew Banking andand other scrutiny, regulatory reformation, economic factors, the Banking Act Act other factors.” factors.”

7.7. Derivatives (4) Derivatives (4)
This is the the lowest position that derivatives have occupiedthe the Banana Skins table This is lowest position that derivatives have occupied in in Banana Skins table since 2000 when they were viewed as an up-and-coming risk. Is thisthis a sign that they since 2000 when they were viewed as an up-and-coming risk. Is a sign that they have lostlost their sting, thatthat people have got used them? Interestingly, bankers have their sting, or or people have got used to to them? Interestingly, bankers ranked thisthis risk much higher (No.than non-bankers (No. 11) 11) and even regulators ranked risk much higher (No. 5) 5) than non-bankers (No. and even regulators (No. 13).13). This reverses the usual position, and may connected with bankers’ pre-pre(No. This reverses the usual position, and may be be connected with bankers’ occupations with credit derivatives. occupations with credit derivatives. TheThe risks derivatives are are still seen lie lie their complexity, andand poor risks in in derivatives still seen to to in in their complexity, a a poor understanding of the the exposures they create. One respondent said they remained understanding of exposures they create. One respondent said they remained “weapons of mass destruction”. Consultant Andrew Leung saidsaid that, the the near “weapons of mass destruction”. Consultant Andrew Leung that, in in near future, “the riskrisk thatthat the depth toxic debt remains largely hidden under the the future, “the is is the depth of of toxic debt remains largely hidden under carpet, especially with commodities andand foreign exchange derivatives and credit carpet, especially with commodities foreign exchange derivatives and credit default swaps”. Some respondents thought thatthat this risk would grow banks default swaps”. Some respondents thought this risk would grow as as banks

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developed ever more innovative instruments to deal with tougher regulation andand developed ever more innovative instruments to deal with tougher regulation squeeze higher margins out outaof a low yield environment. Giles Vardey, consultant to squeeze higher margins of low yield environment. Giles Vardey, consultant to institutional fund managers Babson Capital Europe, saidsaid that “any significant institutional fund managers Babson Capital Europe, that “any significant 'tightening' of banking regulations willwill only servecreate new ways to circumvent 'tightening' of banking regulations only serve to to create new ways to circumvent these rules andand thus create even more exotic products”. these rules thus create even more exotic products”. ButBut others felt there were reasons feelfeel more relaxed about the dangers of others felt there were reasons to to more relaxed about the dangers of derivatives. One saidsaid that “simplification, reduced volumes and better transparency derivatives. One that “simplification, reduced volumes and better transparency have made thisthis market safer”. have made market safer”. Others pointed out out that new regulations will force Over-the-Counter derivative Others pointed that new regulations will force Over-the-Counter derivative trading on to the the open exchanges where it can better monitored andand controlled. A trading on to open exchanges where it can be be better monitored controlled. A UKUK investment manager said that “the move an an exchange-traded basis will investment manager said that “the move to to exchange-traded basis will probably take at least three years. Whilst some of the the work being done will reduce probably take at least three years. Whilst some of work being done will reduce risks through standardisation, the the resulting fragmentation between asset classes and risks through standardisation, resulting fragmentation between asset classes and regulatory environments may adversely impact the the banks’ client base”. regulatory environments may adversely impact banks’ client base”.

Worries about Worries about derivatives are derivatives are easing easing

8.8. Risk management quality (6) Risk management quality (6)
That riskrisk management banks leaves much to be desired is obvious, andand the That management in in banks leaves much to be desired is obvious, the bankers among our our respondents ranked this Banana Skin almost highly as nonbankers among respondents ranked this Banana Skin almost as as highly as nonbankers. “This is the the key,” said one banker.don't think anyone can can say that it does bankers. “This is key,” said one banker. “I “I don't think anyone say that it does not not need improvement and attention.” need improvement and attention.” ButBut what are the issues? what are the issues? Respondents identified a string of failings, including an excessive focus on shortRespondents identified a string of failings, including an excessive focus on shortterm results, inadequate skills, a lack of rigour, poor understanding of newfangled term results, inadequate skills, a lack of rigour, poor understanding of newfangled instruments, overdependence on on boxinstruments, overdependence boxticking andand models, a failure to ticking models, a failure to Is banking even appreciate thatthat risk managementnot not a Is banking even a a appreciate risk management is is a costcost but source of of value etc.. “A profession? but a a source value etc.. “A profession? properly managed business should be on on properly managed business should be concept of banking as as top top of risks,” said Henry Angest, The The concept of banking'a 'a of risks,” said Henry Angest, profession' has has taken a hammering profession' taken a hammering Chairman/CEO of Arbuthnot Banking Chairman/CEO of Arbuthnot Banking in the past 10 years withwith apologists in the past 10 years apologists Group. Group. arguing thatthat there isneed for for arguing there is no no need TheThe question whether banks have question is is whether banks have learning. It is It is enough, they say, to learning. enough, they say, to learnt lessons from the the crisis and taken have an 'appropriate' qualification learnt lessons from crisis and taken have an 'appropriate' qualification without making clear what thatthat without making clear what steps to correct these failings. steps to correct these failings.
cavalier in its requirement A A tone of scepticism pervaded the cavalier in its requirement for for tone of scepticism pervaded the practitioners to have proper andand practitioners to have proper responses here. One respondent feared responses here. One respondent feared relevant skills andand knowledge. relevant skills knowledge. thatthat “board members and senior “board members and senior Principal, professional institute managers may not not have learnt the Principal, professional institute managers may have learnt the lessons of the the recent crisis and that their lessons of recent crisis and that their banks continue to take risks on on their books that they don't understand”. The banks continue to take risks their books that they don't understand”. The managing director of product control at aat a Swiss bank worried that banks would “fail managing director of product control Swiss bank worried that banks would “fail to properly andand rigorously embed new control processes and cultures arising from to properly rigorously embed new control processes and cultures arising from the the lessons learned during the crisis, and return the the complacency that existed lessons learned during the crisis, and return to to complacency that existed before the the crisis”. Some respondents even felt the risks would get worse the the before crisis”. Some respondents even felt the risks would get worse in in difficult period ahead as banks struggled to make profits andand were tempted cut cut difficult period ahead as banks struggled to make profits were tempted to to corners on riskrisk management. Stewart Fleming, research visitor London School of corners on management. Stewart Fleming, research visitor London School of Economics, waswas concerned about “the threat excessive speculation by financial Economics, concerned about “the threat of of excessive speculation by financial means. No other 'profession' is so so means. No other 'profession' is specific banking qualifications or or specific banking qualifications

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institutions, driven not not only extremely lowlow (too low) interest rates and monetary institutions, driven only by by extremely (too low) interest rates and monetary easing, but but also by pressures build up up profitability quickly as possible to to easing, also by pressures to to build profitability as as quickly as possible strengthen capital, cope with cyclical losses andand raise new equity”. strengthen capital, cope with cyclical losses raise new equity”. Many respondents commented on the the need not just for stronger controls but for a Many respondents commented on need not just for stronger controls but for a change in culture to include a more positive attitude towards riskrisk management. A change in culture to include a more positive attitude towards management. A Canadian consultant saidsaid that “there are few really good risk managers. Many suffer Canadian consultant that “there are few really good risk managers. Many suffer from too too little independence authority, andand executive management must be from little independence or or authority, executive management must be attuned to their issues”. A managing director in oneone the the leading US investment attuned to their issues”. A managing director in of of leading US investment banks saidsaidwaswas concerned about “the lossgood people”. banks he he concerned about “the loss of of good people”. ButBut not everyone saw risk management aas a black spot.managing director at aat a not everyone saw risk management as black spot. A A managing director large Swiss bank saidsaid there had been “clear enhancements following the crisis” and large Swiss bank there had been “clear enhancements following the crisis” and the the risk manager aof a large Greek bank said that the work banks had done riskrisk risk manager of large Greek bank said that the work banks had done on on management willwill “improve the efficiency financial institutions andand reduce management “improve the efficiency of of financial institutions reduce systemic risks the the coming years”. systemic risks coming years”.

9.9. Credit spreads (3) Credit spreads (3)
Spreads may bebe Spreads may tightening tightening ‘too fast’ ‘too fast’
TheThe sudden widening credit spreads in mid-2007 waswas one the the triggers the the sudden widening of of credit spreads in mid-2007 one of of triggers of of crisis, propelling thisthis risk high the the list. Concerns thisthis front are now easing as crisis, propelling risk high up up list. Concerns on on front are now easing as markets re-price credit riskriskmore relaxed levels, andand spreads beginnarrow. TheThe markets re-price credit to to more relaxed levels, spreads begin to to narrow. focus of concern has has shiftedwhether the the new spreads accurately reflect the level focus of concern shifted to to whether new spreads accurately reflect the level of riskrisk the the system, whether their seeming return to normality is but but another of in in system, or or whether their seeming return to normality is another symptom of unfounded optimism in the the financial sector. symptom of unfounded optimism in financial sector. Many respondents noted an improvement in the the credit default swaps market where Many respondents noted an improvement in credit default swaps market where different types of credit riskrisk are priced. Onethem saidsaid thatmajor re-evaluation different types of credit are priced. One of of them that “a “a major re-evaluation of credit risks has has now been factored in”. But generally the responses contained a of credit risks now been factored in”. But generally the responses contained a note of caution. A European regulator saidsaid that reversal of the the credit spreads note of caution. A European regulator that “a “a reversal of credit spreads decrease we we are currently witnessing” was a “likely market risk”.German bank decrease are currently witnessing” was a “likely market risk”. A A German bank adviser thought thatthat “spreads are tightening very fast, and may start, once again, not adviser thought “spreads are tightening very fast, and may start, once again, not to reflect the the correct balance between risk and reward”. to reflect correct balance between risk and reward”.

10. Equities (7) 10. Equities (7)
Equities have slipped down the the risk scale, possibly because they have come back so Equities have slipped down risk scale, possibly because they have come back so strongly since the the last Banana Skins survey when they had crashed. But the recovery strongly since last Banana Skins survey when they had crashed. But the recovery is fuelling a fresh set set concerns around the the sustainability the the rally, and what is fuelling a fresh of of concerns around sustainability of of rally, and what would happen if there waswas another crash. would happen if there another crash. Many respondents commented on on the irrationality markets. “If “If only someone Many respondents commented the irrationality of of markets. only someone could explain why equities are are behavingthey are” moaned a UKUK consultant. The could explain why equities behaving as as they are” moaned a consultant. The head of group riskriskaat a UK financial group said that “equity markets could have run head of group at UK financial group said that “equity markets could have run too too ahead if there are are negative earnings surprises”. far far ahead if there negative earnings surprises”. TheThe consequences another crash would be be severe for the “real economy”, consequences of of another crash would severe for the “real economy”, probably plunging it back intointo recession and landing the banks with further heavy probably plunging it back recession and landing the banks with further heavy losses, andand dashing their recapitalisation plans. One respondent pointed out that losses, dashing their recapitalisation plans. One respondent pointed out that equities were important not not just a source of earnings andand capital “but a a equities were important just as as a source of earnings capital “but as as bellwether of confidence” in ain a crisis that was essentially about confidence. bellwether of confidence” crisis that was essentially about confidence.

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11. Currencies (13) 11. Currencies (13)
Focus onon the Focus the volatile volatile US dollar US dollar
TheThe currency markets are expected remain volatile over the the recovery period currency markets are expected to to remain volatile over recovery period because of the the sharp risegovernment borrowing andand the possibilitybig big interest because of sharp rise in in government borrowing the possibility of of interest raterate movementsthe the next year two. One respondent said: “The market is very movements in in next year or or two. One respondent said: “The market is very volatile andand subjectshifts in reaction to statements by senior financial officials”. volatile subject to to shifts in reaction to statements by senior financial officials”. TheThe focusparticularly on the the US with trillion dollar debts, but but also other focus is is particularly on US with its its trillion dollar debts, also on on other vulnerable countries such the the UK well as the the Baltic states whose currencies are vulnerable countries such UK as as well as Baltic states whose currencies are pegged to the the euro, but could snap, plunging the region into economic chaos. pegged to euro, but could snap, plunging the region into economic chaos. Question marks alsoalso hang over the US dollar the the longer term with mounting Question marks hang over the US dollar in in longer term with mounting speculation thatthat could be be toppled from its reserve currency throne. Many speculation it it could toppled from its reserve currency throne. Many respondents focused on the the possibility that sentiment might finally crack, leading to respondents focused on possibility that sentiment might finally crack, leading to the the dollar’s collapse and a major shift the the world’s reserves. bank supervisor dollar’s collapse and a major shift in in world’s reserves. A A bank supervisor sawsaw “possible market upheaval the the dollar becomes less important a reserve “possible market upheaval as as dollar becomes less important as as a reserve currency”. China, with its massive holdings of dollars, is seen as playing a central currency”. China, with its massive holdings of dollars, is seen as playing a central roleroleanyany scenario that develops. in in scenario that develops. ButBut a number respondents were more sanguine about currency risk. “I think we we a number of of respondents were more sanguine about currency risk. “I think have learned to livelive with currency movements” said one banker. Another described have learned to with currency movements” said one banker. Another described the the collapse the the dollar “a lowlow probability high impact event”. third saidsaid collapse of of dollar as as “a probability high impact event”. A A third “sensible hedging helps”. “sensible hedging helps”.

12. Corporate governance (16) 12. Corporate governance (16)
This Banana Skin shows a strong riserise since the last survey, reflecting mounting This Banana Skin shows a strong since the last survey, reflecting mounting concern about the the quality governance within banks. No No surprise, perhaps, that concern about quality of of governance within banks. surprise, perhaps, that non-bankers andand regulators saw itaas a greater risk than bankers. It was also seen to non-bankers regulators saw it as greater risk than bankers. It was also seen to be more of an issue in America than in Europe or the the Asia Pacific region. be more of an issue in America than in Europe or Asia Pacific region. TheThe perceived failings corporate governance are are many. Here aisselection of of perceived failings of of corporate governance many. Here is a selection quotes: quotes: There is “a lack of realism in recognising thatthat the causesproblems There is “a lack of realism in recognising the causes of of problems lie within organisations (as (as opposedpointing at external factors)”. – – lie within organisations opposed to to pointing at external factors)”. Managing director, US US bank. Managing director, bank. TheThe risk lies“the failure of chief executives to serve the the interests of risk lies in in “the failure of chief executives to serve interests of their depositors andand customers rather than their own particular) andand their depositors customers rather than their own (in (in particular) their shareholders' short term interests”. – London trust company. their shareholders' short term interests”. – London trust company. There is concern about “the static andand self-preserving ‘buddy There is concern about “the static self-preserving ‘buddy networks’ in high management thatthat will perpetuate incompetence, hide networks’ in high management will perpetuate incompetence, hide deficiencies, andand leave urgent issue”. – Bank director, Luxembourg. deficiencies, leave urgent issue”. – Bank director, Luxembourg. “Boards are are still underpopulated with serious experts, and thus too “Boards still underpopulated with serious experts, and thus too subservient to management.” – Economist, New York. subservient to management.” – Economist, New York. Will things get get better? The responses here were notable for their scepticism, even Will things better? The responses here were notable for their scepticism, even their cynicism about the the corporate governance debate. Doubts that much would their cynicism about corporate governance debate. Doubts that much would change centred on banks’ seeming reluctance or inability to pick up the the lessons from change centred on banks’ seeming reluctance or inability to pick up lessons from the the crisis.senior Swiss banker said: “Firms’ governance mechanisms andand cultures crisis. A A senior Swiss banker said: “Firms’ governance mechanisms cultures

Scepticism about Scepticism about the prospects the prospects for better for better governance governance

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need to fully embed the lessons from the past 18 months. Many will struggle to do this”. Another concern was the lack of high calibre non-executive directors. Dennis Cox of bank consultancy and training firm Risk Reward, said that “the expectations of management and especially non-executive management is a major concern, and we doubt whether there is the talent required to meet these revised obligations”. Another respondent put it more bluntly: “Reforms will happen – but who in their right mind would want to be a bank NED?” But many respondents also felt that the corporate governance debate was on the wrong track. The risk was that more regulation would weaken the sense of responsibility of bank managements and directors, and that the answer lay in “removing the interference of governments and politics in management”.

Trust
The damage done by the crisis to confidence in banks could be a major source of risk, and banks will have to work hard to repair it. This was a recurring theme in the responses to this survey. A fund manager said that “the fall in confidence by the public, investors and governments has damaged credibility in the sustainability of the system. Redressing this will take years, limiting the ability of a number of banks to regain capital strength and develop.” Adrian Lloyd, enforcement and regulatory affairs director at the UK’s Banking Code Standards Board, said that “confidence in banks in Europe and the USA remains fragile at best. Informed depositors are willing to leave savings in banks and mutuals only where they are secured by government-backed deposit protection schemes or by government guarantees, whether explicit or implicit ('too big to fail').” Several respondents raised the possibility of more bank failures, particularly where governments can no longer afford to bail them out. A UK respondent asked: “If there is another significant bank that fails during this recovery process, what would the public and government reaction be? Has all the stress testing dealt with this issue?” Mistrust is not just about the soundness of banks but about the quality of their accounts. Many respondents felt that “accounting fudges” were being used to conceal the worst of bank exposures, and that sophisticated trading techniques were being deployed to move risk out of sight. A US banker feared that “financialeconomic pressures may lead to 'creative' accounting practices becoming more widespread”.

13. Commodities (12)
Concern about the risks in commodity markets has changed little during the course of the crisis. They are still seen as volatile and unpredictable, with oil and gold heading the list, and China’s voracious appetite and US energy profligacy the causes. Concern about this risk was strongest in the Asia Pacific region (No. 6).

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Respondents made the the point that commodity volatility should not pose a major risk Respondents made point that commodity volatility should not pose a major risk to banks because these markets are are well understood, and there are plenty ways to banks because these markets well understood, and there are plenty of of ways banks can can protect themselves against them. banks protect themselves against them. In some ways the the greater risks in the the political consequences: what will unstable In some ways greater risks lie lie in political consequences: what will unstable oil do to the the Middle East and Russia, how will China react if it cannot gain access to oil do to Middle East and Russia, how will China react if it cannot gain access to the the resources it needs? resources it needs? “Still volatile – andand still proneover-reaction”, saidsaid one respondent. “Still volatile – still prone to to over-reaction”, one respondent.

14. Interest rates (9) 14. Interest rates (9)
Concern about interest rates has has easedat– least for for the time being. The medium Concern about interest rates eased – at least the time being. The medium term outlook (up (upato a year?)for for low and relatively stable interest rates. The fun term outlook to year?) is is low and relatively stable interest rates. The fun comes later, when central banks have to extricate themselves from the the markets and comes later, when central banks have to extricate themselves from markets and governments begin to address their mounting debts. At thatthat point, inflation may also governments begin to address their mounting debts. At point, inflation may also begin to rearrearugly head, andand a riserates looks inevitable. begin to its its ugly head, a rise in in rates looks inevitable. ButBut while the rate outlookalarming, it isitalsoalso some extent predictable. One while the rate outlook is is alarming, is to to some extent predictable. One respondent asked: “What happens when the the 'punch bowl' is removed. Will have a a respondent asked: “What happens when 'punch bowl' is removed. Will we we have series of raterate rises similar1994?” series of rises similar to to 1994?” TheThe impact couldsevere. Michael Taylor, adviser to the the Central BankBahrain, impact could be be severe. Michael Taylor, adviser to Central Bank of of Bahrain, warned thatthat changesinterest rates would hit asset values andand bond prices. “So far warned changes in in interest rates would hit asset values bond prices. “So far the the extraordinary measures have worked the the sense that they have averted extraordinary measures have worked in in sense that they have averted something far far worse, but have we something worse, but have we thereby already laidlaid the foundations for thereby already the foundations for The caution factor The caution factor the the next crisis?” next crisis?”
combination of the following factors Rising rates would put put strain on on combination of the following factors Rising rates would a a strain distracting management from doing their borrowers andand produce a surge badbad distracting management from doing their borrowers produce a surge in in government regulation in the the widest debts. A shift in the the yield curve could job: job: government regulation in widest debts. A shift in yield curve could sense; of repeating the mistakes of alsoalso cause problems. John Grout, sense; fearfear of repeating the mistakes of cause problems. John Grout, the past; uncertainty about the ability of of the past; uncertainty about the ability policy andand technical director the the counterparties to staystay solvent; policy technical director at at counterparties to solvent; Association of of Corporate Treasurers, uncertainty about central bank policy; Association Corporate Treasurers, uncertainty about central bank policy; saidsaid that “big movements must be be impact of central bank policies on the the that “big movements up up must impact of central bank policies on expected at some point. TheThe biggest future value of currencies, andandthe re- reexpected at some point. biggest future value of currencies, on on the emergence of inflation; uncertainty riskrisk for banks a flattening of the the emergence of inflation; uncertainty for banks is is a flattening of about the the inevitability of latter andand about inevitability of the the latter yield curve”. yield curve”. the timing thereof. the timing thereof. The The biggest problem now is the biggest problem now is the

A surge in in interest A surge interest rates is is inevitable, rates inevitable, but also but also predictable predictable

Meanwhile, lowlow interest rates can bring Meanwhile, interest rates can bring All these leadlead to excessive caution, All these to excessive caution, problems of oftheir own. Some problems their own. Some inhibiting the extending of credit to the the inhibiting the extending of credit to respondents sawsaw them providing a spur productive sector, andand correspondingly respondents them providing a spur productive sector, correspondingly to greater risk-taking to earn profits. to greater risk-taking to earn profits. the the increasing risk of mispricing of asset increasing risk of mispricing of asset Consultant Paul Hattori saidsaid that “long values. Consultant Paul Hattori that “long values. term interest rates at lowlow levels will term interest rates at levels will chairman only encourage investors to do do more City City chairman only encourage investors to more stupid things in search of yield as they stupid things in search of yield as they come to believe the the worstover”. They alsoalso squeeze profitability.Luxembourg come to believe worst is is over”. They squeeze profitability. A A Luxembourg banker feared thatthat “the negative impactthe the P&L the the banks may occur before banker feared “the negative impact to to P&L of of banks may occur before balance sheets are are restored from the impact the the current crisis”. divisional balance sheets restored from the impact of of current crisis”. A A divisional director of oneone the the large UK building societies was concerned about “ongoing director of of of large UK building societies was concerned about “ongoing super lowlow interest rates which suppress margins”. super interest rates which suppress margins”.

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15. Fraud (11) 15. Fraud (11)
One reason why fraud has has slipped down the rankingthatthat there have been few One reason why fraud slipped down the ranking is is there have been few recent headline-grabbing cases. In fact, many respondents commented on on the recent headline-grabbing cases. In fact, many respondents commented the surprising scarcity of frauds during a time of recession, which is usually when they surprising scarcity of frauds during a time of recession, which is usually when they come to light, Madoff being a case in point, though thatthat was not exactly bank fraud. come to light, Madoff being a case in point, though was not exactly bank fraud. TheThe incidencefraud “has not not yet risen as much as oneone would expect given the incidence of of fraud “has yet risen by by as much as would expect given the state of the the tide,” said one respondent.am am convinced more serious frauds will be state of tide,” said one respondent. “I “I convinced more serious frauds will be exposed before economic recovery arrives,” saidsaid another. exposed before economic recovery arrives,” another. TheThe main variationthisthis risk was geographical: it scored higherthe the Asia Pacific main variation in in risk was geographical: it scored higher in in Asia Pacific region (No. 10) 10) and among emerging economies (No. 6). region (No. and among emerging economies (No. 6). TheThe concern both about internal andand external fraud systems become more concern is is both about internal external fraud as as systems become more complex andand vulnerable. Advanceselectronic technology are are always widening the complex vulnerable. Advances in in electronic technology always widening the scope for for intrusion and data manipulation, according Topi Manner, executive scope intrusion and data manipulation, according to to Topi Manner, executive vice-president at Nordea Bank in in Finland. Russian respondent saidsaid that vice-president at Nordea Bank Finland. A A Russian respondent that information security waswas probably the greatest risk that Russian banks faced over information security probably the greatest risk that Russian banks faced over the the next 2-3 years. next 2-3 years. A concern among banking respondents waswas the effect that a big bank fraud might A concern among banking respondents the effect that a big bank fraud might have on banking confidence at aat a time when the systemso fragile. TheThe head of have on banking confidence time when the system is is so fragile. head of regulatory strategy at aatlarge US US bank said that “fraud may undermine investor regulatory strategy a large bank said that “fraud may undermine investor confidence resulting in excessive caution”. confidence resulting in excessive caution”.

16. Management incentives (17) 16. Management incentives (17)
What is is worse: What worse: paying bonuses or or paying bonuses banning them? banning them?
TheThe row over bonuses and incentives has pushed this Banana Skin a place. ButBut row over bonuses and incentives has pushed this Banana Skin up up a place. what is the the risk: that perverse incentives will destroy banks, or that new what is risk: that perverse incentives will destroy banks, or that new regulation/tax willwill kill the golden goose? Respondents were sharply divided thisthis regulation/tax kill the golden goose? Respondents were sharply divided on on question. question. Non-bankers tended towards the the firstthese views. TheThe bonus culture was not only Non-bankers tended towards first of of these views. bonus culture was not only out out control but but dangerous: waswas creating the wrong incentives, and dulling of of control dangerous: it it creating the wrong incentives, and dulling bankers’ sense of risk. Moreover, banks were failing to take on board thatthat something bankers’ sense of risk. Moreover, banks were failing to take on board something needed to be done about it. Martin Hall, a non-executive director of Broadcastle needed to be done about it. Martin Hall, a non-executive director of Broadcastle Bank, saidsaid that “banks not not appear have got got the message and are likely to Bank, that “banks do do appear to to have the message and are likely to remain in the the political doghouse”.London consultant saidsaid that the situation was remain in political doghouse”. A A London consultant that the situation was “gradually improving – but but the need for reform not not yet fully ‘owned’ the the “gradually improving – the need for reform is is yet fully ‘owned’ by by firms”. A banker added thatthat “perverse incentives (not necessarily the level of firms”. A banker added “perverse incentives (not necessarily the level of incentives) are are the core our our industry's problems, all all levels significant incentives) the core of of industry's problems, at at levels of of significant management andand risk taking. These have not been solved”. management risk taking. These have not been solved”. TheThe opposing view holds that remuneration should not a political issue, andand that opposing view holds that remuneration should not be be a political issue, that attempts to regulate it could endend damaging the the business, specially if it is done on attempts to regulate it could up up damaging business, specially if it is done on a country-by-country basis rather than through international agreement. A London a country-by-country basis rather than through international agreement. A London investment banker asked: “Will remuneration be sorted out out a level playing field investment banker asked: “Will remuneration be sorted on on a level playing field basis so thatthat there not notrun run talent to other markets, leaving some markets basis so there is is a a on on talent to other markets, leaving some markets vulnerable to ato a shortagetalent, leading to decline in market position?” This waswas vulnerable shortage of of talent, leading to decline in market position?” This not not merely Anglo-Saxon preoccupation. A German bank respondent warned thatthat merely an an Anglo-Saxon preoccupation. A German bank respondent warned tax tax and regulatory interferencebonuses “could lead to ato a deteriorationmorale”. and regulatory interference in in bonuses “could lead deterioration in in morale”.

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A US US bank risk manager even argued that, with banks now holding billions of A bank risk manager even argued that, with banks now holding billions of dollars of taxpayers’ money, it waswas the the public interest have compensation dollars of taxpayers’ money, it in in public interest to to have compensation schemes thatthat attracted the best talentmanage it. “If these firms are are not permitted schemes attracted the best talent to to manage it. “If these firms not permitted to paypay competitively, we will find that those who remainemployment there willwill to competitively, we will find that those who remain in in employment there not not the the brightest and best, and hence not the best stewards turnturn these firms be be brightest and best, and hence not the best stewards to to these firms around andand return the government/taxpayers funds.” around return the government/taxpayers funds.” ButBut others felt the steam was going outthe the issue.regulator saidsaid that there was others felt the steam was going out of of issue. A A regulator that there was “more awareness andand concern about perverse incentives, hence a lowering the the “more awareness concern about perverse incentives, hence a lowering of of riskrisk level”. A Swiss banker saw this risk “falling duecompensation rules”. level”. A Swiss banker saw this risk “falling due to to compensation rules”.

17. Emerging markets (18) 17. Emerging markets (18)
AreAre emerging markets a risky bet in today’s environment, a better prospect than emerging markets a risky bet or, or, in today’s environment, a better prospect than the the developed world? developed world? Clearly, it is hard to generalise, but but the tone many responses waswas cautious. Clearly, it is hard to generalise, the tone of of many responses cautious. Concern about the the macro-economic outlook was stronger among respondents from Concern about macro-economic outlook was stronger among respondents from emerging countries (No. 3) than industrial countries (No. 5), mainly because of the the emerging countries (No. 3) than industrial countries (No. 5), mainly because of dangers over-hasty recovery producing asset bubbles.. There waswas “overconfidence in dangers over-hasty recovery producing asset bubbles.. There “overconfidence in the the safetyemerging markets”, according to Sheila Page, senior research associate safety of of emerging markets”, according to Sheila Page, senior research associate at the the UK’s Overseas Development Institute. “Vulnerabilities remain”, according to at UK’s Overseas Development Institute. “Vulnerabilities remain”, according to the the directorriskrisk management at onethe the large regional development banks. director of of management at one of of large regional development banks.

A better prospect, A better prospect, or or risky bet? a a risky bet?

Some of the the caution hasdo with uncertainty over China’s prospects, the the opaque Some of caution has to to do with uncertainty over China’s prospects, opaque political situation in Russia, andand the growing assertiveness leaders in Latin political situation in Russia, the growing assertiveness of of leaders in Latin America. Ioannis Gousios, director of banking supervision at the the Bank Greece, America. Ioannis Gousios, director of banking supervision at Bank of of Greece, waswas particularly concerned about emerging European economies where, said, particularly concerned about emerging European economies where, he he said, there waswasriskrisk that “loans that were restructured avoid default become nonthere a a that “loans that were restructured to to avoid default become nonperforming anyway, thatthat collateral pledged proves be worth lessless than initially performing anyway, collateral pledged proves to to be worth than initially thought andand that rising unemployment and corporate insolvencies the the region thought that rising unemployment and corporate insolvencies in in region create more badbad debts”. The chief risk officeraat a bankIndia saidsaid there was “a create more debts”. The chief risk officer at bank in in India there was “a general perception thatthat the country either fairly immune to economic activity general perception the country is is either fairly immune to economic activity elsewhere, or is already benefiting from an economic recovery, both of which points elsewhere, or is already benefiting from an economic recovery, both of which points of view might be over-optimistic”. of view might be over-optimistic”. ButBut other respondents were more upbeat. James Prichard, emerging markets other respondents were more upbeat. James Prichard, an an emerging markets trader at WestLB in London, saidsaid that worries about emerging market exposure trader at WestLB in London, that worries about emerging market exposure meant thatthat “many banks are pulling back, leaving just a few playersbenefit”. meant “many banks are pulling back, leaving just a few players to to benefit”.

18. High dependence on technology (15) 18. High dependence on technology (15)
TheThe high dependence technology thatthat banks have built over the the yearsno no high dependence on on technology banks have built up up over years is is longer the the critical issue thatonce waswas (this Banana Skin was consistently the the longer critical issue that it it once (this Banana Skin was consistently in in TopTop Tenearlier times – see p ??). The problems are better understood, the pace the Ten in in earlier times – see page 10). The problems are better understood, of change has slowed, and in some areas such as the customercustomer interface it has pace of change has slowed, and in some areas such as the interface it has even been pushed back a bit withathe drive thedeliverto deliver a more personalised service. even been pushed back bit with to drive a more personalised service. ButBut issues remain. This was rankedTopTop Ten risk the the Asia Pacific region, issues remain. This was ranked a a Ten risk in in Asia Pacific region, particularly among emerging economies. TheThe chief executivean Indian bank saidsaid particularly among emerging economies. chief executive of of an Indian bank thatthat “operational and reputational risks from increasing dependence technology “operational and reputational risks from increasing dependence on on technology andand payment systems are among the risks that banks face currently.” payment systems are among the risks that banks face currently.”

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C S F I / New York CSFI
Bottom line worries Bottom line worries
Ultimately, all Banana Skins are are risks to the bottom line. Here is a selection Ultimately, all Banana Skins risks to the bottom line. Here is a selection comments on thatthat theme. comments on theme. The The prospects banking profitability are are not great, thanks to a raft of factors prospects for for banking profitability not great, thanks to a raft of factors including general economic weakness, low low interest rates, political pressure on including general economic weakness, interest rates, political pressure on banks to engage in low-profit activities for the good of the the economy, and tighter banks to engage in low-profit activities for the good of economy, and tighter regulatory constraints. regulatory constraints. Executive director, banking trade group Executive director, banking trade group There must be concern about whether financial services firms will be ableable to There must be concern about whether financial services firms will be to generate sufficient profit to remain viable. generate sufficient profit to remain viable. Chief executive, UK building society Chief executive, UK building society Lack of profitability is going to be a drain on the the vitality of system going forward, Lack of profitability is going to be a drain on vitality of the the system going forward, all the the morein Europe if leverage is capped withwith relatively little regard the the all more so so in Europe if leverage is capped relatively little regard for for quality of what is being leveraged. quality of what is being leveraged. Credit strategist, multinational development bank Credit strategist, multinational development bank High capital requirements will reduce return on equity, which will lead to lower High capital requirements will reduce return on equity, which will lead to lower equity prices andand more problems raising new capital. equity prices more problems raising new capital. Board member, German bank Board member, German bank

TheThe managementonline systems is ais a big problem,is data security. A Russian management of of online systems big problem, as as is data security. A Russian respondent saidsaid that “as internet banking develops, attacks client bank accounts respondent that “as internet banking develops, attacks on on client bank accounts willwill increase”. The upcoming migration Over-the-Counter derivatives to public increase”. The upcoming migration of of Over-the-Counter derivatives to public exchanges willwill increase technology risk, according oneone respondent. New York exchanges increase technology risk, according to to respondent. New York economist Roger Kubarych saidsaid that firms and regulators take for granted that economist Roger Kubarych that firms and regulators take for granted that information technology is well run.run. “What if it isn't? It has been starvedresources information technology is well “What if it isn't? It has been starved of of resources in many financial institutions for short-sighted, near-term budgetary concerns.” in many financial institutions for short-sighted, near-term budgetary concerns.” Consultant Steve Dyson saidsaid that “the sector needsinvest a huge amount in new Consultant Steve Dyson that “the sector needs to to invest a huge amount in new technology to keep pace with the the monitoring and management risk. This, allied technology to keep pace with monitoring and management of of risk. This, allied with the the need invest in upgrading/replacing legacy systems, willwill placehuge with need to to invest in upgrading/replacing legacy systems, place a a huge burden on budgets over the the next 2-3 years”. burden on budgets over next 2-3 years”. Some respondents made the the point that risk not only lies with the systems but in Some respondents made point that risk not only lies with the systems but in managing – andand retaining – the people who run them and understand them. A banker managing – retaining – the people who run them and understand them. A banker in Luxembourg saidsaid banks depended “on particular individuals with a monopoly”. in Luxembourg banks depended “on particular individuals with a monopoly”.

19. Hedge funds (10) 19. Hedge funds (10)
A dramatic drop in concern here, in lineline with the generally lower profile taken by A dramatic drop in concern here, in with the generally lower profile taken by hedge funds during the the crisis. hedge funds during crisis.

A sharp drop in in A sharp drop concern about concern about hedge funds hedge funds

TheThe funds are not attracting the level attention they did did earlier through their funds are not attracting the level of of attention they earlier through their aggressive position taking, short selling andand shareholder activism. Some respondents aggressive position taking, short selling shareholder activism. Some respondents pointed out out that they were actually better managed than banks. Regulatory moves pointed that they were actually better managed than banks. Regulatory moves are are also afootput put them a shorter leash. “The once dominant sector is no longer also afoot to to them on on a shorter leash. “The once dominant sector is no longer in charge. Real money investors make longer term decisions with their own money”, in charge. Real money investors make longer term decisions with their own money”, saidsaid one respondent. one respondent. ButBut the funds are still making their presence felt. An investment banker said that the funds are still making their presence felt. An investment banker said that while hedge funds “are not not now a concern with respect driving up leverage in in while hedge funds “are now a concern with respect to to driving up leverage

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buy-outs etc., they are making work-outs more volatile/uncertain as they are purchasing distressed debt at significant discounts and acting with a very different agenda to banks within work-outs”. Many respondents said that banks’ exposure to hedge funds needed to be “well-managed”. Referring to regulatory initiatives in this area, one respondent said that “at present there is more risk to the funds than from them”. However some respondents feared that tougher controls would merely drive the sector to less well regulated centres. “Many hedge funds will relocate outside the EU”, said one. In Hong Kong, Paul Lejot of the Asian Institute of International Financial Law said that “a loss of business is likely from the regulated sector”.

20. Rogue trader (14)
This Banana Skin goes up and down in line with recent history. The last survey (in 2008) followed the discovery of Jérôme Kerviel’s massive fraud at Société Générale. Since then, there have been no major incidents, and so the risk of rogue trading is seen to have eased. The question is whether the pressures of recession make a rogue trader more likely. The answer seems to be yes. A regulator said: “The risk is always there. They tend to be discovered in falling markets.” A consultant observed that there are “fewer traders. But those that are left may be under more pressure to save their jobs (which is a more powerful encouragement to fraud than getting a bonus)”. Since major incidents tend to occur every 3-4 years, the time for another one must be approaching.

21. Business continuation (23)
Little change in the perceived risk here: the Banana Skin that shot high up the list in the wake of 9/11 has eased off sharply. Although terrorist attacks continue to earn mentions as potential sources of risk, pandemics such as swine ‘flu are there too, as are crashes in the system. However, the broader feeling is that banks have put a lot of work into this area, and are less vulnerable, though this could also lead to complacency. “Some danger of this falling off the radar”, said one consultant.

22. Retail sales practices (20)
The mistreatment of retail clients continues to be a source of risk to banks, even though the worst of the mis-selling abuses may now be behind us. Some of the risk is of a reputational kind, some financial. In the words of a Canadian banker, the risk is “over-promising in a competitive market fuelled by bonus objectives”. New regulation proposed through initiatives like the FSA’s Retail Distribution Review to separate the sales and advice functions in financial products should help contain some of this risk, though some respondents felt that mis-selling is now so deeply ingrained in banks that they will have trouble adjusting. Regulation will be “a huge shock” said one UK respondent.

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C S F I / New York CSFI
There is alsoalso the wider questionhow the the crisis will affect banking relationships at There is the wider question of of how crisis will affect banking relationships at the the retail end. Some respondents feared that it may aggravate them forcing banks retail end. Some respondents feared that it may aggravate them by by forcing banks to pass on on the costs additional regulation, andand take a tougher lineline with to pass the costs of of additional regulation, to to take a tougher with delinquent customers. There is alsoalso the opposite risk: that bank customers, having delinquent customers. There is the opposite risk: that bank customers, having been rescued from the the banks’ mistakes, will start “mistreating” the banks.group been rescued from banks’ mistakes, will start “mistreating” the banks. A A group strategist at oneone the the large UK banks foresaw further erosion of anyany sense of strategist at of of large UK banks foresaw “a “a further erosion of sense of personal responsibility by consumers”. personal responsibility by consumers”. Richard Higham of of sales training consultancy Mercuri International said the Richard Higham sales training consultancy Mercuri International said the objective for for banks should to make their sales andand risk cultures more consistent. objective banks should be be to make their sales risk cultures more consistent. This would help them “retain good customers who feelfeel abused their treatment This would help them “retain good customers who abused by by their treatment over the the past year”. over past year”.

23. Conflicts ofof interest (21) 23. Conflicts interest (21)
This is oneone those Banana Skins (like corporate governance andand management This is of of those Banana Skins (like corporate governance management incentives) on on which bankers and non-bankers take sharply different views, for incentives) which bankers and non-bankers take sharply different views, for fairly obvious reasons. TheThe bankers think they understand the risk and play it down, fairly obvious reasons. bankers think they understand the risk and play it down, the the non-bankers think the bankers are ignoringwilfully or otherwise. non-bankers think the bankers are ignoring it, it, wilfully or otherwise. TheThe riskthatthat banks will damage confidence placing their own interests above risk is is banks will damage confidence by by placing their own interests above those of their clients, a riskrisk that has grown with the emergence“universal banks” those of their clients, a that has grown with the emergence of of “universal banks” combining many different functions. TheThe bankers’ viewpoint was summed by a a combining many different functions. bankers’ viewpoint was summed up up by respondent from a Channel Islands bank: “This is always an issue, but but well managed respondent from a Channel Islands bank: “This is always an issue, well managed in our our business”. Others said that the perception conflicts, if not not the conflicts in business”. Others said that the perception of of conflicts, if the conflicts themselves, waswas rising. themselves, rising. ButBut with the intrusionstate ownership during the the crisis, these conflicts have also with the intrusion of of state ownership during crisis, these conflicts have also become more complex. Who are are bankers now supposed be be serving: their become more complex. Who bankers now supposed to to serving: their customers, their shareholders or the the taxpayers? One respondent saw the risk customers, their shareholders or taxpayers? One respondent saw the risk increasing “as “as the oligopoly shrinks and governments get more entwined with the increasing the oligopoly shrinks and governments get more entwined with the financial services industry”. financial services industry”. However a number of respondents felt felt that banks and regulators were addressing However a number of respondents that banks and regulators were addressing these conflicts andand reducing the scalethe the risk. these conflicts reducing the scale of of risk.

Conflicts are Conflicts are becoming more becoming more complicated complicated

24. Back office (19) 24. Back office (19)
TheThe risks the the back office usually arise because costcost cutting. Many our our risks in in back office usually arise because of of cutting. Many of of respondents saidsaid that back office budgets had been trimmed partpart recessionrespondents that back office budgets had been trimmed as as of of recessiondriven cutbacks, andand that these were false savings. Even though business volumes driven cutbacks, that these were false savings. Even though business volumes are are down, the complexity the the current environmentplus panics andand failures – down, the complexity of of current environment – – plus panics failures – means thatthat banks need have very robust back offices. It isItnot not only a matter of means banks need to to have very robust back offices. is only a matter of processing business, but but documenting collateral and guarantees, tracking defaults processing business, documenting collateral and guarantees, tracking defaults andand ensuring contract enforceability. ensuring contract enforceability. “Cost cutting andand consolidation strains are impacting the ability [of banks] to “Cost cutting consolidation strains are impacting the ability [of banks] to strengthen processes andand controls around new product offeringsaat a time when they strengthen processes controls around new product offerings at time when they are are already struggling provide an an adequate service for existing clients for already struggling to to provide adequate service for existing clients for products”, saidsaid a London investment manager. products”, a London investment manager.

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On On the other hand, much work has also been done improve thisthis side banks’ the other hand, much work has also been done to to improve side of of banks’ operations through greater automation andand the resolution specific problems likelike operations through greater automation the resolution of of specific problems derivatives settlement. And they have held up well in the the crisis. One banker said that derivatives settlement. And they have held up well in crisis. One banker said that thisthis was “alwaysriskrisk area, but becoming less with established systems andand was “always a a area, but becoming less so so with established systems processes”. processes”. A looming issue is how back offices willwill cope withgrowing regulatory andand A looming issue is how back offices cope with a a growing regulatory compliance workload. A respondent from a large Swiss bank saidsaid that “pressures on compliance workload. A respondent from a large Swiss bank that “pressures on back offices seem to be be easing, however the spectre new regulations andand back offices seem to easing, however the spectre of of new regulations accounting standards willwill add new demands”. Looking at the budgetary implications accounting standards add new demands”. Looking at the budgetary implications of of this workload, another Swiss banker admitted to dilemma over “the“the this workload, another Swiss banker admitted to a a dilemma over implementation of regulations versus costcost control pressure”. implementation of regulations versus control pressure”.

25. Environmental risk (25) 25. Environmental risk (25)
No No change here despite the growing pressures climate change andand the recent change here despite the growing pressures of of climate change the recent prominence of the the Copenhagen Summit. prominence of Copenhagen Summit. Bankers are are not known giving a high ranking to environmental risk. TheThe highest Bankers not known for for giving a high ranking to environmental risk. highest position thisthis Banana Skin has reachedmore than 15 years of surveys is No.No. 25, position Banana Skin has reached in in more than 15 years of surveys is 25, reflecting a belief thatthat the riskprofits is political rather than financial, andand even reflecting a belief the risk to to profits is political rather than financial, even where it isit is financial, the exposures are not criticalnear term. where financial, the exposures are not critical or or near term. At the the same time, though, the environment has always earnedhigh place as a a At same time, though, the environment has always earned a a high place as rising risk: No.No. thisthis year, a par par with concern about the global economy,it isit is rising risk: 10 10 year, on on a with concern about the global economy, so so obviously on the the radar screen. obviously on radar screen. This is ais a risk with many angles: reputation, litigation (banks are “deep pockets”), This risk with many angles: reputation, litigation (banks are “deep pockets”), pollution liability, costcost and direct financial exposure. One respondent listed climate pollution liability, and direct financial exposure. One respondent listed climate change as an issue thatthat could complicate the economic recovery and make life change as an issue could complicate the economic recovery and make life difficult for banks as well. difficult for banks as well. ButBut waswas hard ignore a tone of dismissiveness, even impatience, in the the it it hard to to ignore a tone of dismissiveness, even impatience, in responses. “Overstated” waswas one comment. “At the moment, who cares?” was responses. “Overstated” one comment. “At the moment, who cares?” was another. another.

26. Payment systems (27) 26. Payment systems (27)
An area facing An area facing competition from competition from non-banks non-banks
Like the the back office, thisan area where much work has has been done improve Like back office, this is is an area where much work been done to to improve speed andand reliability, notably the movereal-time payment andand settlementboth speed reliability, notably the move to to real-time payment settlement at at both the the wholesale and retail levels. And these have stood well during the the crisis. But wholesale and retail levels. And these have stood up up well during crisis. But more could always be done in what is, after all, all, “the keyfinancial stability” in the the more could always be done in what is, after “the key to to financial stability” in words of oneone respondent. words of respondent. One riskrisk that was mentioned was that banks may not make the most the the One that was mentioned was that banks may not make the most of of investment they have put put into this area. Payment systems consultant Nick Collin investment they have into this area. Payment systems consultant Nick Collin saidsaid that “the piecemeal deployment of Faster Payments [the UK electronic that “the piecemeal deployment of Faster Payments [the UK electronic payments system] has has meant that the banking industry has not mademuch out out of payments system] meant that the banking industry has not made as as much of thisthis huge leap forward near-real-time payments as they might have done, andand huge leap forward in in near-real-time payments as they might have done, have so far not not beenain a positionbuild on the the relatively rich FPS infrastructure have so far been in position to to build on relatively rich FPS infrastructure with added value applications". with added value applications".

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27. Money laundering (24) 27. Money laundering (24)
Once high on the the risk agenda waswas No. in 2002), thisthis Banana Skinslipping Once high on risk agenda (it (it No. 11 11 in 2002), Banana Skin is is slipping fastfast with the easingconcern. It has hasbe saidsaid that bankers have never taken this with the easing of of concern. It to to be that bankers have never taken this riskrisk seriously as non-bankers, believing it to be “got up”up” politically. But now, as as seriously as non-bankers, believing it to be “got politically. But now, non-bankers too too are less worried, and this year they put it almostthe the very bottom non-bankers are less worried, and this year they put it almost at at very bottom of their list.list. of their Many of the the respondents’ comments focused the the riskregulatory overkill, andand Many of respondents’ comments focused on on risk of of regulatory overkill, the the fact that banks are more vulnerablethisthis Banana Skin from a reputational than fact that banks are more vulnerable to to Banana Skin from a reputational than a financial standpoint. “There is plenty of regulation in place” saidsaid the chairmanaof a a financial standpoint. “There is plenty of regulation in place” the chairman of London banking group. London banking group. ButBut regulators are still focusing it. One said: “During a prudential crisis, thisthis area regulators are still focusing on on it. One said: “During a prudential crisis, area getsgets less attention, henceis aishigh risk.” A Russian banker saidsaid there was a less attention, hence it it a high risk.” A Russian banker there was a temptation for for banks turnturnblind eye eye money flows during recession when temptation banks to to a a blind to to money flows during recession when deposits andand profits were under pressure. deposits profits were under pressure.

28. Merger mania (28) 28. Merger mania (28)
This may not not the the timeembark on a major acquisition spree, andand someour our This may be be time to to embark on a major acquisition spree, some of of respondents even scoffed at the the idea. Many even pointed out that the trend was now respondents even scoffed at idea. Many even pointed out that the trend was now towards demerger as combinations forged in the the heat the the crisis had be be towards demerger as combinations forged in heat of of crisis had to to unwound for competition or other reasons. unwound for competition or other reasons. ButBut theremore to it than that. TheThe banking system will clearly haveundergo there is is more to it than that. banking system will clearly have to to undergo some restructuring as the the dust settles: rationalisation, consolidation, a shrinkage of some restructuring as dust settles: rationalisation, consolidation, a shrinkage of capacity, andand thisbound to require deals to be struck, with the the risk that some of capacity, this is is bound to require deals to be struck, with risk that some of them willwill not work. them not work. Merger mania “could be induced by the the crisis”, said a Swiss banker.might even Merger mania “could be induced by crisis”, said a Swiss banker. It It might even be healthy. A Luxembourg banker saidsaid that “as long the the excess capacityour our be healthy. A Luxembourg banker that “as long as as excess capacity in in industry is not not reduced and more closely adaptedclient-driven earnings potential, industry is reduced and more closely adapted to to client-driven earnings potential, we willwill see continued risk-taking drawing upon market volatile earnings sources”. we see continued risk-taking drawing upon market volatile earnings sources”.

29. Too little regulation (29) 29. Too little regulation (29)
Plenty of of Plenty ‘blind spots’ ‘blind spots’ onon the the regulatory map regulatory map
TheThe persistently low position thisthis Banana Skin over the years suggests that the persistently low position of of Banana Skin over the years suggests that the riskriskregulation is seen to be too too muchit rather than too too little. That remains the in in regulation is seen to be much of of it rather than little. That remains the case, despite the the obvious regulatory failures that ledthe the crisis. While bankers and case, despite obvious regulatory failures that led to to crisis. While bankers and non-bankers put put this low their list,list, regulators placed it higher, at No. 21. non-bankers this low on on their regulators placed it higher, at No. 21. YetYet therea is a vocal minority which asserts – with understandable reasons – that we there is vocal minority which asserts – with understandable reasons – that we need more regulation, or at least better regulation which often amounts to the the same need more regulation, or at least better regulation which often amounts to same thing. A UKUK banking consultant who has responded the the CSFI’s Banana Skins thing. A banking consultant who has responded to to CSFI’s Banana Skins survey for for many years, had the following say:say: “Yes, there will an oversurvey many years, had the following to to “Yes, there will be be an overreaction, but but from a starting point that was manifestly too low. Those who listed [too reaction, from a starting point that was manifestly too low. Those who listed [too much regulation] as the the top Banana Skin2004-6, justjustthe the banking system piled much regulation] as top Banana Skin in in 2004-6, as as banking system piled intointo toxic assets funded cheap wholesale money andand with pressureshow thatthat toxic assets funded by by cheap wholesale money with pressure to to show capital waswas being used ‘economically’, now look absurd. The problem was that there capital being used ‘economically’, now look absurd. The problem was that there waswas too much regulationplaces, but but too littleitof it centred prudential issues.” too much regulation in in places, too little of centred on on prudential issues.”

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Other comments included: “More regulation will come and rightly so”, and “Only a banker would argue there's too much”. Many emphasised the need for better regulation (more professional, better informed), and for gaps to be plugged in a string of areas: disclosure, risk management, governance, international coordination, and specific functions such as derivatives, hedge funds and credit rating agencies. A strong concern was that the regulatory reform effort would flag, leaving necessary work undone. One respondent feared that risky deal-making would get going again “before new regulations and controls can be introduced, together with a failure of regulators to agree on how to reduce moral hazard across the industry. This means that a second melt-down cannot yet be ruled out”. Canadian banking consultant John Pattison feared that governments “will not act to put in place appropriately tighter regulation in a number of areas. Financial institutions do not like some of these proposals but for the sector as a whole and institutions of all sizes they are desirable”. A number of respondents wanted to see a split created between safe “utility banks” serving the high street, and “casino banks” dealing in markets. But they feared that this wouldn’t happen. Andrew Cornford, senior adviser to the Observatoire de la Finance, a Swiss think tank, said that “regulatory reform will concentrate on prudential and transactional problems revealed by the crisis, rather than on structural reforms, in particular the separation of traditional commercial and investment banking and insurance”.

London’s position at risk
A regulatory over-reaction could damage financial centres, particularly London. The group corporate strategist of a large City-based institution said his concern was that “[FSA chairman Lord] Turner's thrashing of the banking sector will reduce London's position on the global stage to the detriment of the entire UK economy.” Some also saw the City vulnerable to a crackdown from Brussels. A respondent from one of the large UK banks said that EU regulations would “force financial institutions outside the UK, either to become concentrated in the US and Caribbean, or increasing activity on continental Europe.” A specific concern is the EU’s proposal to regulate hedge funds and bonuses. A respondent said that “volume and expertise may be lost from London markets as hedge funds relocate to Zug thanks to EU rules, and traders move to avoid UK bonus rules.” Antony Elliott, director of FairBanking in the UK, said that “clear thinking will be needed to separate the issue of safety for UK banks from that of allowing the City to flourish.”

30. Competition from new entrants (30)
Although this Banana Skin is at the bottom of the pile, it contains the important issue of how you stop banks becoming “too big to fail” and make markets more competitive. Yes, there are new entrants: supermarket giant Tesco announced plans to step up its banking presence in the UK as this survey got under way, and at a different level, Chinese banks are emerging as a force on the world stage.

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‘Too small to to survive’ ‘Too small survive’
The The crisis has shown that many banks are big to fail. fail. But the opposite is also true. crisis has shown that many banks are too too big to But the opposite is also true. Many respondents felt thatthat one outcome be a lossloss of banking capacity, particularly Many respondents felt one outcome will will be a of banking capacity, particularly at the the small end where banks have been to sinksink or swim, and where survivors now at small end where banks have been left left to or swim, and where survivors now faceface competition from state-supported behemoths. This concern showedin many competition from state-supported behemoths. This concern showed up up in many markets, including specialised ones like like Luxembourg where small banks feel markets, including specialised ones Luxembourg where small banks feel particularly threatened. particularly threatened. The The chief executive of a Luxembourg bank feared that “many small banks in the chief executive of a Luxembourg bank feared that “many small banks in the private banking business will disappear…because clients will have to go to safer private banking business will disappear…because clients will have to go to safer banks. Small credit providers will alsoalso suffer due to liquidity issues. These trends will banks. Small credit providers will suffer due to liquidity issues. These trends will encourage consolidation from which big institutions will benefit”. In Australia, a a encourage consolidation from which big institutions will benefit”. In Australia, respondent sawsaw heavier regulation “causing demise of marginal players”. respondent heavier regulation “causing the the demise of marginal players”. New regulatory costs will alsoalso heavily on small banks. Antony Thomlinson of City City New regulatory costs will fall fall heavily on small banks. Antony Thomlinson of lawyers Eversheds saidsaid that new funding requirements penalised small banks the the lawyers Eversheds that new funding requirements penalised small banks “to “to detriment of competition in the the banking sector”. David Colvin, executive director of detriment of competition in banking sector”. David Colvin, executive director of Jordan International Bank, saidsaid there was a risk that remedial measures “will place a Jordan International Bank, there was a risk that remedial measures “will place a disproportionate burden on smaller banks andand financial institutions. The counterpart disproportionate burden on smaller banks financial institutions. The counterpart to 'too 'too to fail' fail' is 'too small to survive' which be the the result if the sins of the megato big big to is 'too small to survive' which will will be result if the sins of the megabanks are are visitedthe small”. banks visited on on the small”.

ButBut while this might a good moment for for new competitors launch business while this might be be a good moment new competitors to to launch business models untainted by by the crisis, respondents doubted that they would have the models untainted the crisis, respondents doubted that they would have the stomach for for “My concern is there willwill not realreal new entrants,” said one. stomach it. it. “My concern is there not be be new entrants,” said one. Another saidsaid bitterly: “The real issue unfair competition from state-owned Another bitterly: “The real issue is is unfair competition from state-owned businesses”. businesses”. As As regulation gets tighter, the barriers entry willwill get higher. There were “few regulation gets tighter, the barriers to to entry get higher. There were “few candidates for for entry – and those there are will find it difficultget get established in candidates entry – and those there are will find it difficult to to established in the the facemarket andand regulatory scepticism”, said a respondent. Another observed face of of market regulatory scepticism”, said a respondent. Another observed thatthat it was large, failed banks that attracted capital, not exciting new ones. it was large, failed banks that attracted capital, not exciting new ones. Prof. Michael Mainelli of Z/Yen Group saidsaid the key was not reform regulation Prof. Michael Mainelli of Z/Yen Group the key was not to to reform regulation but buttoughen up monopoly rules to encourage more small banks thatthat were not “too to to toughen up monopoly rules to encourage more small banks were not “too big big fail”. He He said: “The debate should about ‘open’ markets rather than to to fail”. said: “The debate should be be about ‘open’ markets rather than dogmas of ‘free’ or ‘regulated’ markets – breaking up up oligopolies, not saving dogmas of ‘free’ or ‘regulated’ markets – breaking oligopolies, not saving institutions.” A US US respondent agreed, but was not hopeful. “It would a very institutions.” A respondent agreed, but was not hopeful. “It would be be a very good thing to make financial activity more contestable. Smaller institutions, more good thing to make financial activity more contestable. Smaller institutions, more entry andand exit ... ahh that wouldwonderful!” entry exit ... ahh that would be be wonderful!”

The seeds of of the The seeds the next crisis next crisis ‘may already have ‘may already have been sown’ been sown’

Jonathan Howitt, head of group riskrisk at Man Group, said that increased protectionism Jonathan Howitt, head of group at Man Group, said that increased protectionism andand regulation would “stifle the market and product innovation that we needpullpull regulation would “stifle the market and product innovation that we need to to out out the the crisis. Worse still, with fewer banks and higher barriers entry, the the of of crisis. Worse still, with fewer banks and higher barriers to to entry, financial system is far far more concentrated thanwaswas before the crisis. Hence the financial system is more concentrated than it it before the crisis. Hence the seeds of the the next crisis, evenitifisitais a few decades away, may already have been seeds of next crisis, even if few decades away, may already have been sown”. sown”.

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Preparedness Preparedness
We We asked respondents: How well prepared youyou think the sectorto handle asked respondents: How well prepared do do think the sector is is to handle the the risks you have identified? risks you have identified?
2008 2008
WellWell 24% 24% Poorly Poorly 4% 4%

2009 2009 2010
Poorly WellWell Poorly 11% 11% 9% 9%

Mixed Mixed 72%72%

Mixed Mixed 80%80%

Only 9 per per cent respondents thought banks were well prepared, andand per per cent Only 9 cent of of respondents thought banks were well prepared, 11 11 cent thought them poorly prepared. TheThe remainder gave a mixed response. This was a thought them poorly prepared. remainder gave a mixed response. This was a considerably more negative result than last last time when per per cent said “Well” and 4 considerably more negative result than time when 24 24 cent said “Well” and 4 per per cent said “Poorly”.our our 2006 survey, per per cent answered “Well”. cent said “Poorly”. In In 2006 survey, 64 64 cent answered “Well”.
% % Well Mixed Poorly Well Mixed Poorly 12 12 81 81 7 7

Bankers are the Bankers are the most positive most positive about their ability about their ability to to handle risk handle risk

Bankers Bankers

Observers Observers 4 Regulators Regulators 0

4 79 79 17 17 0 90 90 10 10

A breakdown of the the responses shows bankers be the the most positive about their A breakdown of responses shows bankers to to be most positive about their ability to handle risk, andand non-bankers the most negative. Although regulators ability to handle risk, non-bankers the most negative. Although no no regulators thought banks were well prepared to handle risk, most of them gave a mixed thought banks were well prepared to handle risk, most of them gave a mixed response. response. Those who answered “Well” emphasised the the amountwork thatthat had been done to Those who answered “Well” emphasised amount of of work had been done to strengthen banks andand develop better risk controls. typical comment was: “The strengthen banks develop better risk controls. A A typical comment was: “The recent crisis has has heightened the senseawareness of, andand appreciation for, various recent crisis heightened the sense of of awareness of, appreciation for, various risks. This, coupled with active regulatory oversight, ought to enable the the sector with risks. This, coupled with active regulatory oversight, ought to enable sector with the the necessary mindset manage the the key risks faced the the industry.” Those who necessary mindset to to manage key risks faced by by industry.” Those who answered “Poorly” saidsaid that banks had not learned the lessons from the crisis and, if answered “Poorly” that banks had not learned the lessons from the crisis and, if anything, hadhad become complacent. UKUK respondent said: “The fundamental anything, become complacent. A A respondent said: “The fundamental discipline of fearing bankruptcy is now severely diminished for for large institutions, discipline of fearing bankruptcy is now severely diminished large institutions, leaving regulation andand political pressure fill fill the gap. This not notviable way leaving regulation political pressure to to the gap. This is is a a viable way forward.” forward.” TheThe “Mixed” responses stressed the difficulty generalising about a sector which “Mixed” responses stressed the difficulty of of generalising about a sector which hadhad been sharply split intointo winners and losers, the the point wherewaswas now been so so sharply split winners and losers, to to point where it it now possible to differentiate very clearly between well andand badly run banks. One senior possible to differentiate very clearly between well badly run banks. One senior banker said: “My impression is thatthat many banks have learned the lesson and are banker said: “My impression is many banks have learned the lesson and are focusing andand improving risk management, and are readyaccept lower profitability focusing improving risk management, and are ready to to accept lower profitability andand RoE. Unfortunately there are still many banks, probably one thirdthe the ones I RoE. Unfortunately there are still many banks, probably one third of of ones I have talked to, thatthat believe that they did nothing wrong and thatisitbusiness as as have talked to, believe that they did nothing wrong and that it is business usual.” usual.”

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C S F I / New York CSFI

CSFI

CENTRE FOR THE STUDY OF FINANCIAL INNOVATION

5, Derby Street, London W1J 7AB, UK Tel: +44 (0)20 7493 0173 Fax: +44 (0)20 7493 0190

Banking Banana Skins 2010
Each year we ask senior bankers and close observers of the financial scene to describe their main worries about the banking industry as they look ahead. We’d be very grateful if you would take a few minutes to fill out this form, and return it to us by December 19th CSFI, 5 Derby Street, London W1J 7AB, UK Fax: +44 (0) 20 7493 0190 Email: info@csfi.org.uk Name Institution Position Country Replies are in confidence, but if you are willing to be quoted in our report, please tick

Question 1. Please describe your main concerns about the safety of financial institutions (both
individual institutions and the system as a whole) as you look ahead over the next two to three years.

Please turn over

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Question 2. Here are some areas of risk which have been attracting attention. How do you rate their
severity, and what is their trend: rising, steady or falling? Use the right hand column to add comments. Insert more risks at the bottom if you wish.

Severity
1=low 5=high 1 Back office Big market movements: 2 - commodities 3 - credit spreads 4 - currencies 5 - equities 6 - interest rates 7 Business continuation 8 Capital availability 9 Competition from new entrants 10 Conflicts of interest 11 Corporate governance 12 Credit risk 13 Derivatives 14 Emerging markets 15 Environmental risk 16 Fraud 17 Hedge funds 18 High dependence on technology 19 Liquidity 20 Macro-economic trends 21 Management incentives 22 Merger mania 23 Money laundering 24 Payment systems 25 Political interference Regulation: 26 - too much 27 - too little 28 Retail sales practices 29 Risk management quality 30 Rogue trader 31

Trend
Rising Steady Falling

Comment

Question 3. How well prepared do you think the sector is to handle the risks you have identified?
Poorly Mixed Well

Comment:

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CSFI RECENT PUBLICATIONS
92. “BANKING BANANA SKINS 2010: after the ‘quake.” The CSFI’s regular survey of banking risk. Sponsored by PricewaterhouseCoopers. By David Lascelles. February 2010. ISBN 978-0-9561904-9-9. 91. “FIXING REGULATION” By Clive Briault. October 2009. ISBN 978-0-9563888-0-3. 90. “CREDIT CRUNCH DIARIES: the financial crisis by those who made it happen.” By Nick Carn and David Lascelles. October 2009. ISBN 978-0-9561904-5-1. 89. “TWIN PEAKS REvISITED: a second chance for regulatory reform.” By Michael W. Taylor. September 2009. ISBN 978-0-9561904-7-5. 88. “NARROW BANKING: the reform of banking regulation.” By John Kay. September 2009. ISBN 978-0-9561904-6-8. 87. “THE ROAD TO LONG FINANCE: a systems view of the credit scrunch.” By Michael Mainelli and Bob Giffords. July 2009. ISBN 978-0-9561904-4-4. 86. “FAIR BANKING: the road to redemption for UK banks.” By Antony Elliott. July 2009. ISBN 978-0-9561904-2-0. 85. “MICROFINANCE BANANA SKINS 2009: confronting crises and change.” By David Lascelles. June 2009. ISBN 978-0-9561904-3-7. 84. “GRUMPY OLD BANKERS: wisdom from crises past.” March 2009. ISBN 978-0-9561904-0-6. 83. “HOW TO STOP THE RECESSION: a leading UK economist’s thoughts on resolving the current crises.” By Tim Congdon. February 2009. ISBN 978-0-9561904-1-3. 82. “INSURANCE BANANA SKINS 2009: the CSFI survey of the risks facing insurers.” By David Lascelles. February 2009. ISBN 978-0-9551811-9-1. 81. “BANKING BANANA SKINS 2008: an industry in turmoil.” The CSFI’s regular survey of banking risk at a time of industry turmoil. May 2008. ISBN 978-0-9551811-8-4. 80. “MICROFINANCE BANANA SKINS 2008: risk in a booming industry.” By David Lascelles. March 2008. ISBN 978-0-9551811-7-7. 79. “INFORMAL MONEY TRANSFERS: economic links between UK diaspora groups and recipients ‘back home’.” By David Seddon. November 2007. ISBN 978-0-9551811-5-3. 78. “A TOUGH NUT: basel 2, insurance and the law of unexpected consequences.” By Shirley Beglinger. September 2007. ISBN 978-0-9551811-5-3. 77. “WEB 2.0: how the next generation of the Internet is changing financial services.” By Patrick Towell, Amanda Scott and Caroline Oates. September 2007. ISBN 978-0-9551811-4-6. 76. “PRINCIPLES IN PRACTICE: an antidote to regulatory prescription.” The report of the CSFI Working Group on Effective Regulation. June 2007. ISBN 978-0-9551811-2-2. 75. “INSURANCE BANANA SKINS 2007: a survey of the risks facing the insurance industry.” Sponsored by PricewaterhouseCoopers. By David Lascelles. May 2007. ISBN 978-0-9551811-3-9. 74. “BIG BANG: two decades on.” City experts who lived through Big Bang discuss the lasting impact of the de-regulation of London’s securities markets Sponsored by Clifford Chance. February 2007. ISBN 978-0-9551811-1-5. 73. “BANKING BANANA SKINS 2006” The latest survey of risks facing the banking industry Sponsored by PricewaterhouseCoopers. By David Lascelles. April 2006. ISBN 0-9551811-0-0. 72. “THE PERVERSITY OF INSURANCE ACCOUNTING: in defence of finite re-insurance.” An industry insider defends finite re-insurance as a rational response to irrational demands. By Shirley Beglinger. September 2005. ISBN 0-9545208-9-0. 71. “SURVIVING THE DOG FOOD YEARS: solutions to the pensions crisis.” New thinking in the pensions area (together with a nifty twist by Graham Cox). By John Godfrey (with an appendix by Graham Cox). April 2005. ISBN 0-9545208-8. 70. “NOT WAVING BUT DROWNING: over-indebtedness by misjudgement.” A former senior banker takes an iconoclastic look at the bottom end of the consumer credit market. By Antony Elliott. March 2005. ISBN 0-9545208-7-4. 69. “BANANA SKINS 2005” Our latest survey of where bankers, regulators and journalists see the next problems coming from. Sponsored by PricewaterhouseCoopers. By David Lascelles. February 2005. ISBN 0-9545208-6-6. £19.95/$29.95/€22.95 £25/$50/€40 £25/$50/€40 £25/$50/€40 £25/$45/€35

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