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Risks in mergers, mega banks

September 15, 2008

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THE Basle Accord-II provides a formula for determining the adequacy of bank capital by relating it to risk-weighted value of a bank’s assets.

For complying with this stipulation, the accord doesn’t specify minimum bank capital in terms of an amount. But, on September 5, the State Bank of Pakistan (SBP) may have done that.

Starting with Rs6 billion by end-2009, bank capital must increase every year by Rs4 billion (by Rs5 billion in 2011) until 2013 to reach Rs23 billion. Banks failing to meet SBP’s risk rating (CAMEL-S) will have to maintain higher capital and, henceforth, initial capital for new banks will be Rs23 billion. All these steps aim at encouraging ‘consolidation’ in the banking industry through a ‘second’ round of mergers.

There is some logic in the move. In the unfolding scenario some small banks must merge to create viable entities, but it also raises some questions: is SBP anticipating rapid economic growth and credit expansion or a big rise in bank risk, or having fewer banks to watch will permit SBP to take on NBFIs as well without increasing its current capacity, or curbing cartelisation by mega banks isn’t a challenge now.

The sub-prime crisis proved that banks’ audit, risk management, and governance standards are diluted by merger-driven expansion. Higher capital indeed enhances loss-absorbing capacity but avoiding losses — the prime objective — requires improving internal and external institutional arrangements to monitor and control risk i.e. inculcating commitment, prioritising expertise and enforcing stiff regulatory discipline. Mega banks defy implementing all these strategies.

This isn’t a fresh discovery; after each size-driven crisis eventually subsided, greed took the better of bank owners’ and managers’ senses until they re-discovered that ‘big wasn’t beautiful’. Yet, oddly, as the current crisis caused by large mismanaged banks reaches its peak, some central banks are enforcing regulations to create mega (and therefore inefficient and defiant) banks in the name of consolidation.

Reserve Bank of India (that may allow greater foreign bank presence in India) believes that “intensifying competition could accelerate consolidation” but admits that “while this may be a positive move, it may, at the same time, raise the risk of concentration” and the moral hazard that the state may then be obliged to bail out big banks if they collapse or, alternatively, let the entire financial system fail.

For decades, Pakistan relied on mega banks, which wasn’t the right choice. Just one proof thereof is the creation of ICRC to takeover the bad loans of these banks. On the other hand, prudently managed banks created in the 1990s did well. Those that came under stress or collapsed owed their fate to the fact that visible misfits were licensed to establish and operate them.

Bank mergers weren’t always fruitful. Firstly, due diligence exercises to establish the reality of assets and liabilities of the acquired banks weren’t exhaustive enough. Secondly, shifting account data from one IT base to another led to distortions in reporting. Thirdly, merger of managements and their philosophies was painful and for prolonged periods disrupted the business of the customers of the merged banks.

Mega banks make regulators vulnerable but regulators don’t realise it until confronted with defiance of these banks, or the banks come under stress and become unmanageable for the regulators. As the current economic recession presses ahead, the US and European central banks are portraying this weakness, and sending a clear message to the overambitious central bankers.

Central banks must realise that, besides concentrating power in few hands, mega banks with huge branch networks and customer bases increase operational, contagion and systemic risks — each the focus of caution in the risk management strategy prescribed by Basle Accord-II; it implies re-modelling banks to an ‘optimal size’, under their given circumstances.

This envisages aligning a bank’s network, product range and customer base with its managerial, systems and connectivity capacities for consolidating at each day end the entire exposure to risk that its network has booked during that day, which was creditably approved and whose booking was properly supervised. Sounds idealistic alright but doesn’t the imperative quest for excellence imply trying to achieve the ideal?

A bank’s network, product range and customer base give rise to risks and, ironically, each banking fiasco reveals that central banks lack the capacity to effectively regulate these areas. Evidence suggests that the factor causing these failures is lack of relevant experience among central bankers because most of them have only academic, not practical knowledge of running commercial banks.

This gap is compounded by weaknesses of the judicial system, and un-regulated credit referencing, asset valuation, custodial, warehousing, and goods clearing and transportation services, but especially audit. Belated enforcement of ‘compliance’ (self-audit by front-line staff) impliedly admits the limitations of audit. External auditors, on whose certification of a bank’s accounts the regulators rely, audit only a fraction of a bank’s branches.

Bigger the bank smaller is this fraction and, logically, should lower the confidence in external auditors’ certification of that bank’s accounts. These being the harsh realities, is it wise to push smaller banks to merge and form mega banks? Shouldn’t we strive for improving the risk management capacities of prudently managed and more extensively audit-able medium-size banks? By all estimates, the coming two years would be tough for Pakistan’s economy and will depress banks’ profit. This will limit all (not just small) banks’ choices in meeting SBP’s minimum capital requirements by injecting the Basle Accord-specified Tier-1 capital (i.e. equity) or Tier-2 capital (i.e. subordinated 5-year debt). Banks may therefore opt to earn even higher profits and delay the process of economic revival.

For Pakistan, supporting its SMEs should be the priority, which won’t be served by merging well-managed smaller banks into mega banks because the arrangement won’t meet this objective as effectively as we need in order to expand and bolster Pakistan’s SME base; even in highly developed economies SMEs holds the key to ensuring economic uplift on a sustained basis.

We need efficient banks with close customer contact and with the capacity to cut SMEs’ cost of doing business. Mega banks with multiple management layers, and therefore as much disconnected with their customers, won’t help. Besides, only smaller banks can (in customer perception) be credibly focused on their businesses. Long chains of authority dilute that perception.

Finally, creating defiant power centres is inadvisable in a set-up that suffers from deficiencies in its judicial and regulatory regimes. The ‘capital adequacy’ route to creating more such entities will worsen this milieu. Instead of copying the West’s failed experiment of creating mega banks, let smaller but prudent, responsive, and efficient banks stay in business by softening the capital enhancement demands.