Wednesday, April 15, 2009

Will banking become boring?

An article which coincides my point of view...
Btw, I am still haunted with my decision of pursuing a career in the Industrial sector as against one in an Australian Investment Bank ( though I could have been fired a goof 3-4 months ago atleast.. the lure is still there.... hmmmmmmmmm)

FOR quite some time now, many of those who have headed for some of the best known business schools in India and abroad have done so in the hope of making it to one of the top banks — or “shadow banks”— of the world. Commercial banks apart, investment banks, hedge funds and private equity have hogged the lion’s share of graduates from these places. Part of the motivation has come from the mouth-watering presentations made by the world’s leading financial firms. At top B-schools in the US, some firms were known to lay out a career path for graduates that led up to a million dollars in three years flat and up to ten million dollars in ten years’ time. That path may have been strewn with 18-hour workdays seven days a week but it has still proved irresistible to many. The other element in the lure of financial firms has been the sizzle and fizz of innovation, the opportunity to dream up and sell exciting, new financial products. This is set to change in the years ahead. Some of the change was already in evidence in the recent placement season at the leading B-schools in the country. The great names in investment banking that used to swoop down on some of the best talent failed to show up — because many are now history. At IIMA, one of the biggest recruiters this year was not Lehman Brothers but our own Union Bank of India. You could call it a revolution of sorts. There is more change along the way. One of the few things that are certain in these uncertain times is that financial innovation, risk-taking and the profits and rewards that went with them will be reined in. That should cause the financial sector itself to shrink in relative importance in the advanced economies. Financial regulation is in for a sweeping overhaul. In particular, three key elements of regulation are poised to change the face of the financial sector. The first is that capital requirements for banks and other financial intermediaries will go up. This will undermine one of the key sources of abnormal profitability in banking — extraordinary leverage. One of the revelations of the present crisis is that many banks and investment banks were operating at a leverage of 30 or more. Hereafter, banks will find themselves subject to a regulatory minimum of capital that will be above the 8% required currently under rules framed by the Bank for International Settlements. This is the capital that is required to be set aside against “risk-weighted” assets. It is very likely that, on top of this, banks will be subject to a limit on leverage as conventionally measured. As equity capital is costlier than debt, an increase in capital requirements (or a decrease in leverage) is bound to push up the cost of funds for a bank. This will impose a cost on bank customers — a lower deposit rate or a higher borrowing rate or both. Higher borrowing costs, in turn, will tend to depress output. But financial instability carries its own costs: the loss of output as a result of a financial crisis can be anywhere between 5% and 45% of GDP. The judgement today is that the latter outcome is less preferable. Higher capital is seen as crucial to stability. Once capital requirements for banks go up, we should expect bank profitability to fall. The halcyon days of return on equity of 20% or more in banking may well be over. SECONDLY, regulators are going to be far more sceptical about the supposed benefits of financial innovation. It is clear that the explosive growth in one innovation, securitised credit, laid the seeds for the present financial crisis. Moreover, as a report prepared recently by the head of UK’s Financial Services Authority (The Turner Review) points out, innovation has spurred growth in the financial sector in ways that were either illusory or harmful. Financial sector value-added as a proportion of GDP in the UK rose from 5% to 7% in the period 1995-2007. Partly, this reflected the illusory gains in a rising market arising from mark-to-market accounting. The review suggests that the surge in value-added was also harmful in so far as it arose from rents from complex financial products. The Review notes: “Wholesale financial services….grew to a size unjustified by the value of its service to the real economy”. There is talk of excesses in the financial sector. It would be more accurate to say that the financial sector itself constituted an excess both in terms of its relative size in economies and the sort of returns it generated. It is unlikely that banks will hereafter be able to launch product innovations at will. Thirdly, we must expect constraints on bankers’ pay. Regulators will insist that incentives for bankers be based on measures of performance that better reflect risk and the long-term performance of banks. More importantly, higher capital requirements and lower profitability in banking will limit rewards in the financial sector. Outsized bonuses will not be passé but they will be more difficult to come by. This is greatly welcome and somewhat overdue. Thanks to absurd compensation packages, financial firms (along with IT in India) have created huge distortions in the labour market. They have tended to lay a disproportionate claim on the pool of human talent to the exclusion of manufacturing and other sectors. Will these changes in regulation — higher capital requirements, constraints on financial innovation and tighter norms for incentives — make banking a ‘boring’ sector rather like some regulated utility? Not really. The management of risk that is or ought to be the core of banking will remain challenging and exciting. Besides, innovation is not just about product innovation, it is also about process innovation, finding ways to deliver products more efficiently to customers and broadening financial inclusion. While pay packages in banking will be less extravagant, bankers won’t be exactly starving. What the emerging direction of regulation will do is strip banking of some of its hype, the glamour and danger that one associates more with adventure sports. Actually, the comparison is inapt. In adventure sports, it is the sportsman who pays dearly for his mistakes. In banking, it is the audience that has all too often ended up paying the price.

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