The bull market mindset that stumbled in the financial crisis of 2008 has led to the start of what I would call the decade of risk management and regulation.
The pendulum has also swung on the risk-versus-return conundrum. In the present volatile markets, I believe that risk is a more important driver than return in most trading transactions.
The demise of Lehman Bros, Bear Sterns and American International Group started the swing with various regulatory investigations set up particularly in the US. Concerns raised included:
n The lack of transparency;
n Fragmented, uneven risk management;
n Inadequate risk governance, management practices and infrastructure; and
n The insufficient use of collateral and vulnerable market infrastructure.
Politicians, financial regulators, bankers and various anti-Wall Street movements all knew something had to be done.
Probably the first co-ordinated global regulatory response was the November 2008 Group of 20 (G20) meeting in Washington. It gave finance ministers a reform mandate aimed at “strengthening the resilience and transparency of credit derivatives markets, reducing their systemic risks and improving the infrastructure of over-the-counter markets”.
These measures were endorsed at the September 2009 G20 meeting in Pittsburg, US. As a member of the G20, South Africa was obliged to implement these reforms where necessary.
The G20 reforms were a catalyst for co-ordinated global regulatory responses, the most important of which was Basel lll.
The Basel Accords are a series of recommendations on banking laws and regulations issued by the Basel Committee of Banking Supervision under the auspices of the Bank of International Settlements (BIS). Basel l was first enacted in the 1980s and Basel ll was revised last year to what is loosely dubbed “Basel two and a half” and it expires at the end of this year.
The US opted not to implement Basel ll and the financial crisis erupted when US banks started making risky investments in the subprime mortgage market.
High-risk assets were moved to unregulated parts of the bank’s holding companies. Also, risks were transferred directly to investors by securitisation – the process of taking a non-liquid asset or group of assets and transforming them into a security that could be traded on open markets.
Now in response to a dynamically changing market profile, Basel lll will descend on the world banking system from January 2013. This aims to:
n Improve the banking sector’s capital adequacy and absorb shocks from financial and economic stress;
n Improve risk management and governance; and
n Strengthen the transparency and disclosures of banks.
My overall assessment is many banks will fundamentally rethink their business models, evaluate their portfolios and move out of complex or less liquid instruments. Aside from the much-publicised liquid asset requirements, banks will need to hold prohibitive amounts of capital for proprietary trades and for over-the-counter trades (OTC) or off-market trades that are not cleared through an exchange.
Already in South Africa a number of banks have closed their proprietary trading desks and others are considering their options. It is likely that banks will start clearing OTC instruments through exchange clearing houses.
There is also a possibility that banks will charge more for loans to businesses as they strive to meet the new capital and liquidity requirements. More resources will need to be devoted to risk management.
Although Basel lll in effect triples the size of capital that banks need to hold against losses, our local banks are well capitalised and have a credible history of risk management.
However, banks in some developing countries will be hit by the part of Basel lll known as the “liquidity coverage ratio”, which requires banks to hold assets that are easy to sell in the event of a market crisis.
At the JSE we are responsible for risk managing and guaranteeing the settlement of a central order book of cash equity transactions at an average of R13 billion a day at present or R3.3 trillion in the 249 trading days of 2011.
We are now subject to new and more demanding international standards for payment, clearing and settlement systems that have been issued by two BIS committees.
These 24 new standards, or principles, ensure that the essential infrastructure supporting global financial markets is even more robust and thus better placed to withstand financial shocks than it currently is. The standards apply to all important payment systems, central security depositories, securities settlements systems, central counter parties and trade depositories. The JSE aims to comply with these principles by the end of this year.
Everywhere one looks there seem to be new initiatives, structures or reports to mitigate against risk. Many businessmen might believe that the pendulum has swung too far towards regulation.
However, they must realise that it was reckless, naked capitalism that bought the world to the edge of a depression in 2008. Only a couple of months ago a rogue trader evaded the sophisticated risk management systems at JP Morgan and it also appears that Barclays has been manipulating interbank lending rates in the UK.
Moreover, we’re still on the edge of the abyss due to poor regulation for many years of the banks and economies of a number of countries in southern Europe.
Here we must pause to reflect on our country’s blessings. Our financial system is sophisticated and the World Economic Forum has rated South Africa as number one in the regulation of capital markets for the past two years.
Despite our political and economic problems, we are comparatively well off when measured against many European countries. Our country is not bankrupt nor is there any prospect of it going bankrupt.
Friends of mine who have visited Europe recently came back to South Africa with horror stories of what the recession has done to places that were previously tourist meccas.
On another positive note for the country, South Africa’s inclusion in Citigroup’s World Government Bond index from October is a vote of confidence in our financial markets, in which the JSE plays an integral part. Citigroup announced that South Africa had satisfied its three requirements of size, credit and lack of barriers to entry.
We are the first African market and only the fourth emerging market along with Mexico, Malaysia and Poland to qualify. Our bond market offers an established yield curve and some traders regard it as relatively safe, bearing in mind the euro zone’s debt crisis.
This inflow of money could lower South Africa’s cost of borrowing and possibly even strengthen the rand.
From January to mid-June this year, foreign purchases into our bond market have risen 45 percent at R44.3bn compared with last year. The overall volume for the same period stands at R11.1 trillion this year compared with R9.6 trillion in 2011.
Humphrey Borkum is the chairman of JSE Limited.