More trading, less lending: The future of banking

More trading, less lending: The future of banking

By Riyadi

JAKARTA (JP): Old and new: traditional and modern banks. This
was the theme of a seminar held here on Friday. The old banks
rely on loan-deposit businesses, while new banks rely on trading
businesses, said Heinz Riehl, former vice president of Citibank
New York.

Although both kinds of banks are intermediates between those
who need money and those who have money, the ways they
intermediate are different.

Intermediary is traditionally done on the balance sheets of
the banks, via loan deposits. The banks need the minimum spread
between the deposit and lending rates to get an acceptable return
for their capital.

"The new bank does not do that anymore," Riehl said at a
seminar here last Friday, organized jointly by InfoBank magazine,
the Indonesian Bankers Club and the Indonesian Forex Club.

In the new banks, Riehl continued, their old borrowers have
now become the issuers of tradable debt instruments, and their
old depositors have now become investors in these debt
instruments.

Take the following example. Alpha Company, a borrower at Beta
Bank, needs money for its expansion program. Instead of borrowing
money from the bank, it issues promissory notes. The bank buys
the notes and sells them to investors: the people who used to be
its depositors.

"You see, the bank is still doing intermediation, but instead
of doing it on the balance sheet...it is doing off the balance
sheet through trading. The bank buys obligations, turns around
and sells them to those who have the money," Riehl said.

He pointed out that intermediation on the balance sheet
requires adequate equity capital, which needs a minimum spread.
This requires a larger spread, especially when the bank is lowly
leveraged. Consequently, credit-worthy companies will not pay for
such a large spread as they can get much cheap funds by issuing
debt instruments.

Meanwhile, doing intermediation off the balance sheet, through
trading, does not require such a big spread because banks can get
better returns annually -- compared with loan-deposit businesses
-- as they do trading businesses everyday.

"Everybody is happy. The companies are happy because they can
raise the money cheaply, The investors are happy because they get
better returns. And the banks are happy because they get the
right kind of income, non-fund revenues," Riehl said.

Safer

For banks, such trading is much safer. The banks do not lose
the money if a company goes bankrupt. The investors do.

"It is not unfair. Investors get higher yields. If they don't
want the risk, they can deposit their money in banks but with
lower yields," Riehl added.

In other words, bad loans are the biggest worry for the old
banks, which still rely on loan-deposit businesses. When their
borrowers go bankrupt, they suffer losses.

The biggest risk for the new kind of bank is price risk,
"trading against prices". Beta Bank buys Alpha Company's
promissory notes worth US$100 million. While the bank is holding
the notes -- before selling them -- interest rates rise. As a
result, the price of the notes goes down.

"So price risk is much more prominent today, than it used to
be," Riehl noted, adding that such price risk has elevated the
importance of risk management.

"Risk management is not risk avoidance. Risk management is
this: to the best of our ability we try to estimate the size of
the risk and make sure that we get paid for it," Riehl explained.

By trading, Riehl noted, banks can increase their earning per
share, and make more money without issuing new shares.

He said trading businesses started about 15 years ago in the
United States and has become a major feature in modern banking
businesses.

"You see, it will happen here in Indonesia," Riehl said
firmly. He urged the participants, mostly bankers, to initiate
trading businesses in the country.

"Most of you might say, 'well in Indonesia we don't do it. No
one has ever done it...' You say, 'once the market is developed,
our bank will do it.' If you all think that way, no-one will do
it," he said.

"If not now, when, if not us, who," Riehl said, quoting a
famous phrase of U.S. President Ronald Reagan's. "You don't have
to invent anything. The technology is there. All you have to do
is import it."

He suggested that a number of local banks propose to the
monetary authority to change the regulations or issue new rulings
to provide a legal basis for this approach, and help make Jakarta
a modern financial market.

"It is very important that this be understood as good for the
country. If it is good for your banks only, you will never see it
done," he warned.

He argued that a modern financial market will benefit the
country because it will provide better financing and eventually
help lower inflation rates.

"When you talk about lower inflation, then they (the monetary
authority) will begin to listen," he predicted.

Meanwhile, T.A. Sutanto, president of Bank Dharmala, noted
that trading still has negative connotations in Indonesia,
especially after the losses incurred by Bank Duta in margin
trading.

Banking analysts often cite the case of Bank Duta, which
suffered US$419.6 million in losses from foreign exchange trading
in 1990, as an example of the danger of derivatives trading.

Sutanto said derivatives trading is all right for local banks
as long as the risk can be calculated or is for hedging purposes.
Besides, he added, the central bank has given the green light to
derivatives trading.

According to Bank Indonesia's guidelines on derivatives, the
derivatives transaction local foreign exchange banks can perform
are limited to those dealing with foreign exchange and interest
rates, excluding those dealing in stocks and futures. Banks may
enter transactions on stock-related derivatives only with the
consent of the central bank.

Sutanto acknowledged that few banks will be ready to shift to
trading. "Merchant banks are probably the best placed, as they
have different types of customers."

He said most banks in Indonesia are still in retail banking,
because of the high returns there. "Even Citibank here is in
retail. And its retail earnings are much better than the others."

Riehl suggested that the existing "old" banks modernize their
banking practices by securitizing their loans so that they can
sell them to investors. They could conduct trading activities for
their traditional customers in order to generate more fee-based
income.

In Indonesia, a number of large banks have started such
trading activities, mostly loan syndications and trading on
securities and derivatives products, to improve their fee-based
income.

Publicly-listed Bank Bira, for instance, has been active in
fee-based businesses in addition to its normal banking
activities, including the arrangement of loan syndications and
fixed income papers. It claims to be the market leader in both.