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.