It’s liquidity that kills banks

People shop at a department store in New York City on Friday. The US economy shrank 0.3 percent in the third quarter. The decline was due in part to consumers cutting spending by the largest amount in 28 years, a strong signal that the country has fallen into recession. Photo: AFP

Some new lessons need to be learnt or perhaps they are old ones. Financial strength is making a welcome comeback. Benchmarks of acceptable leverage and capital ratios are being revised. And regulators will need to address the pro-cyclicality of capital requirements caused by the interaction of fair value accounting and Basel 2 capital adequacy rules.
There will be a renewed focus on liquidity. This crisis has shown that it is liquidity that kills banks, not just a shortage of capital. Regulators and banks themselves need to understand their liquidity vulnerabilities more clearly.
And the market and industry will need to consider whether badly-aligned incentives have contributed to the crisis: both the market incentives which, until recently, encouraged banks to grow fast and gear up, persuading them to take on higher risk than was sustainable; and compensation structures in the industry, which have so often encouraged too much opacity and excessive risk taking.
But underlying all of this is a fundamental trend in the world economy which, in my view, will not be de-railed even by today's crisis and which we need to recognise for what it is.
And that is the rebalancing of the global economy towards Asia, home to over half the world's population, and its implications for the Middle East. In the long-term, it is this shift that will affect financial markets most profoundly.
Asia and the Middle East will continue to outgrow mature markets. Even in the current economic climate, our short-term projections are for slowing but still quite resilient growth: an expected 6.4 per cent this year slowing to 5.7 per cent next. Given that the emerging markets economies are collectively as large as the US economy, continued growth should help exporters from the G7 countries. But crucially this growth will also stimulate regional and domestic demand for capital.
As Asian and Middle Eastern economies grow larger, we will see the continued development of regional and domestic capital markets. In the light of this financial crisis it would be hardly surprising if caution and scepticism about the Western model of capital markets were to increase amongst emerging markets. Nevertheless, I believe the direction is clear -- regional capital markets will develop and more of the capital generated in the fast growing emerging markets will stay closer to home in the future.
What are the implications of these profound shifts for mature economies over the longer-term? I am not a doomsayer. It is important to remember that economic growth is not a zero-sum game. Therefore the rapid growth of emerging markets does not signal an absolute decline in the economies of mature nations.
The pie will grow. But it does entail a loss of share -- the developed world will have a smaller share of a larger pie. Indeed, this has been the experience of the US since the 1950s.
Capital markets in the developed world will likewise suffer a loss of share. And in the near-term, at least, an absolute decline is also likely as the deleveraging of the financial system works its way through.
And what are the implications of all this for the fast growing regions of Asia and the Middle East?
First, that creating financial systems which are both more sophisticated and more stable will be a major challenge, but it is not one that can be avoided. As economies become larger and more sophisticated, they need fully functioning capital markets to ensure the efficient allocation of capital.
For all that the western markets are in crisis, neither the world at large nor Asia in particular can turn the clock back to a simpler era in which capital markets played only a marginal role in economic development.
The main challenge lies in the dichotomy that financial markets, as this crisis has demonstrated, are increasingly global, while the policymakers and regulation that governs them remain predominantly national. Greater international cooperation will be required to place the financial system on a more stable footing. And given that financial crises are a recurrent feature in our lives, we will need more global regulatory coordination to deal with them when they do arise.
At the same time, as Asian and Middle Eastern economies grow and become more important as investors in the world economy, their responsibilities will also become more complex. And their voices will need to be heard in the dialogue about world trade and investment policy that must surely continue.
For there is a clear threat that the financial crisis may rekindle protectionist tendencies. In this new, and more fragile world order, preserving the free-trade and open investment orientation that has helped humanity to become more prosperous than ever before in the last 50 years will be a major challenge, especially if the world faces a major slow-down.
Globalisation is not a new phenomenon; it allowed the world to prosper in the late 19th century when, despite high tariffs, rapidly falling transport costs prompted an explosion in world trade. This earlier wave of globalisation was brought to a halt by the first world war, and then regressed through the 1930s, as a result of protectionist and competitive devaluation with eventually unspeakable consequences.
Since the 1950s, there has been steady progress in liberalising trade and investment, led by a strong power, the US, that has created prosperity the like of which had never been seen before.
Free markets are in the dock today, as the full extent and pain of this crisis is revealed. But as we look beyond the turmoil, and as policymakers consider how to prevent future crises, we must strive at all costs to avoid repeating the protectionist errors of the 1930s. Instead, we must remind ourselves constantly of the immense wealth and prosperity that free markets have helped create for humankind.
This crisis is severe; it is without doubt the most serious for many generations, and it is hard to look beyond the sea of red on trading screens to the future.
Nevertheless, the crisis will pass; trust and confidence must and will be rebuilt. More importantly though, it is important to understand this crisis for what it is and what it isn't. It is not just about a housing bubble in the US, nor just about a consumer debt explosion in the developed world. It is part of a much more fundamental shift in the world economy, from one dominated by a single nation, to one in which wealth is created and shared much more widely -- a world which is more complex and in which international cooperation to ensure stable, efficient, open capital markets becomes more and more important for us all.

Stephen Green is the group chairman of HSBC Holdings. The article (last part) is adapted from his October 20 speech at the FT/DIFC World Financial Centres Summit.