Decoding the "Enigma" of Banks

The volatile crisis across banks in the US continues unpredictably with the recently declared bankruptcy by the First Republic Bank. This marks the third bank to fail in the last few months.

Saigon Investment has gathered extensive information and analysis on the recent bank failures in the US and the lessons they hold for Vietnam. For a better and more comprehensive understanding of the global banking system in relation to its effect in Vietnam, Saigon Investment interviewed Professor Tran Ngoc Tho, a financial expert who has conducted extensive research on banking models across the globe as well as in Vietnam.

Journalist - Sir, please could you explain in simple terms what is causing the current banking crisis in the US?

Prof. Tran Ngoc Tho: - A bank crisis can vary across countries due to different reasons and conditions, but the most common factor is that the banks rely far too heavily on debt leverage, which causes a high level of ambiguity. After each crisis, people seek a permanent solution to prevent a recurrence. However, there is no foolproof solution to address the problems plaguing banks concerning debt leverage and ambiguity. By studying banks in the US and also the banks in Vietnam that are under weak control, it is clear that insufficient capital and too much ambiguity are key factors that can lead to the demise of a bank in any country.

- Sir, in your opinion, do regulatory agencies and policymakers acknowledge that these factors can cause a serious crisis in banks?

- From a Vietnamese standpoint and by observing the banking system in the country, I can evaluate these factors by using a metaphor from a book by Professor Anat Admati of Stanford University and Martin Hellwig of the German Institute of Economics. They both argue that misconceptions within the banking sector are the primary reason for bank failures. The metaphor draws from Hans Andersen's fairy tale "The Emperor's New Clothes."

In this folk story, two tailors convince the emperor that they possess the ability to weave extraordinary clothes that are invisible to those who are ignorant or incompetent. Although the officials sent to supervise the tailors see nothing out of the ordinary, they actually praise the magnificence of the nonexistent garments to avoid appearing foolish. Even when the emperor parades through the streets of the capital wearing these invisible clothes, the crowds cheer the emperor in admiration and pretend to see what isn't even there in reality. It's only when a little child exclaims, "The emperor is wearing no clothes!" that the crowds too acknowledge the truth, which was glaringly apparent throughout.

This metaphor highlights our limited understanding of banks, despite our daily interactions with them. We lack the legal tools to comprehend the risks banks face until one day some hidden truths become visible and apparent to all. However, the main reason for the success and failure of banks lies in people's misconceptions. Banks are considered distinct and separate from all other companies and industries in the economy. Anyone who questions the risks of their operations being deemed incompetent. By exploiting this unique status, banks amass a significant amount of assets and enjoy numerous privileges, while investing only a minimal sum in capital. To put it bluntly, the banking interest groups and their associates in the political and economic arena are too formidable to challenge.

- Sir, could you provide more specific details about these two major factors leading to bank failure, namely, insufficient capital and the ambiguity that you mentioned earlier?

- We can better comprehend these issues by clarifying the concept of bank capital. This aligns with the approach of Professors Anat Admati and Martin Hellwig in discussing how banks fail. The concept may seem inherently simple to people at large but for banks, its peculiarities create a mystery in the banking industry.

For instance, suppose I want to purchase a house worth VND300 billion but can only pay 10 percent upfront, which is VND30 billion. To cover the remaining VND270 billion, I must take out a bank loan, using the house as collateral. We can visualize this transaction through a simple balance sheet. The left-hand side represents my assets with the house valued at VND300 billion. The right-hand side represents the financial resources involved in the house, including the VND270 billion loan and the VND30 billion down payment. The difference between the value of the house and the amount owed represents my equity in the house, which is also known as bank capital. Here's where things start to get interesting. As a banker, if my equity is VND30 billion, it means I owe the bank VND270 billion from people's deposits.

But what happens if the house value drops? Let's say the price decreases by 5 percent to VND285 billion. After deducting the VND270 billion loan, the bank equity is reduced to only VND15 billion. In this way, a mere 5 percent decrease in house prices wipes out 50 percent of the bank equity. If the house price drops by 10 percent, it will completely eliminate the bank equity. And if this drop in value exceeds 10 percent, the bank will have negative equity which is commonly referred to as default. This simply exemplifies how borrowing magnifies risks. In Vietnam, we even have the concept of a zero-dong bank, but in realistic terms, it should be referred to as a negative-dong bank.

When borrowing magnifies risks, even a small 10 percent decrease in asset value can deplete the bank's equity. On the other hand, even a slight increase in house prices can generate substantial profits. This danger lurks in the banking system. Unfortunately, compared to the highly analyzed manufacturing sector, the banking sector is the least regulated.

- Sir, what is the current equity status in the banking system in Vietnam as per your assessment?

- The case example I have just given illustrates that bank capital is dynamic and depends entirely on unknown risks that arise across various scenarios. When I borrowed money from the bank, my equity was VND30 billion. However, various unforeseen risks emerge which then cause house prices to suddenly drop and subsequently also reduce equity. In practice, this does not pose a significant problem if the bank does not immediately sell the house and depositors continue to deposit money. This loss is only on paper since current accounting rules do not reflect such losses until maturity.

Therefore, if we solely rely on accounting data, we may not see a sharp decline immediately or even see negative capital in the bank. Take the case of the recently bankrupt Silicon Valley Bank (SVB) in the United States, which incurred losses on securities held until maturity amounting to US$15.1 billion, nearly equal to its US$16 billion equity before the bankruptcy. Hence, prior to going bankrupt, SVB was essentially like a zero-dong bank, yet it reported good profits. No one noticed this fact or raised an alarm. This begs us to ask about the functioning of the regulatory agencies.

Regarding equity capital in our banking system and its current level, only the management agency, which is the State Bank of Vietnam, holds accurate information or at least we hope so. However, the recent ongoing shock events in the real estate market demonstrate that real estate-friendly banks are highly vulnerable to even minor asset price decreases. I'm concerned about policies that facilitate increased banking investments in corporate bonds, which, if not regulated, can lead to serious consequences.

- Sir, does this mean that banks with a larger exposure to the real estate market will face more risks?

- In the mortgage example I spoke about earlier, if the property price drops by more than 10 percent, I might even lose the motivation to repay the bank. If the house prices fall by another 5 percent, I can only repay the bank if I have an opportunity to recoup 50 percent of my equity. Such a situation is practically unthinkable.

Hence in such a situation, finding a viable solution is challenging. Therefore, banks often resort to playing a risky game by even bending or breaking the law, such as by investing in high-risk projects instead of lending to small and medium enterprises. Their only hope is for a revival in the real estate market. In a way, this raises the question of whether banks will purchase corporate bonds from real estate companies.

- Sir, would it be right to say that the immediate solution would be for banks to raise more capital?

- For now, let's set aside the discussion of whether the Government should save or not save banks, and how the law should be improved to prevent bankers from taking advantage of the current banking system. Now there are two crucial considerations. First, the current law stipulates limited liability for banks, which encourages excessive risk-taking behavior. If a bank fails, it will undoubtedly have a ripple effect throughout the entire system, causing severe consequences for the banking and financial systems and also the overall economy. Second, in order to curb excessive risk-taking by banks, it is necessary to further increase the capital.

After the recent US banking crisis, it is likely that lawmakers will push for an even higher capital requirement, potentially even doubling the current requirement. Many international proposals suggest that banks should maintain enough capital with a Tier 1 equity ratio of 30 percent of total assets. Preliminary estimates indicate that the Tier 1 equity to total assets ratio of Vietnamese banks is currently only a few percent, which is alarmingly low. Additionally, regulations governing bank liquidity ratios also need to be strengthened. If bankers perceive that they have incurred substantial losses, they will hesitate to take excessive risks.

- Sir, most Vietnamese banks claim to be Basel 2 compliant, with some asserting to even have achieved Basel 3 standards. Would this be sufficient to limit risk-taking by banks in Vietnam?

- Many argue that one of the reasons behind the ongoing banking crisis in the United States is the excessive complexity of Basel regulations. These regulations seem to be exclusively designed by the mathematicians of the Basel Committee and seem to lack the involvement of industry experts. The formulas used to calculate risk-adjusted capital according to Basel standards are so convoluted that they resemble the folk story of the emperor’s invisible clothes, where even the emperor himself did not fully comprehend what he was in for but pretended to do so. Banking experts hesitate to challenge these regulations due to fear of being criticized for lack of knowledge, incompetence, or banking expertise. Some mathematical concepts may sound transcendent, but in reality, no one truly understands them.

For instance, the market risk regulation for securities traded by banks is calculated based on a once-in-thousand-year risk scenario. However, despite these tough measures, a major banking crisis seems to occur every 15 years in the United States, as occurred in 2008 and now in 2023. Furthermore, the recent failure of SVB has been attributed to its excessive holdings of government bonds. This crisis teaches us that even government securities, which are deemed safe assets, will still carry risks. Looking back at Vietnam, I notice that the State Bank of Vietnam (SBV) is considering reducing the risk coefficient for social housing mortgage loans when calculating the Capital Adequacy Ratio (CAR) from the current range of 25 percent to 100 percent to around 12 percent or 50 percent. In this move, caution will be necessary when considering such a proposal.

- Sir, thank you very much for your insights.

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