Saturday, December 20, 2008

What a regulated banking sector looks like

India too, had a real estate bubble; yet Indian banks were not hurt as it burst. Joe Nocera, of the NYTimes, writes how: (note, this blog post is not an endorsement of Indian banking, it is merely to show that different worlds can exist)

All lending to individuals is based on their income....We never gave more money to a borrower because the value of the house had gone up.

{About India's bank-regulator-in-chief}: "He basically believed that if bankers were given the opportunity to sin, they would sin." ....About two years ago, he started sensing that real estate, in particular, had entered bubble territory. One of the first moves he made was to ban the use of bank loans for the purchase of raw land, which was skyrocketing. Only when the developer was about to commence building could the bank get involved — and then only to make construction loans.....

When Mr. Reddy saw American banks setting up off-balance-sheet vehicles to hide debt, he essentially banned them in India. As a result, banks in India wound up holding onto the loans they made to customers. On the one hand, this meant they made fewer loans than their American counterparts because they couldn’t sell off the loans to Wall Street in securitizations. On the other hand, it meant they still had the incentive — as American banks did not — to see those loans paid back.

...He increased risk weightings on commercial buildings and shopping mall construction, doubling the amount of capital banks were required to hold in reserve in case things went awry. He made banks put aside extra capital for every loan they made....

{Once irate at the regulations, Indian bankers now say:}

...Ms. Kochhar said that the underlying risks of having “a majority of loans not owned by the people who originated them” was not apparent during the bubble. Now that those risks have been made painfully clear, every banker in India realizes that Mr. Reddy did the right thing by limiting securitizations. “At times like this, you tend to appreciate what he did more than we did at the time,” said Mr. Kapoor. “He saved us,” added Mr. Parekh.

My commentary: if banks make thirty-year loans, then their business planning and practices have to reflect a long-term vision as well. The current methods of securitizing loans that Wall Street invented seem to introduce very perverse incentives. A NYT article a couple of days ago wrote about how at Merrill Lynch, in 2006, very large bonuses were paid out based on that year's profits; yet the transactions made that year have caused losses in 2008 exceeding two decades of that institution's earnings, and ended its independent existence.

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