SERIOUS MONEY:Banks must contend with rising credit costs, low coverage ratios and impending funding issues, writes CHARLIE FELL

THE BUSINESS of banking has a long and rich history. The first banking operations predate the invention of coinage and emerged in the Fertile Crescent between the twin rivers of the Tigris and the Euphrates more than 5,000 years ago, as agriculture, industry and commerce began to organise.

Banking activities had become sufficiently important by the second millennium BC that written standards of practice were deemed necessary and were incorporated into the Babylonian Code of Hammurabi, the earliest known formal laws.

The innovation spread to ancient Greece and beyond but largely disappeared throughout the western world following the fall of Rome in AD 476.

Banking activity reappeared in the 11th and 12th centuries in response to the growing needs of the Crusades and increasing trade with the Levant. Religious orders such as the Knights Templar and the major banking families of Venice and Genoa came to dominate international finance; the term banchieri was coined to denote bankers as they sat behind a bench, or banco, where they changed money, received deposits, made loans to individuals and states, issued letters of credit and honoured promissory notes.

Banking crises were common as excessive credit booms gave way to inevitable busts, though perhaps the most prominent in the Middle Ages was the general crisis of confidence from 1341 to 1346 that resulted in the failure of several notable Italian banking families, including the Bardis and the Peruzzis.

History was not always kind to failed bankers. In Catalonia on February 13th, 1300, for example, it was established that a banker who went bankrupt would be vilified by a town crier and forced to live on a strict diet of bread and water until depositors were repaid in full. Worse was to follow and modified regulations in 1321 established that bankrupt bankers who did not repay their depositors in full within one year would be beheaded directly in front of their bench.

Times have changed, which is just as well, given that the excessive risk-taking and leverage in the banking system during the ill- fated credit-fuelled expansion of recent years has resulted in 124 banks closing their doors in the US this year, with a further 552 institutions at risk of failure in the near future.

Despite record monetary and fiscal stimuli equivalent to roughly 25 per cent of gross domestic product (GDP), delinquency rates across all major loan categories continue to rise and, at more than 7 per cent, are more than five percentage points above the cycle low recorded in the first quarter of 2006 and are already ahead of the peak registered during the severe industry downturn of the early 1990s.

More than one in four institutions were unprofitable in the third quarter and, although the capital market activities of the major financial conglomerates boosted the industry’s aggregate net income, rising credit costs continued to weigh heavily on earnings.

More than one half of all institutions reported earnings deterioration year-on-year and, collectively, small to medium-sized banks continue to be unprofitable.

Not surprisingly, regional banks have lagged the recovery in the major stock-market indices since March and investors are still nursing heavy losses since the start of the year.

The industry’s problems have been well documented, although the notion that the banking sector’s woes are attributable to misguided bets on complex structured finance products is misleading, if simply not true.

The reality is that the hunt for yield in a low-return world contributed to an insatiable thirst for growth that led to a sorry deterioration in lending standards and basic portfolio diversification principles.

Furthermore, excessive asset growth led to reduced dependence on stable deposit funding and an increasing reliance on unpredictable money and capital market sources.

Securitisation accelerated the process but a general belief in continued economic stability as far as the eye could see had already contributed to a lending cycle that was built on shaky foundations.

The banking sector’s thirst for growth resulted in the industry’s net loan book growing at a rate of more than 9 per cent a year from 2001 to 2007, or four percentage points in excess of the rate of nominal GDP growth over the same period.

Aggressive lending policies led to an increasing dependence on real estate for growth and such asset-based lending was considered to be of low to moderate risk because asset prices were rising.

Real-estate lending grew at double-digit rates from 2001 to 2007, or more than twice the rate of economic growth, and exposure increased by roughly 10 percentage points as a share of total loans over the six-year period to more than 55 per cent.

The damage caused by non-performing residential mortgages is well known, but the same lending practices were also apparent in commercial mortgages, and losses are mounting on these assets, which account for one-quarter of total loans.

Aggressive funding policies saw deposits fund less than 60 per cent of total assets at the industry’s peak and, though the ratio has since improved to 65 per cent, it is still well below the funding ratio typical of the 1980s.

Furthermore, the increased reliance on wholesale funding was accompanied by a dramatic shortening of maturities from almost eight years in 2002 to just three years today, of which roughly $1.5 trillion (€1 trillion) will fall due by the end of 2012. Upcoming funding pressures simply add to the industry’s woes.

Banks are taking corrective action and the deleveraging process is under way. Total loan balances have dropped by more than 7 per cent since the start of 2008, funding and capital ratios have improved and cash reserves currently amount to 10 per cent of total assets.

It is clear that banks are taking the necessary action to repair ailing balance sheets, but rising credit costs, low coverage ratios and impending funding issues mean the supply of bank credit will remain impaired for some time.

The V-shaped recovery embedded in stock-market indices at current prices looks optimistic.