Banks need a new model

07 November 2008

Finance houses are turning away from the investment banking model. The real test will be if the recession hits the real estate market.

As the world’s financial system tries to untangle itself from a web of debt, confusion and paralysis, many different factors have been blamed.

The US Federal Reserve, ratings agencies and mortgage brokers have all been accused of irresponsible behaviour that led to the crisis.

But the quickest to shoulder some blame and adapt have been investment banks. At the heart of the crisis was their habit of using cheap funding to buy complex financial products and try to make a return.

As funding became more expensive, and highly indebted investment banks faced defaults on some of their investments, losses were quickly racked up.

Many banks had no way of dealing with those losses except to ask for fresh injections from shareholders.

In the Gulf, most banks also have a retail deposit base, which gives them access to a more stable, and relatively cheap, funding source, but not all of them.

While conventional and Islamic investment banks in the region are less sophisticated than their US counterparts, and so less prone to substantial losses, they are not totally isolated from the strategic shift.

Many of the institutions formed out of the 1970s oil boom, in particular, fell into the same trap as international banks, investing in products that quickly turned from profitable highly-rated instruments to defaulting, low-rated ones.

Arab Banking Corporation has decided the best way to cope is to move away from investment banking. Others will have to follow or at least be able to reassure their shareholders they will not make the same mistakes again.

The real test will come if a deep global recession hits the region coupled with a potential fall in the real estate market, which most banks are highly exposed to.

This would lead to more heavy losses and could make regional governments and other shareholders start to question whether following a strategy now abandoned by the biggest banks in the world still makes any sense.

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