Bank loans and securitization 129
employ too many workers, and shutting them down would lead to major social
troubles. The good news is that, as China watchers have been suggesting, there is a
broad awareness that the country’s banks need to:
Improve their governance
Learn to assess risk better, and
Take measures to contain their sprawling exposure to credit risk.
11
The bad news is that abiding by these three messages means adopting processes
that could lead to the feared credit crunch. This is precisely why a case study on
China’s banking mess is so interesting. The current banking problems started in the
post-Mao years, with China’s rulers giving too much weight to the advice of different
‘experts’ and not enough to the evidence that:
The economy was growing well beyond an affordable pace, and
Neither the politicians themselves nor the central bankers were really in charge.
It is not the intention of this text to give advice. Nevertheless, generally speaking, to
improve the function of its banking system, and its loans structure, a country needs
financial reform, risk-based pricing of loans and other financial products, as well as rig-
orous transformation in corporate governance. In the most absolute sense, it also has to:
Train its commercial bankers and central bankers in risk management, and
Equip them with the technology which permits them to effectively exercise this
function.
Altogether that will take years. In parallel to this, to avoid another wave of bad
loans, China’s banks have to introduce – and without loss of time – better organiza-
tion, training and empowering their loans officers to say no to potential bad debts, in
spite of the borrower’s political patronage. It will also be wise if the government
ensures that the country’s banks abide by international capital adequacy standards
promoted by Basel II (see section 6.6), because these represent a long experience
compressed into some crisp guidelines.
6.5 Bank regulation and risk control
One of the curiosities of a leveraged economy is that while the party lasts bankruptcies
of credit institutions hit a bottom; but then there is a spike as the bill becomes due. The
American banking system came under stress in the late 1980s because of the real estate
and junk bond bubbles. Not only did the savings and loans industry collapse, but also
commercial banks have been feeling the heat – the bankruptcy of the Bank of New
England is an example.
130 The Management of Bond Investments and Trading of Debt
0
300
400
200
500
100
0
$20
$25
$10
$15
$35
$40
$30
NUMBER
OF FAILURES
$ TRILLIONS IN
NATIONAL
PRINCIPAL IN
DERIVATIVES
1987 1989 1991 1993 1995 1997 1999
600
$45
$50
1985
1988 1990 1992 1994 1996 1998 20001986
$5
Figure 6.3 An interesting trend in bank failures and the growth of derivatives
in the US markets
On the other hand, as Figure 6.3 shows, the banks’ failure rate significantly dropped
in the 1990s. This may seem curious, but according to experts the reason lies in the
fact that the derivatives market built itself up. What were then the new financing
instruments created a striking pattern, with the flight into derivatives giving the wrong
message that the banking system had recovered. The trouble is that:
Derivatives are not a cure but a process for rolling over the unpayable claims of
the banking system, and
These claims accumulate into larger and larger unpayables which one day reach
explosion point and somebody has to foot the bill.
Statistical evidence beyond Figure 6.3 suggests that using derivatives in a big way
has turned the global financial system into a highly geared environment in which, up
to a point, bank failures indeed became hidden. The gearing, however, has continued
and as the ongoing exposure accumulates, it eventually shows up as a bubble. This,
in a nutshell, is the financial story of the late 1990s. The silver lining is that:
A market with no bank failures is often one in which financial services are expensive
and consumer choices are limited.
Or, alternatively, one in which risks are compounded to explosion point, which
comes after a critical threshold is exceeded.

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