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Monday, 7 July 2008

'This financial crisis is far from over'

Business Times - 05 Jul 2008

THERE would be few people who have seen banking and financial turmoil as close up, and from as many angles, as Shaukat Aziz. In his 30-year-long career at Citibank alone, he had first hand experience of several banking crises. In particular, during the early 1990s, he was in the thick of the action when Citibank got into deep trouble after vast amounts of its loans to Latin America, as well as domestic real estate loans, went sour. At that time, he played a key role in convincing Saudi Prince Alwaleed bin Talal - his one-time client - to invest some US$600 million equity into Citi - an equity injection which many observers believe helped save the bank.

Then, as Pakistani finance minister from 1999 to 2007, Mr Aziz was the architect of the economy's dramatic turnaround from near-bankruptcy.

Given his experience, it seems irresistible to ask him for his take on the global financial crisis now unfolding and the lessons he would draw.

It is clearly something he has been watching closely; 'I was hoping you would ask that,' he says.

Mr Aziz points out that the crisis started with securitisation, mainly of US mortgages. 'People who packaged and originated these securities were not carrying the risk,' he notes. 'The whole focus was originating the mortgages, packaging them, having them rated and then selling them to investors.'

'Nothing wrong with that if you do it right. But as the appetite for more securitised paper grew, people who were originating the mortgages put more pressure on their sales forces to generate more paper.'

'So one lesson here - and we're still learning - is that anybody who originates and packages securitised products must hold a certain percentage of the risk. They should not be allowed to trade out 100 per cent. If they were to keep say, 20 per cent, they would monitor the value of the assets. And the rating agencies should not be the primary entities (involved in rating assets). They should be secondary.'

There was also a serious failure of risk management, according to Mr Aziz. 'This should have never been abdicated,' he says. 'Institutions holding the paper must at all times track what the risks are. That didn't happen. Perhaps there was an over-reliance on rating agencies. But when you have a dynamic portfolio where markets are changing, the environment is changing and risk parameters are changing, ratings can get outdated pretty fast. So the risk management department must always have its finger on the pulse and not abdicate its responsibilities to other institutions.'

Finally, there was greed, he says, coupled with faulty incentives: 'Financial institutions face pressures to grow, to show high earnings and pay high compensation to the individuals involved. But compensation should be tied to the maturity of the securities sold - maybe higher compensation initially, but there should always be a direct link to maturity.'

All that, in essence, created the huge capital shortages we now see in large American and European financial institutions.

Mr Aziz sees sovereign wealth funds (SWFs) - government entities with large pools of investment capital, such as the Government Investment Corporation of Singapore - as key players in repairing the capital positions of troubled institutions.

'SWFs are probably the best investors available,' he points out. 'They are not intrusive, they do not look for board seats, they are mature and long term investors. And history shows that if you bet on the right institutions you end up making a lot of money.'

From the regulatory standpoint at least, now is a good time for SWFs to invest, he adds. 'When you enter a market or an institution in a crisis mode, the regulatory environment is favourable and the signals tend to be green. But when you go in during normal times, you will see many amber signals and some red signals. If you enter when the country receiving the money feels they don't need it, there will be barriers. Those barriers drop during an environment of crisis.'

'But this crisis is far from over,' he says. While the financial sector's woes are well-known, the knock-on effects on the real economy are still to play out. 'I am not sure the ripple effects are fully understood. You will see a softness in real estate prices in the US and elsewhere. And as the real economy slows, unemployment will increase and income levels will go down - so there may be more pain to come. The full impact will unfold only in the future. And I think financial institutions may see more pressure on their asset quality, depending on how the real economy reacts.'

I ask him what challenges he sees for Citibank, which he knows so well and which is among the worst-hit financial institutions in this crisis.

'The challenge for Citi is to get all the different parts of the institution working complementary to each other,' he suggests. 'They have done it in the past, they can do it again. Naturally, individual businesses have to be looked at for returns and if they don't make sense, they have to be spun off. The core competencies of an institution like Citi, in my view, are an ability to work in diverse markets and have diverse business products, complementing each other and not conflicting with each other.'

Finally, he cautions that Asian economies cannot but be affected by the crisis and will not 'decouple' from those in the west, as some optimists suppose.

'I don't believe in decoupling,' he says. 'It's a flawed concept. I believe in globalisation. In this day and age, we must believe in the globality of markets and in linkages.'

'Of course the impact will vary and not everybody will be affected to the same degree. But no economy can isolate itself.'

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