Banks Will Have to Accept Lower Profits, Finance Watchdog Warns

Banks will be forced to accept lower levels of profit as controls on their debt-fueled expansion are tightened up to prevent a re-run of the current crisis, the international body responsible for global financial stability has warned.

Mario Draghi, the chairman of the Financial Stability Forum (FSF), said that in the new post-credit crunch world, banks would have to carry less debt and have higher capital reserves in order to prevent the "perverse incentives" that were at the root of the bank collapses across the globe.

"It's what everybody now understands," Draghi said in Washington. "It seems easy, it seems simple, but somehow it's a very difficult concept to put in people's heads, for one reason: profits are going to be lower in the financial services industry in the future."

The FSF, which includes central bankers and financial regulators, said that since the fire sale of Bear Stearns in March, "strains in the financial system have deepened to unprecedented levels, necessitating extraordinary emergency measures".

In a report presented to G7 finance ministers at the International Monetary Fund in Washington this weekend, the FSF said work was already underway on a comprehensive reform package designed to tighten accounting standards; force banks to reveal their exposure to complex derivatives trades; and prevent excessive lending in boom times.

Draghi said there was a close link between the lack of transparency and the recent run on bank shares. "When the market doesn't know what's in the balance sheets, it is bound to ask for more capital."

He said that the previous rules of the financial market had encouraged an explosion of off balance sheet vehicles, because banks were not required to hold capital against them. When the crisis began, however, financial institutions had been forced to take responsibility for these arms-length assets.

Draghi urged governments to work closely together in tackling the crisis, warning that if one country offers weaker financial support for its banks and their savers than another, there was a risk that speculators would move in to attack institutions.

Draghi said that it would be impossible to repair the damage to the financial system overnight. "Credit markets have dried up everywhere. Liquidity has been drying up for many months. We don't have a silver bullet to change this in a minute."

The FSF said it would closely monitor the global response to the crisis, and would seek to ensure that emergency plans produced by individual countries were consistent with each other. It added that it wanted to mitigate the "pro-cyclicality" in the financial system, a trend that encourages banks to lend excessively in good times, but to rein in credit when it is most needed.

It will insist that banks hold more capital, take a more cautious view of possible losses, and reform pay structures that reward risky decisions.

Draghi said that while much of the FSF's work was for the medium and longer term, there were two reforms that would help alleviate the current crisis.

He called for a central body to be set up, to act as a hub for the market for so-called "over-the-counter credit derivatives", the complex bets between investors. Draghi said that the current system left individual institutions dangerously exposed to losses, and a centralized system would reduce the systemic risk.

The second reform was for better accounting standards, so that off balance sheet activities were disclosed and open to valuation.

Credit agencies also came under criticism from the FSF, which called on them to come up with better rules for assessing the risk from products such as mortgage-backed securities, losses on which have been at the heart of the credit crunch.