"Why banking is an accident waiting to happen"

Martin Wolf, the well respected lead economics editor of the Financial Times, turns to a favorite topic: why banks regularly get themselves in trouble. His answer: it’s “a risk-loving industry guaranteed as a public utility.” Privatizing gains and socializing losses, particularly if the employees share in that arrangement, is a formula for reckless behavior.

Wolf takes note of the persistent high profitability of the banking industry, in return on equity terms, and attributes it to formal and informal public guarantees (they allow banks to borrow more cheaply than otherwise) and undercapitalization relative to the risks assumed. But there is another way to look at bankings’ relative profitability. Remember, ultimately, the banking industry provides services to the productive economy and individuals and extracts fees for those services. Its high profits represent a wealth transfer from the productive sector to what ought to be a support function.

Wolf briefly reviews some possible remedies, such as Andrew Smithers’ call for much higher capital requirements, or Henry Kaufman’s prescription of more extensive regulation of firms too big to fail. The likely outcome would be that those companies would reconfigure themselves to operate in a smaller, less regulated format (which would be fine if the line between “too big to fail” and everyone else has been drawn correctly). Another proposal, from McKinsey’s Lowell Bryan more than a decade ago, was to have banks segregate their guaranteed depositary activities, which could invest only in the safest of assets, from their risk-taking operations.

Banks are wards of the state. The sooner the powers that be recognize that and treat them accordingly, the better off the rest of us will be.

From the Financial Times:

Why does banking generate such turmoil, with the crisis over securitised lending the latest example? Why is the industry so profitable? Why are the people it employs so well paid? The answer to these three questions is the same: banking takes high risks. But the public sector subsidises this risk-taking. It does so because banks provide a utility. What the banks give in return, however, is gung-ho speculation.

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Perhaps the most striking characteristic of the banking sector is its profitability. Between 1997 and 2006, for example, the median nominal return on equity of UK banks was 20 per cent. While high by international standards, this seems not to be exceptional. In 2006, returns on equity were about 20 per cent in Ireland, Spain and the Nordic countries. In the US they were a little over 12 per cent. Returns in Germany, France and Italy seem to have been close to US levels.

As Andrew Smithers of London-based Smithers & Co and Geoffrey Wood of the Cass Business School at the City University London note in a splendid report, from which I have taken these data, long-run real returns on equity in the US have been a little below 7 per cent.* Another study estimated the global real return on equity in the 20th century at close to 6 per cent.**

A starting assumption for a competitive economy is that returns on equity should be much the same across industries. If a particular industry earns two or three times long-run average returns for a while, one should expect an offsetting period when returns will be below that average. If the high returns are very high, as they are, the low returns are likely to be negative.

Yet banks are also thinly capitalised: the core “tier 1” capital of big UK banks is a mere 4 per cent of liabilities. If returns on equity become negative in a thinly capitalised business, many banks will become insolvent. The point can be put more tellingly: these high returns on equity suggest that banks are taking substantial risks on a slender equity base. But the slenderness of that base also means that insolvency threatens when bad times arrive.

How do banks get away with holding so little capital that they make the most debt-laden of private equity deals in other industries look well-capitalised? It can hardly be because they are intrinsically safe. The volatility of earnings, the history of failure and the strong government regulation all suggest that this is not the case. The chief answer to the question is that banks benefit from sundry explicit and implicit guarantees: lender-of-last-resort facilities from central banks; formal deposit insurance; informal deposit insurance (of the kind just extracted from the UK Treasury by the crisis at Northern Rock); and, frequently, informal insurance of all debt liabilities and even of shareholders’ funds in institutions deemed too big or too politically sensitive to fail.

Such assistance reduces the cost of the debt associated with any level of equity, since lenders know they are protected by claims on the state, as well as by the equity cushion. This, then, allows banks to take more risk. If things go well, shareholders earn exceptional returns. If they go badly, the downside cannot exceed their equity. Beyond that point, creditors and government share the losses.

Governments are not totally stupid. They guarantee banks because the latter provide a social utility: a safe haven for money, and a payment system. But governments also realise that they are providing incentives for banks to economise on capital and take on risk. So governments impose capital-adequacy ratios, rules on risk management and (if they are sensible) liquidity requirements, as well. Unfortunately, these institutions are not only complex, but are staffed by single-minded and talented people. They go round regulations, just as water flows round an obstruction.

The result of this ingenuity includes “special purpose vehicles”, hedge funds and even, in some respects, private equity funds. These are all, in varying ways, off-balance-sheet banks: ways to exploit the exceptionally profitable opportunities (and corresponding risks) created by high leverage and maturity transformation. Securitisation, to take a salient example, is a clever way to shift what would once have been bank loans on to the books of these quasi-banks, with the consequences we all now see.

Quite as important as the tussle between regulators and shareholders is that between shareholders and their employees. In an industry with long periods of high profitability, followed by massive write-offs, the ideal employment contract for the employee has high bonuses for short-term performance.

Assume, then, a run of profitable years in which shareholders receive high returns and employees are handsomely rewarded. Then comes the year of the locusts. Many employees may then lose their jobs. But since they do not receive negative pay, they are able to keep their earlier gains.

So what we have is a risk-loving industry guaranteed as a public utility. One result has been insufficient capital. That permits splendid returns in good times. But the capital may well prove inadequate in bad ones. The loss of capital could well lead to a tightening of credit in the years ahead.

If so, the structure and regulation of banking might have to be reconsidered, again. One possibility would be higher capital requirements. This would lower peak returns and so reduce the chances of subsequent negative returns. Mr Smithers and Prof Wood suggest a 40 per cent increase in capital for the UK. Other possibilities are measures to make regulation easier: narrow banking is an old favourite, although hard to make work. Henry Kaufman, a highly experienced observer of credit markets, suggests intense scrutiny of banks deemed “too big to fail”.

What seems increasingly clear is that the combination of generous government guarantees with rampant profit-making in inadequately capitalised institutions is an accident waiting to happen – again and again and again. Either the banking industry should be treated as a utility, with regulated returns, or it should be viewed as a profit-seeking industry that operates in accordance with the laws of the market, including, if necessary, mass bankruptcies. Since we cannot accept the latter, I suspect we will be forced to move towards the former. Little can be done now. But when the recovery begins, we must impose higher capital requirements.

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  1. a

    Hear, hear.

    Higher capital requirements especially for instruments for which the bank itself measures the risk, since these measures are only verified by backtesting against a historical sampling of prices, which tends not to catch the true risk.

  2. Molly

    Yves – thank you for a most informative post; definitely gives helpful perspective to the cyclical, ‘lack of institutional memory’ nature of the banking industry.

  3. Anonymous

    The author fails to acknowledge that securitization and SPVs are already captured under existing capital requirement rules (i.e. rules for ‘liberating bank capital’ via those means). Perhaps the rules should be changed, but not because banks are circumventing the rules that already exist.

    The rest is speculation. It isn’t clear yet how well the industry’s capital will stand up to this round of losses until the ultimate losses are known, which will be some time yet.

  4. Mencius Moldbug

    If banks are to be “wards of the State,” why not just nationalize them all? Why maintain the pretence that this is a private industry? Whose interests, exactly, does this serve?

    In future, when you need a loan, you’ll just apply to the government. The State will bundle your loan with other similar securities, guarantee it, and sell it. When lending policies are standardized by regulators, all loans are securitized, and the market for loans is protected by the Greenspan put, we have basically reached this point already.

    You have already done the math. In an open-loop financial system with systematic mismatched maturities, banks are and always will be wards of the state.

    In fact, it seems a sensible step to exchange their present names, such as “Citigroup,” “Bank of America,” and so on, for a numbering system ordered by present market cap. So we could call them People’s Bank #1, People’s Bank #2, etc, etc.

    In case this strikes you as a little creepy, however, Austrian economics is only a click away.

  5. Anonymous

    One would have to say eyeballing the charts there is a big drop in relative earnings still to come if 1990s are the benchmark, and note that if they 90s are the benchmark there is one hell of a lot of scaremongering, weeping, wailing and gnashing of this year-end bonus cheques from guess who at this point in the relative earnings cycle. Moreover one doubts that the powers that be wish to wave their magic wand ineffectually for fear of losing their audience’s attention, hence the abracadabras and and accompanying ramping.

    Will cosmetic surgeons.. ski resorts and purveyors of fine stuff keep the Xmas spirit alive?


  6. minka

    Heavens! Heavens!

    Are we questioning the deregulation orthodoxy?

    My dears, we must remember: regulation everywhere and at all times is always The Problem. The Federal government should be reduced in size until it can be drowned in a bathtub. Grover Norquist said that and he must be right because he’s a leading Republican, and we all know they are the Grownups in the political sphere.

    Myself, I think there is only one function of government: to investigate the marital lives of all public ‘servants’ and if they are not properly monogamous according to Christian principles, Impeach em!

  7. Mencius Moldbug

    Minka, dear – you’d think that if the “deregulation orthodoxy” was so orthodox, they’d have done something about that darned New Deal by now.

    It’s so cute when the defenders of power, privilege and the status quo try to make themselves over as dissidents. In general, I think, they actually believe it. But why wouldn’t they?

    But excuse me. I need to go to my economic-royalist meetup. Plus my crown needs letting out again, and I’ve got some peasants to thrash. I’m telling you, it’s not easy being “orthodox.”

  8. James

    Let assume this crisis passes. Can you even imagine the amount of moral hazard that will have built up in this system?

  9. Juan

    The bourgeois state is a mediation between capital and labor, between capital and “the people”. Its provision of subsidies to the former is structural as it must perpetuate those social relations that it’s embedded within and which dominate it, and it must do this even when, in so doing, it undermines society-in-general.
    Crisis is never simply economic or political or social but all and more. The decades of Long Slowing and associated crisis management stand as testimony to capital grown senile, progressively less able to stand without the crutches of subsidy.
    Laying blame at the foot of government(s) alone is backwards, merely provides an excuse for all types of reactionary, ‘if only’ beliefs.

  10. Anonymous

    Great thoughts from

    How the US money market really works
    By Henry C K Liu


    And the rate at which the central bank lends money can indeed be chosen at will by the central bank; this is the rate that makes the financial headlines. In the US, the central-bank lending rate is known as the Fed funds rate. The Fed sets a target for the Fed funds rate, which its Open Market Committee tries to match by lending or borrowing in the money market. Thus fundamentally, the money market is not a free market, but one dictated by the central bank with a particular preference for the resultant state of the economy. The so-called free-market capitalism operates through this command money market. Thus at the heart of the free-market ideology is a fiat money system set by command of the central bank. The Fed is the head of the central-bank snake because the US dollar is the key reserve currency for international trade. The global money market is a US dollar market. All other currencies markets revolve around the US dollar market.

    When a government’s Treasury issues sovereign debt, the money proceeds go to finance the portion of the fiscal budget not covered by taxes. When government runs a fiscal deficit, it takes money from the private sector by issuing sovereign debt and spends the money back in the private sector. Thus the important issue is not if the government runs a fiscal deficit, but how the fiscal deficit is spent. A fiscal deficit does not reduce the total money supply; it only increases the amount of debt. But monetary economists such as Hyman Minsky assert that whenever credit is issued, money is created. Thus the issuing of government bonds is the government’s way of issuing money without the involvement of the central bank. This is why Federal Reserve Board chairman Alan Greenspan is always warning about the fiscal deficit.

    Yet the notion that government borrowing crowds out private borrowing is controversial. Fiscal deficits do not even directly affect short-term interest rates, which are set by the central bank. If the government wishes, it can take money directly from the central bank, which is legislatively authorized to issue money by fiat as the sole legal tender in the nation. A country’s fiat money enjoys currency because the government accepts it for payment of taxes.

    Fiat money is in fact a form of tax credit, or sovereign credit. Sovereign debt instruments do have a market function: they provide the assets that a central bank can buy or sell in the repo market to meet its Fed funds rate targets.

    Bonus material>>>>>>>

    Hence investors in credit-linked obligations (CLOs) are exposed not only to inherent credit risk of the reference portfolio but also to operational risk of the issuer. Systemic stability cannot be enhanced when the system is decapitated, as exemplified by the 1998 collapse of Long Term Capital Management (LTCM), which required Fed intervention to prevent systemic instability. With world financial markets already suffering from heightened risk aversion and illiquidity from the 1997 Asian financial crisis, officials of the Federal Reserve Bank of New York judged that the precipitous unwinding of LTCM’s portfolio that would follow the firm’s default would significantly add to market problems, would distort market prices, and could impose large losses, not just on LTCM’s creditors and counterparties, but also on other market participants not directly involved with LTCM. In an effort to avoid these difficulties, the Federal Reserve Bank of New York (FRBNY) intervened with the major creditors and counterparties of LTCM to seek an alternative to forcing LTCM into bankruptcy. The hedge-fund industry has since grown with an increased number of funds, which will make the dispersed risk crisis more complex for future Fed intervention by virtue of the large number of interested parties that need to be satisfied.

    Greenspan acknowledged that derivatives, by construction, are highly leveraged, a condition that is both a large benefit and an oversized Achilles’ heel. It appeared that the benefit had been reaped in the past decade, leading to a wishful declaration of the end of the business cycle. Now we are faced with the oversized Achilles’ heel, with “the possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked”. According to Greenspan, “only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence central banks have, of necessity, been drawn into becoming lenders of last resort.”

    Greenspan asserted that such “catastrophic financial insurance coverage” by the central bank should be reserved for only the rarest of occasions to avoid moral hazard. He observed correctly that in competitive financial markets, the greater the leverage, the higher must be the rate of return on the invested capital before adjustment for higher risk. Yet there is no evidence that higher risk in financial manipulation leads to higher return for investment in the real economy, as recent defaults by Enron, Global Crossing, WorldCom, Tyco and Conseco have shown. Higher risks in finance engineering merely provide higher returns from speculation temporarily, until the day of reckoning, at which point the high returns can suddenly turn in equally high losses.

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