Friday, 19 September 2008

Thank God for Our Boring Banks

19th September 2008
The Malta Independent - Friday Wisdom

When developments on Wall Street become headline news on Main Street then something spectacular must be going on in the financial markets. And indeed it was dismally spectacular this week seeing a 158-year-old US investment bank file for bankruptcy. Lehman Brothers was the fourth largest US investment bank and with the developments of this week it means that three of the largest five US investment banks have disappeared in six months.

Bear Stearns and Merrill Lynch had to be sold for a song to much larger universal banks whereas Lehman filed for bankruptcy. The remaining two investment banks, the largest of the five, Morgan Stanley and Goldman Sachs, are in much better financial shape but still their business model is broken and their future as a standalone investment bank is gravely in doubt.

What has caused this dramatic transformation of investment banks from riches to rags? This time last year these banks were overflowing with hubris, paying their executives multimillion dollar bonuses and presenting themselves to investors as infallible money printing machines.

I should firstly explain what investment banks are and how they differ from the traditional banks which we are used to over here. Investment banks are not deposit taking retail banks. They do not run any sizeable branch network offering retail products to small clients and collecting funds through cheap deposits in order to fund their investment and lending activities. That is the function of traditional commercial banks like our own HSBC, BoV, APS and Lombard.

Investment banks fund themselves by large wholesale deposits from large corporate and high net worth clients and particularly by borrowing from other banks on the inter-bank market. Investment banks use this funding in order to finance their own trading activities, in the process leveraging up their balance sheets by borrowing on the strength of their brand and credit rating much more than is normally prudent.

Furthermore as investment banks have their roots in merchant banking they also have substantial expertise in money broking and merger and acquisition advisory services which requires top of the range human expertise and network connection, but very little capital as it is basically a commission business without having to carry any assets on balance sheet.

So what has gone wrong? As always the problems were sowed gradually over the years but they erupted with unexpected violence over the last 12 months. I categorise the problems into four inter-connected sections: Lax regulation, over lax monetary policy, management hubris and financial over-leverage

Following the great depression of the 1920s, central banks were created to regulate financial markets and to act as lender of last resort to keep order when occasionally the market suffers from lack of confidence by depositors or investors. It started from very rigid regulation which was gradually eased particularly in the late 1980s and 1990s believing that the free market and aggressive competition would force the market to regulate itself.

We were wrong. Bankers are subject to the same greed and short-termism as anybody else and clearly rather than regulate themselves they over-indulged in quick-buck type of trading activities without giving much attention whether the complex financial instruments they created could stand up to the test of time in the long term.

This lax regulation was compounded by the over-lax monetary policy in the period 2001-2005 following the burst of the tech bubble and the 9/11 events which threatened the throw the whole economy into recession. To mitigate a deep recession, central banks cut interest rates to historically low levels and kept them low for an overly long time. Cheap money is an invitation to borrow extravagantly and investment banks did just that and over leveraged their balance sheet to blow up their trading activities and make easy money by generating and selling complex products mostly linked to US real estate. US property was itself inflating a price bubble as a result of easy low cost mortgage availability.

All this could only happen if bank management betrayed their traditional values and replaced it with hubris of a kind yet unseen. Traditional normally paid bank executives were looked down upon and disdained by the new million dollar Ph. D. yuppies who thought they can make sure profit by accurately projecting asset prices through complicated mathematical models.

Internally banks had to manage culture clashes between the dull old-fashioned bankers and the new bubbly million dollar mathematical gurus. Management hubris leaned in favour of the new kids on the block not least because if the latter get millions of dollars in bonuses their bosses would get even more, sometimes much more. Traditional banking moral values were forgotten too easily and too quickly.

As a result senior management allowed their balance sheets to be hijacked by the new yuppie vultures who leveraged it beyond all limits of prudence, with the tacit complicity of regulators who were sleeping at the wheel and rating agencies who were too ready to accommodate for a fee, basing themselves on fake re-assurances that complicated risk control models and systems compensated for the excess risks of over-leverage. Nobody seemed to care too much that risk control systems which work well when liquidity and confidence are in abundant supply, tend to go haywire when liquidity and confidence join hands and hibernate concurrently as they normally do.

What is happening now is that the markets are presenting their bills for past excesses. The markets will only clear when they hit bottom and hopefully these events get us nearer to the bottom. Hopefully we will learn enough from this to ensure that firstly we invigorate regulation acknowledging that financial institutions are too important to be allowed to make fools of themselves. Complex derivative products are to be abolished and what is allowed has to be simple enough to be easily understood by whoever is invited to buy them.

Secondly monetary policy has to be re-tuned to become responsible not only for retail price inflation but also for asset price inflation in order to avoid skipping from one financial bubble to another.

Thirdly bank management have to regain the humility to become dull again and to be paid normal executive salaries.

And lastly regulators have to ensure that banks and financial institutions are not allowed to over-leverage and that capital adequacy have to be generous and not minimalist in approach.

Thankfully although our own banks and insurance companies are being hit by market instability and by the dubious accounting rule of forcing them to mark to market even investments they are capable of holding till maturity, our institutions are still the dull traditional value-rich institutions capable of weathering this storm, with distress measured by how much less profits they make rather than how much losses they will tot up.

Thank God for our boring banks. Thank God for their strong capital. Thank God for our thrift culture which permits our main bank to issue 10-year subordinated bonds at a rate they would have to pay for 12 month money on the inter-bank market. Thank God for our over-liquid markets permitting our banks to carry long term mortgages on their books funded by plentiful deposits.


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