It’s dawning on policymakers that letting bankers take the wheel means the economy gets driven into a cul-de-sac

August 22nd, 2011

There are eerie parallels between the continuing precipitous falls in the shares of  European and UK banks and the stomach-churning gyrations seen in September and October 2008. And it’s kind of ironic that one of the biggest fallers, Barclays, bought Lehman Brothers before superimposing its own investment banking logo on the failed bank’s iconic 745-751 Seventh Avenue building (pictured above). But it seems that if governments, regulators and bankers had done more to address the root causes of the first global financial crisis, then #gfc2 might well have been avoided.

The symptoms are certainly similar: in the last couple of weeks we’ve seen hair-raising plunges in the share prices of leading banks and insurers amid panic and mayhem in the markets; abortive attempts by eurozone governments to prop up the shares of financial institutions with short selling bans; a flight to the safety of gold, whose price today soared to $1900 an ounce, and top-rated government bonds; and a surge in the credit default swaps used to insure banks’ debt (the CDS on Barclays jumped to 390bp last Friday).

Banks (in)ability to fund themselves remains a core issue. This time around, the EU leaders’ cack-handed handling of the eurozone sovereign debt crisis, coupled with investors’ continuing uncertainty about the banks’ true level of exposure to PIIGs debt, has dented investors trust in banks, and made investors, who include banks, reluctant or unable to provide short-term funding. Last time it was fear of subprime contagion.

Lost cause?

Unfortunately, ill-considered and reckless lending to over-indebted, irresponsible and sometimes mendacious borrowers is a common strand. If you’re interested, Reuters IFR has provided a fascinating insight into the funding crunch banks are facing, while the BBC’s Robert Peston has explored how the interconnectedness of markets exacerbates the picture for banks.
It didn’t help much when it emerged on Wednesday that the engine of Europe’s economy, Germany, had spluttered and stalled (in the second quarter German growth came in at just 0.1%, way below expectations, while eurozone growth came in at just 0.2%). These anaemic figures gave rise to fears of a double dip recession on both sides of the Atlantic, which immediately effected the banks (after all, a double-dip would create a further sea of bad debts and stymie their recovery plans).

Markets were further spooked when it emerged that an unidentified European bank had taken $500m in emergency, one-week funding from the ECB. Then on August 18, The Wall Street Journal published a story saying US regulators have been scrutinizing the dollar funding positions of the US subsidiaries of European banks. The sense of déjà vu was overwhelming, and many were bracing thesmelves for another Lehman seizure.

However, I would contend that factors such as weaker-than-expected growth, a possible return to recession, and a little local funding difficulty ought to be water off a duck’s back for any solid and well-managed financial institution. Had the banks driven real change through their organizations and genuinely sought to reinvent their business models to ensure they had a sustainable future in the wake of October 2008’s near meltdown — and I’m afraid that continental banks have been dragging their heels even more than their US and UK counterparts in this regard — they would have been much less likely to be blown over.

Hope for the future?

I accept that some banks have made important changes. Some have abandoned the hubristic dreams of empire (HSBC, RBS and Lloyds are all exiting scores of overseas markets and selling off non-core businesses) that obsessed their management pre-crisis. Some have scaled back their dangerously bloated pre-crisis balance sheets, some have partially weaned themselves off state-subsidized funding, and some have bolstered their capital positions. For all I know some may even have devised less clunky ways of gauging their own enterprise-wide liquidity and risk positions.

But this has, for the most part, been tinkering around the edges. Many banks remain firmly ‘in denial’. Barclays’ Bob Diamond and Deutsche Bank’s Josef Ackerman spring to mind as leaders who have done more than most to resist attempts at reform. Both of these senior bankers have, I believe, sought to undermine attempts to rein in bonuses; scare-mongered about the economic impact of capital and liquidity reforms; obfuscated in front of political juries and commissions; and arm-twisted EU politicians into ensuring their institutions don’t get short-changed in the event that peripheral members of the eurozone default (whilst apparently having few qualms about condemning the citizens of these countries to decades of austerity).

Diamond has made clear he thinks the time for remorse and apologies is over, and that it would be great for everyone if the politicians would just get off their backs and let the banks get back to “business as usual”.

Well, I’m afraid it’s becoming increasingly apparent that Diamond is wrong. With this second crisis, it’s clear that the need for a fresh approach, and one that is not dictated by bankers, is more urgent than ever.

One of the best summaries of how to resolve the problem of the banks comes from from Andrew Smithers, founder of Smithers & Co. He went through this with me when  I interviewed him for QFINANCE last year. Smithers said:-

The solution is easy: First, you have to make the banks competitive. And second, you have to remove the subsidy. The problem is not introducing such simple changes; it is making the politicians understand that they need to make them. One of the big problems is that politicians tend to get their advice from bankers—who are the worst people to listen to. Clearly the bankers are not well placed to give advice—they don’t even understand this situation themselves. If they did, and they were credible advisers to government, we wouldn’t be in the mess we’re in today.

They also have a conflict of interest. The banks also give a lot of money to politicians, so naturally they have privileged access and are more likely to be listened to by policymakers than others who might have a better understanding of the situation, who are perhaps better placed to come up with intelligent solutions.

I don’t believe in microregulation, but I do believe you can get around this problem by breaking up banks. One way of achieving that—which would also work in the field of market-making (formerly known as “jobbing”)—is to insist on escalating capital requirements accordingly to size; that is an effective way of offsetting the size advantage and the tendency toward oligopoly.

On a related note I also recently chanced upon this Nov 2008 piece by hedge fund manager Hugh Hendry, who said the problem is that, ever since the 1998 bailout of Long Term Capital Management, the people running massively-geared, reckless and immoral financial institutions have been able to count on being bailed out if their institutions fail. It is perhaps no surprise that Hendry favours a great deal more Darwinian, Schumpeter-style creative destruction and less Keynesian molly-coddling of failed institutions. It’s also worth pointing out, that as I said in my ‘Game Over’ post, we simply cannot afford to bail out the banks a second time around.

If Europe’s politicians have learnt nothing else from the past few years, it is that allowing themselves to be steered by discredited bankers means they will probably drive their economies into a cul-de-sac.

The original version of this article was published under the headline ‘Cry for banking reform as policymakers drive economies into a cul-de-sac’ in QFINANCE on August 22nd, 2011


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1 Comment for “It’s dawning on policymakers that letting bankers take the wheel means the economy gets driven into a cul-de-sac”

  1. Since I wrote this blog post, Barry Ritholtz of the Big Picture has written a much better piece on why we are in the current mess. Basically, Barry says government was far too soft on banks at the time it rescued them in the the Oct 2008 crisis. Barry suggests the only solution is to take the sort of tough remedial action that was so desperately needed then (including forced liquidation of crap assets, bringing an end to the “extend and pretend”, “delay and pray” culture of obfuscation that has pervaded the banking sector over past three years) now. Barry writes: “If the banks come crawling back to Uncle Sam for another bailout, it will be proof that “rescuing” failing financial institutions that blow themselves up is the exact wrong strategy.” http://www.ritholtz.com/blog/2011/08/big-banks-under-capitalized-overexposed-opaque/

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