Banks at Risk: Global Best Practices in an Age of Turbulence

INTRODUCTION

ASHES OF THE HEROES

Financial crises are not easy to come by—and a good thing this is. The great financial crisis that began in 2007 and never truly ended has cost the world trillions of dollars in productivity lost as a result of the massive downturn precipitated by the credit crisis, during which walking wounded and zombie banks were mistrusted by their healthy (or otherwise) counterparts. The resulting confidence crisis made financing hard to come by for any but the safest, most well-run, and highest-rated institutions.

According to the International Monetary Fund (IMF), by 2009 the crisis had already cost the world US$11.9 trillion (U.S. dollars used from here on)—the equivalent of 20 percent of the world’s annual economic output. This sum comprised capital injections pumped into banks to prevent them from collapsing, the soaking up of toxic assets, debt guarantees, and central bank liquidity support.¹ While much of these funds is actually liquidity that was provided for but may never be called upon (that is, the funds have been set aside not lost forever), until the funds are reallocated they represent finance that is not being used to build schools, repair roads, fund social projects, or hire government workers.

More than $10 trillion of the money in the IMF’s calculations comes from developed markets, with the United States the largest single contributor to the pool. (The U.S. gross domestic product [GDP] is currently more than $14 trillion.) Mervyn King, governor of the Bank of England, notes that output from the countries most affected by the crisis is 5 percent to 10 percent below what it would have been had there not been a crisis, and that the direct and indirect costs to the taxpayer have resulted in fiscal deficits in several countries of over 10 percent of GDP—the largest peacetime deficits ever.² Indeed, when comparing the cost of the financial crisis bailout to the Marshall Plan, a plan for rebuilding a shattered Europe after World War II, it is clear how bloated the scale of repairing significant disasters has become and how ineffective as well: the cost of the Marshall Plan from 1948 to 1952, which succeeded in bringing the GDP of the 17 recipient countries back to pre-war levels, was a mere $13 billion, or 5 percent of the U.S. GDP at the time.

The IMF also reports in its summary of an April 2010 meeting of G-20 leaders that the impact of the global financial crisis is cutting deep into national budgets. Net of amounts recovered so far, the fiscal cost of direct support has averaged 2.7 percent of GDP for advanced G-20 countries. In those countries most affected by the crisis, however, unrecovered costs are on the order of 4–5 percent of GDP. Amounts pledged, including guarantees and other contingent liabilities, averaged 25 percent of GDP during the crisis.³ Furthermore, reflecting to a large extent the effect of the crisis, government debt in advanced G-20 countries is projected to rise by almost 40 percentage points of GDP during 2008–2015.⁴

The road to debt has turned into a highway for most affected nations. The debt to GDP ratio of Ireland, for example, has reached 32.5 percent, largely as a result of the bailout of its two largest banks. The government of Ireland has announced a four-year budget cut of $20 billion to bring the ratio down to the single digits. Other countries have a tougher fight ahead of them to rein in their debt. The United States, for example, has a federal debt of $14.6 trillion, more than 94 percent of the country’s GDP.⁵ The U.S.’s debt has not been in single digits since 1917, and was higher than it is now only in the World War II era (in 1946 it was 121 percent of GDP).

While financial crises cause untold human misery by setting back the development of individuals and businesses (or, at the very least, by bringing them back to a level that they may have been at had they not overextended themselves before the crisis), they do offer an opportunity to study the problems in the financial system and to thereby improve it. A great deal of discussion has gone into reforming post-crisis regulatory structures, capital regulations, liability structures, cross-border trade, liquidity ratios, and even the role of banks vis-à-vis other parts of the financial services industry, such as insurers and unregulated bank-like organizations that form the shadow banking industry. But it is still uncertain whether these discussions are going in the right direction to achieve any sort of long-term improvement of the financial services system.

Financial crises are inescapable, and successful risk management techniques can merely lessen their effects or partially mitigate them at best. Risk is eternal, which is why banks are supposed to be good at understanding it and pricing for it. However, cataclysmic financial crises should be something that we have been able to move past, owing to lessons learned from the last big one: the Great Depression. Beginning in 1929, the Depression lasted into the early 1940s and saw international trade plunge by up to 66 percent. Unemployment in the United States rose to 25 percent, and some countries felt much higher levels of joblessness. Crop prices are believed to have fallen 60 percent, and industrial production and wholesale prices plummeted. Protectionism also surged, sharpening the downturn and lengthening the crisis. The event gave Federal Reserve Chairman Ben Bernanke the material to write his PhD dissertation and build his reputation as an economist; similarly, the crisis that happened on his watch is likely to give a string of future federal reserve chairpersons the material to write their dissertations.

Certainly, 2007 was very different from 1929 in terms of the sophistication of the financial system that had come to a grinding halt: in 2007 the system was larger, it was more concentrated, it was more global, and it had supranational bodies—such as the Committee of European Banking Supervisors, the Bank for International Settlements (BIS), and the International Organization of Securities Commissions—watching over banks. It also had sophisticated risk management agreements such as the Basel Accord on capital adequacy (Basel II), which all of the big banks were compliant with, including the ones that suffered the greatest difficulties. None of these sophistications was sufficient to prevent a massive collapse in confidence in banks, caused by their poor risk management abilities and improper business procedures, and the resulting chaos.

We can only hope that the mid- and long-term outcome of these two crises will also be different. The Great Depression and the policies of economic isolationism that followed it helped escalate the tensions that eventually launched World War II, with its unprecedented destruction, madness, and misery. The response of the current crisis has already been a bit different: certainly, currency and trade spats and other forms of chauvinism have flared, as have political cracks in the European Union exacerbated by sovereign debt crises and runaway budget deficits. There are concerns that nationalism is on the rise and that it will spawn selfish beggar-your-neighbor actions. How effective our response to this crisis will be is being determined now, at a national level such as in the United States and the United Kingdom; at a regional level such as in Europe; and at a global level through gatherings such as the G-20. It is not clear whether we are heading in the right or wrong direction.

There is at least one parallel between the Great Depression and the current crisis, however: if one of the results of the Great Depression of 1929 was the Glass-Steagall Act (1933), which separated commercial banking from investment banking until 1999 when it was repealed by the Gramm-Leach-Bliley Act (1999), then so are the Volcker Rules a result of the 2008 crisis, which try to do the same by repealing Gramm-Leach-Bliley. The ball is clearly in the court of the regulators, who need to find solutions to the problem of risk management in banks while also deciding how to handle interconnected systemically important financial institutions so that large man-made financial disasters do not recur. The regulators also need to accurately predict future problems arising from innovation in financial services, avoid unintended consequences of their reforms, and prevent the choking off of capital—from both onerous capital requirements and a counterparty mistrust—thereby preserving economic growth. It will be a tough balancing act, and as the crisis has demonstrated, regulatory reform needs to be carefully thought through lest the next crisis be bigger than the current one. With some measures already in place—capital requirements, bank taxes, bail-ins, living wills, and salary and bonus caps—conversations have become speculative: opponents of new measures are calculating the impact they will have on GDP, while proponents are arguing that the long-term good of mitigating or softening future crises outweighs their short-term impact. Clearly, this is where King’s assessment of business activity after the crisis being 5 percent to 10 percent below what it would have been had there not been a crisis fits in.

BANKS, REST, AND MOTION

Since the start of the financial crisis, regulators have weighed in on the key lessons of the crisis in their public statements and speeches. Donald Kohn, vice chairman of the Federal Reserve Board, discussed The Federal Reserve’s Policy Actions during the Financial Crisis and Lessons for the Future,⁶ while Federal Reserve Board Governor Daniel Tarullo expounded on Lessons from the Crisis Stress Tests⁷ and gave his thoughts Toward an Effective Resolution Regime for Large Financial Institutions.⁸ Andrew Haldane, executive director of Financial Stability at the Bank of England, asked The Contribution of the Financial Sector: Miracle or Mirage?⁹ and Adair Turner, chairman of the U.K.’s Financial Services Authority (FSA), spoke in January 2009—at just the time when bankers lived day-to-day with the uncertainty and fear about whether their banks or counterparties would stand or fall—on The Financial Crisis and the Future of Financial Regulation.¹⁰ More recently he asked What Do Banks Do, What Should They Do, and What Public Policies Are Needed to Ensure Best Results for the Real Economy?¹¹ Ironically, these are questions that will soon be better answered by the Bank of England than by the FSA, as the latter will be phased out as a financial regulator when the United Kingdom implements a new future of financial regulation—a future different from the one that FSA head Turner might have imagined in his speeches. Meanwhile, Jaime Caruana, general manager of BIS, aimed to tie it all together by his discussions Reestablishing the Resilience of the Financial Sector: Aspects of Risk Management and Supervisions¹² and The Challenge of Taking Macroprudential Decisions: Who Will Press Which Button(s)?¹³

Various organizations have weighed in on the solutions to the crisis and have outlined proposals that need to be put in place to prevent a repeat of the crisis. IMF policymakers have focused their attention on five key goals for financial sector reforms; namely, (1) ensuring a level playing field in regulation (and avoiding regulatory arbitrage where financial institutions and other entities could move business to more lax jurisdictions as the need suited them); (2) establishing greater supervisory effectiveness; (3) building coherent resolution mechanisms for both national level and cross-border financial institutions; (4) creating a comprehensive macroprudential framework; and (5) allowing a greater remit in addressing emerging exposures and risk in the financial system.¹⁴

Commentators such as Nassim Taleb, Joseph Stiglitz, Simon Johnson, Niall Ferguson, and Jeffrey Sachs have come up with various priorities for global financial services reform. These priorities include breaking up institutions that are too big to fail as a way to limit systemic risk (Malcolm Gladwell has said that Citigroup should be broken up into a million pieces;¹⁵ it hasn’t been), building up a robustness against high impact rare events (Taleb’s Black Swans), and moving, as Paul Krugman suggests, to regulation of institutions that act like banks¹⁶ (such as hedge funds and other parts of the shadow banking system), which amass liquidity like banks do but are not banks and are not supervised by bank regulators. Other commentators have suggested creating an early warning system to help detect systemic risk, nationalizing insolvent banks, creating a system of maintaining sufficient contingent capital as a form of insurance premium to governments during boom times that could be drawn upon in bad times, and various forms of bank taxes.

King, among his radical reforms, calls for limited purpose banking, which ensures that each pool of investments made by a bank is turned into a mutual fund with no maturity mismatch, and a move to divorce the payment system from risky lending activity.¹⁷ Ultimately, however, King proposes a solution that is not complex: Banks should be financed much more heavily by equity rather than short-term debt. Much, much more equity; much, much less short-term debt. Risky investments cannot be financed in any other way.¹⁸ Liability structures are among the key problems of the financial crisis, especially an over-reliance on short-term liquidity for long-term assets, and the problems that arise when the former cannot be renewed—as would happen in a crisis of confidence in the banking system such as the one that occurred—have now been made crystal clear: they are the kiss of death to banks and the economies attached to them.

The IMF proposed a bank tax in its April 2010 G-20 leaders report.¹⁹ The tax aims to give governments a mechanism to help them recover the costs of direct fiscal support of failed financial institutions through levies on banks and taxes on bonuses. It proposes two types of tax: a financial stability contribution linked to a credible and effective resolution mechanism and a financial activities tax on the profits and remuneration of financial institutions. Banks already pay plenty of taxes; this would be yet another one. Hungary has become one of the early adopters of this tax concept; it remains to be seen if other countries will follow its lead. The United Kingdom, which has suffered greatly from the maladies of its financial sector, is becoming increasingly hostile to the banks headquartered there, and the regulation of this systemically important (yet accident prone) industry has become exceedingly political. Chasing this business away, which is what might happen with these punitive reglations, will be hard to deal with for the United Kingdom which, according to the Bank of England, sees 10 percent of its GDP coming from financial services (the comparable figure for the United States is 8 percent).²⁰

Many countries in the world aspire to become financial centers and increase the level of participation financial services provide to their economies, although given the financial crisis, some may be re-thinking their goals; certainly, many would be secretly pleased that they had not arrived at their goals before 2008. Less happy are countries such as Iceland, which could only afford to be a financial center in good times, and the United Kingdom, where the financial center story has become hyperpolitical: taxpayers have bailed the system out all that they can bear and are doing everything they can to drive banks that are headquartered there to seek new homes. Switzerland, which is the home of two massive global banks—each of which has a balance sheet larger than its own GDP—has imposed extraordinarily fierce capital requirements on both UBS and Credit Suisse, requiring them to hold additional amounts of both equity capital and loss-bearing contingent capital, bringing their total holding of equity-like capital to 19 percent (the BIS standard is only 7 percent).

For jurisdictions that have banks under their supervision, new ideas are needed to deal with the ones that get into serious trouble. Opinions vary on what form bank resolution and support should take, and the great thinkers of the world are trying to find a way to deal with banks that fail. The solution that has been used so far, that of propping them up, is clearly unacceptable, but the alternatives are unattractive. It is, quite simply, a lose-lose situation; call it after me the deluge.

DANGER!

The size of institutions is a focal point in discussions of banking reform—the bigger they are, the harder they fall, and the term too big to fail (TBTF) seems to be on everyone’s lips. The discussion about size gets complicated when it becomes clear just how difficult it is to determine how big a TBTF bank would be—considering the fact that Lehman Brothers was not very big, TBTF banks may actually be relatively small. The term systematically important financial institution (SIFI) has come into vogue and includes both institutions that are not big and non-banks such as AIG. But the labels SIFI and TBTF are in fact irrelevant because, given their interconnectedness, almost all banks are TBTF and SIFI.

And given the sovereign debt crisis taking place in Europe, there are other concerns than the ones around banks, concerns about another type of TBTF: the question has arisen whether there should be some new form of linguistic gymnastics that allows sovereign states to be included in the term, even if their balance sheets are quite small compared to those of banks. But perhaps sovereign default is not as serious a concern as bank failure, because the largest banks have balance sheets larger than all but the four largest economies in the world:²¹ more than 50 of the world’s largest banks have assets of more than $1 trillion, while Greece—which has caused so much concern in the European Union—had, in comparison, a GDP of only $355 billion in 2009.

Beside the problems nations face managing their debt, the threats to all nations of a massive failure of their financial services system is very real and, despite the fact that these systems are supervised by powerful regulators, their size and strength mean they can easily take on a life of their own. Banks tend to grow faster than the economies that house them because of their financial success (in good times), high profitability, and the great wages they can promise their staff. In the United Kingdom and the United States, the two countries that have been the most impacted by the global financial crisis, banks have grown tremendously, either through organic growth or by acquisition, and the biggest ones have grown faster than any of the others.

This tremendous growth can be seen in a set of data on the top 10 banks in each country prepared by the Bank of England. In 1960, the largest bank in the United Kingdom was Barclays, and its assets represented 10 percent of the U.K.’s GDP. The other nine banks in the list had contributions in the single digits. The assets of these 10 banks together had a value of 40 percent of the U.K.’s total GDP, and the top 10 banks represented 69 percent of the U.K.’s total financial services sector. By 2010, the story was quite different: RBS had become the largest bank in the United Kingdom, with assets totaling 122 percent of the U.K.’s GDP, followed by Barclays (110 percent), and HSBC (105 percent). The 10 largest banks have assets 4.6 times the economy of the United Kingdom and represent nearly the entire financial services sector in that country (97 percent).²² It seems there are barely any small banks left in the United Kingdom, but as King warns, We have seen from the experience of first Iceland, and now Ireland, the results that can follow from allowing a banking system to become too large relative to national output without having first solved the ‘too important to fail’ problem.²³

The concentration problem that the United Kingdom suffers from is not shared by the United States: because it is so much bigger than the United Kingdom and has so many financial institutions (7,830 banks are part of the Federal Deposit Insurance Program as of 2010, although this number will continue to shrink as more institutions close—140 banks failed in 2009 and even more failed in 2010—and regulators hold off issuing new banking licenses). Between 1960 and 2010, the largest bank in the United States (in the inclusive years it was the Bank of America) saw its assets grow from 2.1 percent of GDP to only 16.7 percent of GDP. In 1960, the top 10 banks had assets that represented 9.9 percent of the total U.S. economy and 20.3 percent of the banking sector; in 2010 those numbers swelled to 62.4 percent and 73.6 percent, respectively. But the banks are still growing rapidly in terms of their relative size to the economy. The Bank of America today represents to the U.S. financial services industry roughly the equivalent of all of the top 10 banks of 1960 put together, and has assets as a percentage of GDP that is more than that of those institutions as well.²⁴

Banks like to think that being larger and more diversified make them more stable; regulators agree with the latter but are undecided on the former. But whether they are big or small, banks are all founded on a single premise: confidence. Money flows into banks when confidence is high, but flows out when confidence disappears: a double-edged sword. In the crisis, ethereal, fickle confidence was the rarest of commodities, and banks suffered from a near-crippling lack of it. This was evidenced by the premia for insurance on their defaults (five-year senior credit default swaps), which from 2008 to 2010 ranged in the United Kingdom from 202 basis points (HSBC) to 354 basis points (Standard Chartered Bank) and in the United States from 100 basis points (Bank of New York Mellon) to 621 basis points (Citigroup). In happier times, when defaults were thought remote—if they were considered at all—the values were typically in the single digits.

Given the concerns we have about large banks—whether we should have confidence in them and the harm they can cause when they collapse under the loss of this confidence—would we be better off if we were to go back to the banking system of 1960, when smaller and less-connected institutions would cause less damage if they were to fail? Perhaps so: this has been advocated by many thinkers. But if we did take this step, then we would have to imagine our financial services industries looking a lot like those of India or Germany: fragmented, and with no banks truly large enough to take on the financing of huge infrastructure projects. Germany has for a long time been urging its banks to consolidate in order to benefit from efficiencies of scale and broader geographic distribution. In India, the size of the financial services industry has been bemoaned as too small, lacking the capacity needed to finance the type of projects the country needs to push on with growth.

While we are correct to have concerns about the concentration of banking assets in a handful of large banking institutions, there are corresponding concerns that some of the solutions we are coming up with to address weaknesses in our financial services industry will create instability by increasing concentration instead of reducing it. Rules introduced by the Basel Committee on Banking Supervision to add to the Basel Accord on capital adequacy, which are being referred to as Basel III, will make certain businesses more expensive to be in, which will in turn cause (relatively) smaller players to exit these businesses and focus on the businesses they are strong in. This concentration effect in some businesses, such as payments or trade finance, may be one of the unintended consequences of current regulation, and there are certain to be others.

Given the lessons of the financial crisis, an understanding of what to do with banks that are failing and solutions for preventing this from happening are needed. Neel Kashkari, the interim assistant secretary of the Treasury for Financial Stability in the U.S. Department of the Treasury from July 2006 to May 2009 (under Treasury Secretary Hank Paulson), has described the difficulty officials faced in September 2008, when several large Wall Street institutions saw crumbling investor confidence and were ready to collapse, as well as the conflict regulators faced over the lack of proper tools to settle the problem. Liquidation, Kashkari said, was a way to punish failure, but would have led to huge investor losses, as business partners would shun a bank marked for