“These steps will allow us to restore more normal market functioning and encourage private capital to further support the reinvigoration of financial markets” - Federal Reserve chairman Ben Bernanke (like Theodor Roosevelt leading the charge up San Juan Hill)
US government is about to unveil a $250bn (£143bn) bank rescue plan today, as world shares rise dizzingly in anticipation and some short-sellers got burned. The plan represents TARP's replacement with SARP as the money will come from the $700bn bail-out package approved by Congress and represents all but $100bn that is available at the discretion of the Fed, US Treasury and the White House. The FT jokes about Brownian Motion. The US SARP copies steps taken by the UK and other European countries (together worth about twice TARP) whereby the US will buy stakes in its largest banks including Citigroup, BoA, Wells Fargo (+Wachovia), Goldman Sachs and Morgan Stanley. This plan was agreed or dictated to US banks at a special meeting last night. The aim - as in the UK - is to increase the banks' depleted reserve capital ratios in the hope that banks can then resume normal lending patterns and end the continuing credit crunch. As with SARP, the US Treasury will announce temporary insurance cover for loans between banks (paid for by much increased fees demanded by FDIC from under 1% to over 2%, which will moderate any fall in LIBOR).
Own Capital reserves of the banks should be a minimum of 8% ratio to risk adjusted assets (assets less collateral with both assets and collateral risk-rated), which typically means a ratio of 4% to gross assets. Regulators are insisting on Economic Capital buffers, however (to take account of economic and systemic conditions), that will roughly double the minimum capital reserve requirements. That means if banks do not get a relatively free or low cost own capital top-ups, they would have to halve their assets and that means drastically cutting back on outstanding loans just as the world is into a period of domino recessions! The Credit Crunch crisis had various triggers that I have explained elsewhere in these blogs. One threshold was the middle of last year when securitised assets originated by banks (to get them off the books) matched or exceeded assets remaining on their books. Ironically, it was Basel II regulatory regime (8% /RWA reserve ratio etc.) that majorily prompted banks to rapidly refinance their retail banking. They foresaw competitive consolidation of banks in the US and Europe as some banks would find themselves constrained from maintaining asset growth while those with spare reserves could become predators in the M&A of banks. Securitisations typically had three tiers or tranches, senior (AAA), mezzanine (AA-) and basement (usually held by the banks with 'first loss' exposure defaults in the underlying loans, while Mezzanine and Senior were more secure, covered by insurance and CP). By the first half of 2007 many banks (in their anxiety to maximise capital and minimise on balance sheet exposure) had sold off even the basement tranches (arguably, to unwitting investors). This was as serious, or more serious in hindsight, than the so-called 'irresponsible lending' i.e. 'irresponsible selling'. When these lowest quality tranches were used as collateral or sought to sell-on their price fell dramatically as it became apparent that defaults in sub-prime mortgages (and credit cards) were rising and that recession conditions appeared imminent. The knock-on effect was collapse in the market prices and risk ratings of the whole asset class, an asset class worth as much as all of banks' retail assets! Banks had to shore up these (with insurance, derivatives and/or other collateral), buy them back on balance sheet or let the Special Purpose Entities in which they had been vested simply go bust. The scale was so huge and the uncertainties so great that banks lost confidence in each other and the ratings agencies responded by progressively down-grading almost everyone - having rated these complex instruments AAA in the first place and taking huge fees for this from the issuing banks! The irony includes that those banks with large off balance sheet exposures that expected to to be winners in a recession and related shock events turned out to be the losers as any above average exposure to mortgages especially (typically one third of all commercial banks' assets) was punished by ratings agencies, in the interbank money markets, and eventually by equity markets (equity being typically two thirds of banks' own capital).
What would have happened if Basel II had been complete and well-imbedded before this among all the banks. Basel II after all had as a major aspect prudential treatment of off balance sheet exposures and of securitisations generally, whether on or off the books? Given time operating under the new prudential rules would banks have stopped originating further securitised assets and traded their way out of their off balance sheet exposures with far less fatal disruption to interbank lending? Governments efforts inspired by Gordon Brown and Alistair Darling's equivalent of the Thin Red Line (Crimean War) are currently focused on holding and repairing the line of re-capitalising banks to meet and exceed minimum Basel II ratios.
The excess over the minimum ratios are called 'buffers' - dictated by regulators, advised by Central Banks, and agreed with banks on the basis of internal shock scenario stress tests. Before, the credit crunch (before it became public knowledge from Summer 2007 onwards) banks employed rather moderate stress tests that rarely resulted in more than a third of banks' own capital being threatened. This irritated the regulators, but they lacked any precisely detailed prescriptions as to how to do this modeling and how severe to set the shocks. Relating banks to underlying economies was an unknown or dark art. What was a theoretical conundrum however, rapidly became a current reality with levels of liquidity risk no banks were prepared for. Like boy scouts caught with their pants down when a storm blows over their badly sited tents, the banks literally panicked not knowing what to do first. Perhaps a yachting race is a better analogy. Do you trim sail and stop to help others or decide this is just a squall and try to outrun it? Those with tents or sails intact mostly laughed at the others and took commercial advantage (not realising that the gales were bigger and getting worse), all being equally bad at weather forecasting (risk accounting). No banks that have proved to be stronger than others have survived better only because they knew better: a matter of good luck as much as good judgment (or as the Northern Irish say, 'bad luck, good luck and look out').
Could regulators have examined risk systems, accounting and scenario forecasting more assiduously in time? The job of risk auditing a bank is akin to a full financial audit. The regulators do not have the skilled manpower no matter how hard they tried to build it up (banks paid more, and anyway ,there were nowhere near enough true experts), but regulators also did not delegate the job to the audit firms, who are not trained or tasked with assessing risk cultures and systems. Therefore, banks, all of whom did less than they should, could not expect severe regulator's supervisory reviews, especially not if your bank is a national treasure, a champion on whom depends much of the reputation of the whole of the national financial sector. Very few envisaged that the markets might do the audits instead?
BIS, ECB, FSA and all other national regulators stated clearly that Basel II is a requirement necessary to keeping your banking license. It is designed by experienced senior bankers and will be the hard core of how banking is done in the future, as essential and basic as double-entry bookkeeping, and something that the executive boards of banks are personally liable for! Yet, of all the senior bankers I have met, few could bring themselves to see all this as anything more than irksome, comparable to a tax liability, a peripheral compliance matter, eminently delegated to the lower orders in the engine room; why take an interest in anything without a bonus attachment; career death (so true!). I preached the contrary to 100s of disbelieving suits e.g. get this bit wrong and the losses on your securitisation issues and cost of capital will break you; many times the cost of getting it right! Or, reputation risk alone here and here will cost half your own capital. Or, how will or can you replenish 150% of your own capital over say, 4 years? I also told banks that so long as their balance sheet profiles were typical of the market with no inexplicable spikes then when recession strikes and your bank is insolvent the regulators cannot blame you because all banks will be in the same boat! I was wrong on that, for while the general principle is true, it is only now being recognised by government and regulators, and in any case there is a domino sequence to events; some banks become basket cases before others do!
To know big banks you have to know the somewhat arrogant and supremely comfortable trust that exists within the corporate culture. 'Too big to fail' is not merely an external assumption. To the professionally curious one might test these beliefs by examining research by the central banks of Spain, England, Ireland, Sweden, Finland, Germany and France on specific techniques of risk assessment with the aptly named Old Lady of Threadneedle Street more focused on macro-systemic conditions of risk. The abiding problem, akin to the pre-war question of how do you get a shared sense of urgency until War is actually declared, was that
central banks & regulatory supervisors could not prescribe models and precise remedies – not enough epistemological certainty about modeling techniques and accounting data (competing academic camps at work) and not enough John the Baptists out there preaching the only road to salvation; life's too short for Greek mathematics.
I know of banks whose whole insolvency has been caused by very few individuals far below decks far more effectively than even the most commanding of commanders on the bridge could achieve. The biggest irony is perhaps that banks have been brought to their knees as much by IT nerds as by T-shirt wearing structured product traders, by grey-faced collateral managers in back offices as by Champagne Charlie, bonus-enriched financiers, by office politicians as much as by market traders. Points of failure do not correlate with authority and salary, though ultimately responsibility begins and ends at the top. Edinburgh Evening News today is hand-wringing over the “loss of RBS” even more than was the case only days ago about HBoS. Inevitably about to become 60% government-owned, the working assumption is that RBS will be unsentimentally and unceremoniously sold off soon! The trauma can hardly be comparable, however, to the feelings in Belgium about the fate of Fortis (about which I know a great deal more than can be stated here). If there is a long term story about the fate of banks as national institutions it starts long ago, a generation back, when banks decided that automation (computerisation) could supplant how banks relate to their customers. Banks lost the ethical and moral superiority they relied upon for centuries in times of economic crises; they traduced the loyalty of customers and before long the ethical motivation disappeared within the banks that no amount of 'we are a family', 'your friend for life' etc. rhetoric could repair. RBS's current advertorial strap-line is “making it happen”. Like any perusal of Chairman's statements even in recent months will show there was a head in the sand bs that was transparently a misrepresentation of the reality everyone else recognised. It is noteworthy that of the 400+ bankers already arrested by the FBI in the US, over 90% of the charges concern saying one thing in public and something entirely opposite in private!