When Lehman Brothers crashed in October 2008 and precipitated the financial crisis, some of the world’s biggest banks were put on life support as the contagion spread around the world. In America, Britain, Switzerland, Germany, Greece, Spain and even Iceland, institutions considered to be impregnable suffered near-death experiences.
But you would never think so now. Nearly everywhere you look, banks that were once terminally ill have made rapid and in some cases pretty miraculous recoveries. Albeit with the benefit of taxpayer-funded rescues, most of Wall Street’s giants were very much back in business within two or three years and are now returning handsome profits.
However, the crisis left its mark, even among that vast population of banks that flew through it. It has to be remembered that most firms in Asia, Australia, New Zealand, Canada and Latin America weathered the storm well. After all, it affected not so much individual banks, barring a relative handful of famous names, but the financial system as a whole.
A new breed of banking
Despite that, the banking landscape has changed as a result, especially in Wall Street. Bear Stearns, the first to fail, was absorbed by JP Morgan Chase. Merrill Lynch merged with Bank of America – and it wasn’t a merger of equals. Morgan Stanley and Goldman Sachs converted themselves into commercial banks. And Citigroup used its time in bail-out to raise cash and shed assets at a furious rate. So they’re not the banks they were.
And although it’s not something that the public notices, behind the scenes the biggest banks, collectively known as Sifis (systemically important financial institutions), have undergone a dramatic spring clean of their capital, admittedly under pressure from governments and regulators. Take just the one issue of leverage – the amount banks raise in various forms of debt for every dollar they hold in deposits. Some were leveraged as high as 50 to one – hedge fund-style levels – while 30 to one was relatively common. As for Lehman Brothers, it had no deposits at all, precariously funding itself on the overnight market. But not any more. According to recent figures from the US Federal Reserve, financial sector debt has shrunk over each of the last four years and had fallen to $13.9trn last year compared with $17.1trn at the onset of the crisis.
“We may still hate the [American] banking system,” observes trenchant US columnist Daniel Russo, “but the reality is that it is much better capitalised than it has been in years”. Russo says that fewer banks are failing – in the years immediately after the crisis regional institutions were toppling almost on a weekly basis in the US. In fact, federal supervisors had got so adept at shutting down ailing local banks that they were arriving on a Friday and leaving on Monday morning after merging the mismanaged firm with a stable rival and changing the nameplate. Outside the US, few appreciate the rate of consolidation in its banking sector. According to the Federal Deposit Insurance Corporation, there are now some 1,600 banks less than there were at the end of 2007, down about 20 percent.
Although the scale is different, much the same phenomenon has occurred around the world as banks hastily repaired their balance sheets. Take the issue of leverage again, if only because it’s a major focus of regulators who are working on an easily explicable format for measuring just how indebted banks really are. Banks now take it for granted that they will no longer be able to design their own leverage ratios under proprietary models, as they did before the crisis. As the Bank of England’s Deputy Governor for Financial Stability Sir John Cunliffe pointed out recently, the whole concept of firms coming up with their own ratios is full of “inescapable weaknesses”. And so it proved.
The global banking sector, however, has actually changed its ways. It has collectively adopted more responsible lending policies and the quality of loan books has improved as a result (see Fig. 1). Bit by bit, low-quality assets have been sold off to shadow institutions that specialise in the management of higher-risk debt. Vitally, the investment banking divisions whose reckless accumulation of suspect debt instruments wrought most of the havoc, have been split – or are in the process of being split – from the deposit-taking divisions.
Shocked by what happened and by what they subsequently discovered about the habits of some of the systemically important firms, in the intervening years regulators have subjected them to a blizzard of reforms designed to make them more stable. Although some institutions lobbied hard against certain aspects of the regulations, all are moving quickly to meet much higher standards of, for instance, capital buffers. Indeed, bowing to the inevitable, most banks are ahead of the official timetable.
In a complete turnaround of the laissez-faire style of regulation that prevailed before the crisis, the authorities are coordinating their efforts through global bodies such as the Financial Stability Board. The goal is to subject banks to common, cross-border standards that, as far as is possible, allow authorities to make internationally transparent assessments of their soundness. Also, they are determined to prevent firms exploiting opportunities in “regulatory arbitrage” by setting up operations in a jurisdiction with softer rules than elsewhere.
Of course it’s not possible to entirely repair such a heavily damaged sector within a few short years. After all, globally, banks lost $1.5trn in just two years, between 2007 and 2009. Ever since, liquidation experts have had a field day – in Germany, for instance, Lehman Brothers Bankhaus collapsed owing the Bundesbank €8.5bn, and it has taken years to sort out the mess. Now, however, the global tidy-up operation is nearing its end.
Work to be done
If they haven’t read it yet, most senior bankers could do worse than obtain a copy of a book that has greatly influenced regulators: The Bankers New Clothes: What’s Wrong with Banking and What to Do About it. Written by Anat Admati of Stanford’s Graduate School of Business and Martin Hellwig of the Max Planck Institute, its premise is that higher capital ratios were the starting point for reform.
According to the authors, banks had rendered themselves unsafe because they made money out of their fragility – their self-designed ratios for capital and liquidity were daringly low, mainly because they permitted sky-high leverage ratios. As it happens, the influential Financial Times economist Martin Wolf, a member of UK’s Independent Commission on Banking, agrees wholeheartedly with the main proposition of The Banker’s New Clothes. He wrote last year: “It makes no sense to build either bridges or banks that collapse in the next storm. One makes banks stronger by forcing them to fund themselves with more equity and less debt.” Although not many banks are moving towards an equity ratio of 20-30 percent, which the authors suggest is the more appropriate number, they are rapidly heading in the right general direction.
So how much safer are the banks? The main reform is that the minimum tier one capital ratio has been raised for most banks from a lowly four percent to a more robust six percent of risk-weighted assets. Also, the actual composition of tier one capital has been revised to make banks safer in the event of a crisis. Further, there is now a countercyclical capital buffer that can be raised or lowered according to the growth of credit. If regulators judge that too much credit is being handed out, they will insist on a compensating increase in the buffer.
The truly giant institutions will be required to build a risk-based capital surcharge that reflects the degree of their systemic risk. In short, the big boys must take a hit for the heightened danger they are judged to be running. Boardrooms have raised their game, also under pressure from regulators following another avalanche of research about directors’ responsibility for the crisis. “During the financial crisis it came to light that many of these risks [in bank governance] had been neglected, underestimated or – particularly in the case of systemic risks – not understood and taken into consideration,” pointed out Klaus Hopt of the Max Planck Institute, a German research institute, in a recent paper.
Unless they stumble onto the road of reform, the big institutions are very much in the eye of relentless regulators. In August, Standard Chartered took a $300m hit from probably the world’s most aggressive agency, the New York Department for Financial Services. Its heinous crime? Alleged deficiencies in its information technology systems. No overt damage was caused, no money-laundering rules breached, and no Libor was rigged. As one analyst wrote: “there appears to be no suggestion by the NYDFS of any wrongdoing or breach of regulations by Standard Chartered”. So in this new environment, banks can be punished merely for being fallible.
In the World Finance Banking Awards 2014, we highlight the banks and leaders who have helped to rebuild an industry. There is also a selection of expert commentary, making the supplement the ideal companion for those in the industry, and for those who need to know who is defining the markets, and where.
