Banks, Bankers, and Bankruptcies Under Crisis

Understanding Failure and Mergers During the Great Recession

D. Chorafas

• Publisher: Palgrave Macmillan
• Year: 2014
• ISBN:
  9781137436993
• Topic: Economics
• Subtopic: Macroeconomics
• Index: Economics

Banks, Bankers, and Bankruptcies Under Crisis uses case studies of failed banks, banks that would have failed without taxpayer intervention, and in some cases banks obliged to merge under government pressure, to better understand global banking today.

1

Banks “Too Big to Fail”

1. Large and Complex Banking Groups

According to the Bank for International Settlements, “Institutions that are too big to fail—those that created intolerable systemic risk by themselves, because others are exposed to them —pose a significant challenge.”¹ Moreover, “Mergers and acquisitions that have formed a part of the crisis response . . . may have increased the number of such institutions . . . [and officials realize that big size] creates an unsustainable structure.”²

There are various ways of measuring a bank’s size. One of the popular measures is market capitalization. This is an unstable metric. An alternative measure is monthly asset value—provided we are clear which are the “assets” and what they are worth. Still another measure is the institution’s product channels and the number of markets to which they appeal. The premise is that each channel has to have a critical mass in order to increase its appeal, expand its services, and provide a profit.

With the economic and financial crisis that started in July–August 2007 with the subprimes and reached a first high-water mark with the bankruptcy of Lehman Brothers, AIG, Fannie Mae, and Freddie Mac³ in September 2008, Large and Complex Banking Groups (LCBGs, the so-called big banks) have been in the frontline of both huge losses and a virtually unlimited amount of support by sovereigns to keep them out of failure and oblivion.

There is no universally convergent opinion about the wisdom of a financial supermarket, a trend that characterized the last 30 years but is now been questioned. In an interview he gave to CNBC on November 12, 2013, Ken Griffin, the CEO of Citadel, the hedge fund, said that the capital market should be pulled out of the banking system’s realm. He also emphasized that big banks have become too difficult to manage. Smaller banks, and a greater number of them, are easier to control and might help to lower interest rates.

Another point Griffin made in the course of the same interview is that there have been no important benefits from quantitative easing (QE) to outweigh its cost to the economy. In his opinion, it is necessary to change the perception that the Federal Reserve influences the long-term interest rates. Other financial experts have questioned the decision of having monetary policy and bank regulation under one roof. Still another domain of divided opinions is the role of rapid innovation in finance.

Those who relish rapid growth and exotic innovations in the banking industry say that to stay on top a financial institution must keep on breaking the sound barrier. Decisions must be fast and unequivocal. There is no time for committees or staff meetings in this business. The job must get done. Yet, but which job?

• Growth for growth’s sake?⁴

• Leveraging for leveraging’s sake?⁵

• Risk taking, by always assuming a greater exposure?

Marcel Ospel, the CEO of UBS, did all that and he failed, taking the global Swiss bank along with himself to the abyss and damaging his reputation. Companies of all sorts, not just financial, that adopt the policy of doing away with limits to exposure, and consider risk control to be a nuisance, are growing fast, blinded by their own success. Then, they fall even faster than they rose, or they become prey to takeover by competitors who know how to keep their financial staying power. True enough, times have changed:

• For centuries in the financial products market novelty was slow and growth was modest.

• Today, the innovation of financial instruments has moved to a higher gear, but the risks have also increased significantly and this is not properly reflected in their pricing.

The message is that while opportunities abound, so do hazards, and forgetting about them proves to be a costly mistake. As a financial entity makes its way from youth to maturity, discipline in estimating risks and rewards wanes. Traditional management techniques developed during banking’s slow-moving decades have proved to be totally inadequate. The most successful financial institutions have been those whose management adjusted itself, its policies, and its tools to the fast-paced changes in the financial markets:

• From new product development that provides clients with a real service

• To the cultural change necessary to be truly in charge of risk.

This adaptation is necessary but it is not easy. Discipline has few friends, and it encounters many stumbling blocks. Therefore, it comes as no surprise that enormous challenges have been confronting LCBGs in exposing and in accessing long-term wholesale funding. The latter is generally reflected in a shift in the maturity profile of new debt issuance toward shorter maturities as investors try to control their risks.

After the July–August 2007 economic and financial crisis, the LCBGs’ lucrative “new” product—the subprimes—lost its market, while at the same time a relatively large stock of bank debt was due to be rolled. This made several big banks vulnerable and they were increasingly faced with stressed market conditions.

In addition, the erosion of the LCBGs’ profitability meant that these institutions were unable to be in control of their capital adequacy through the retention of earnings, and therefore to alleviate investors’ concerns about their shock-absorbing capacities. Their management was forced to raise fresh equity capital under:

• An uncertain market response,

• Sharply rising required rates of return on bank equity, and

• A rapidly growing criticism that big banks were the problem rather than the solution.

This criticism grew to cover practically all financial conglomerates, which means any holdings whose exclusive or predominant activities consist of providing services in at least two of the three financial sectors: banking, securities, and insurance. The economic crisis, critics added, has been created by big banks, their greed and an ill-conceived innovation in financial instruments, followed by the drying up of credit in spite of lavish public money thrown to the financial industry.

The aftereffect has been that finance and banking got unstuck from the real economy, becoming unable or unwilling to serve the needs of industrial and commercial firms—which, after all, is what the banking industry is all about. Economists say that, in retrospect, above everything else, the 2007–2014 crisis has been the documentation of the financial industry’s failure to perform its social duties. Banks and their bosses only worked for themselves and their bonuses, not for their community.

An interesting hindsight is that even if governments rushed to shower the banks and other financial institutions with taxpayers’ money, in an effort to avoid a new Great Depression, existing evidence suggests that the financial industry has passed its peak as the growth sector of the economy. The aftereffects of the 2007–2014 crisis also revealed benefits from what was believed to be the twenty-first century’s wave of rapid financial innovation and its practical use.

This provided a flagrant contrast to the past: From letters of credit in medieval times to personal loans and mortgages in the 1920s, financial innovation benefited the real economy. But for the real economy nothing positive resulted from securitized subprimes, structured investment vehicles, and conduits. Their better-known aftermath has been the economic crisis followed by public indignation and a torrent of red ink.

Apart from major losses with derivative financial instruments and other trades, global large and complex banking groups as well as other credit institutions (the so-called nonbank banks) have been confronted with a significant increase in nonperforming loans and charge-off rates. Worse, estimates of potential loan and trading losses continued to increase as the macroeconomic climate deteriorated.

The losses affected households as well, particularly in terms of indebtedness⁶ and rising unemployment, which had an evident impact on debt-servicing ability. Residential and commercial property became a source of worry while corporate default rates reached higher levels, with nonperforming loan rates of US banks hitting 4 percent in early 2009, and total net loan write-offs (charge-offs) going beyond 2.5 percent—an increase not seen since the Savings and Loan crisis of the late 1980s.

Following the persistence of problems in the credit markets, several well-known financial guarantors also reported large losses. Together with the guarantors’ reduced capital buffers, this resulted in limiting guarantees on bonds. (When available, such guarantees have been helpful in securing access to medium-term funding.)

The net result of these developments has been that LCBGs, as well as medium-sized and even smaller banks, confronted challenges in ensuring that their funding bases remained stable and diverse enough to cope with adverse disturbances. In the absence of this stability, in October 2008, governments implemented measures designed to alleviate strains on the banking industry in their jurisdiction. Theoretically, but only theoretically, the main objectives of lavish public support schemes were to:

• Restore the provision of credit to the economy,

• Promote a timely return to “normal” market conditions,

• Assure the long-term viability of banks,

• Preserve a level playing field in the market, and

• Contain the impact of salvage operations on the public finances.

These goals have been targeted but not necessarily achieved through different forms of assistance ranging from direct handouts (read: bailouts, section 2) to the guaranteeing of bank debt liabilities and measures designed to relieve banks from risks embedded in troubled assets. The better-managed banks appreciated the need for deleveraging but the majority did so by scaling back on their lending rather than by way of recapitalization in conjunction with a sharp reduction in their liabilities.

2. Big Bank Bailouts and Bail-ins

With the economic and financial crisis that started in mid-2007 and the credit crisis that added itself to an already precarious situation in September 2008, the Large and Complex Banking Groups grew even bigger. By doing so they sowed the seeds of the next crisis unless, of course, sovereigns bend over to pull them out of the abyss using an unlimited amount of taxpayer money—the bailouts. Or, the law of the land obliges all financial institutions to create capital buffers well beyond their shareholders’ money including bondholders and other parties—the bail-ins.

In a bailout a third party takes on someone else’s debt obligations. This is typically, though not exclusively, arranged by the government when there is an economic...

Table of contents

• Cover
• Title
• 1   Banks “Too Big to Fail”
• 2   Banks and Regulators
• 3   Banking Practices and the Evolution of Trading Rules
• 4   Euroland’s Banking Union and Its Stress Tests
• 5   Lehman Brothers and Bear Stearns
• 6   American International Group
• 7   Federal National Mortgage Association and Federal Loan Mortgage Association
• 8   Citigroup
• 9   British Banks at the Edge
• 10   Euroland’s Banks
• 11   The Challenges Japan Faced with Its Banking Industry
• 12   Japanese Banks That Bled in a River of Red Ink   Japanese Banks, Economic Deflation, and Creative Accounting
• Notes   Japanese Banks, Economic Deflation, and Creative Accounting
• Index   Japanese Banks, Economic Deflation, and Creative Accounting