Other people’s money: why bankers keep screwing up
Monkeys do what monkeys do. Remember that when bankers get your goat. Call it cynicism or call it just realism but the purpose of this website is to encourage customers of the financial services industry to be less trusting and regulators to be smarter about how they control the industry. Of all the financial services this blog comments on, commercial banking is the one that least needs people and which is most harmed by people. It needs clever people least of all. This insight is critical to understanding how commercial bankers managed to lose essentially their entire equity capital base and why taxpayers are being called upon to recapitalise much of the banking system, here and in many other countries.
Whether you are looking for someone to blame or for the lessons that might prevent a repetition, you will miss the point if you focus on bank management and bonuses. You will even miss it if you go one step back and focus on shareholder influence, or the lack of it. In the modern world of democratised finance, both bankers and fund managers play with other people’s money. They will never behave like capital owners. Banks only respond to rules and to effective, canny policing of the rules by bank supervisors and monetary authorities. This is where the mistakes were made. The bankers did what they always do if allowed to get away with it: game the rules.
Boring boring banks Commercial banks, which take deposits from and make loans to real customers, whether households or businesses, perform the function of a boring but necessary utility, a bit like the national grid. Not dependent on the personal wealth and integrity of private bankers, individual shareholder-owned institutions and their management count for virtually nothing, as becomes apparent when we nationalise failed banks. There is no unique property or know-how, just a fungible fabric of bricks, mortar and computer systems supporting the much bigger financial assets and liabilities. Like a neutron bomb, you take out the people and the financial balance sheet will survive, both the liabilities (customers’ assets) and the assets (customers’ liabilities).
For centuries bankers have from time to time launched attempts to escape the boring reality of sound balance sheet management. In my own City career it has happened in the UK with lending binges in commercial property and cross-border sovereign debt and it has just happened again in housing finance across the banking industry but coupled with building societies turning themselves into commercial banks and commercial banks turning themselves into investment banks. Other countries have similar histories of serial banking crises brought on by banks becoming too ambitious.
In the nature of bank balance sheets, the warning signs will typically be the same in every crisis: high competitive growth in lending. It does not happen by accident: it has to be a deliberate strategy. So even without looking at the balance sheet it will be evident from stated policy goals, such as increasing market share or diversification of the loan book. Self-selected incentives may also be one of the warning signs: bankers designing employee payoffs maximised by loan volume where shareholders’ utility calls for loan quality.
Checks and balances This implies two layers of checks and balances: other managers with wiser heads; and shareholders. As we have seen from the early investigations into the management context in this particular crisis, there has been a weakness of peer pressure in most banks and this aspect needs to be developed. One symptom to emerge is that boards contain few experienced bankers, increasing the dependence on senior working bankers to provide a counter balance to the growth motive.
As an investment manager myself, I am embarrassed that professional investors did not provide the checks and balances that management lacked. Pressure can easily be exerted on ambitious banks by withholding new equity capital or senior debt (which will almost certainly be called for to finance strong balance sheet growth), blocking share issues for acquisitions or by selling shares of recalcitrant banks. The international nature of capital markets may appear to weaken these controls but investment management firms have also become global in scale and are in may respects better organised collectively.
This assumes professional money managers are themselves well-informed about banks as investee companies, understand the risks of highly leveraged balance sheets and mismatches between both the liquidity and duration of their assets and their liabilities and realise that recorded profits are largely notional, based on an assumed emergence of profit over the life of an asset. These are important distinctions relative to most other businesses but it is possible thay are not widely understood by portfolio investors unless they are highly specialised.
If professional investors are not safe assessors of the risks of financial companies, we might still expect them to have a sound enough grasp of economics to recognise from non-bank evidence, such as an unsustainable housing boom, when bankers collectively are behaving dangerously. I would not take that for granted either.
Besides, this fanciful view of how professional investors help keep markets rational ignores completely the distortions in their own incentives, as agents employed by capital owners rather than as owners themselves.
Back to supervision So if we cannot rely on shareholders, who can we rely on? Easy: bank supervisors. The only way to limit the damage bankers do is to regulate their balance sheets. Governments do this not just to acquit a responsibility for the solvency of financial institutions but also as a big part of their responsibility for monetary policy (because banking creates money) and as a tactical tool of economic management.
Bank supervision takes several general forms, whatever the specific structures in each country. Balance sheets can be directly controlled, such as by calling for higher reserve holdings with the central bank, or by imposing limits on lending or deposit growth. Balance sheets can also be controlled indirectly through the regime of prudential capital adequacy, because total balance sheets are leveraged multiples of a small capital base.
Imprudent changes in prudential regulation The current banking crisis has characteristics that are directly related to some major changes in prudential regulation, nowadays negotiated on a multilateral basis, and in the way banking volumes are controlled as a matter of economic management. These changes have increased the scope for banking to become more international and more innovative in developing variants of traditional forms of banking asset and liability.
Both tendencies are potentially more efficient in terms of banks’ important economic role in the allocation of capital, which deals with destinations and forms rather than just quantities. But they were also changes that weakened prudential control.
A particular feature of this crisis is the role of securitisation of bank loans. Not new in itself, the variant in this cycle was the spurious transformation of the risks of individual mortgage loans when sliced up into a separate levels of seniority and repackaged. This enabled banks to escape growth constraints by assigning less capital to the risk of the package than was appropriate or by moving tranches off their balance sheet, the so-called ‘originate and distribute’ model.
Wiser heads, both in the banks and regulators, would have questioned the alchemy of creating lower risk than the sum of the parts. They would also have questioned the risk of a distribution model that booked immediate accounting profits on sale and triggered immediate bonuses, creating powerful incentives to manufacture and sell without limit.
Government’s role Wiser heads in government would also have seen that new sources of credit were creating a housing bubble. But our Government was not alone in believing increasing home ownership, and sufficient credit to support it, were important policy goals somehow divorced from prudent financial management, including their own.
This is a deliberately general sketch common to most countries. But investigation of the specific causes in the UK will have to focus on whether splitting the monetary policy and prudential oversight functions between the Treasury, the Bank of England and the FSA seriously weakened control.
Judgement in the court of public opinion will also hear the claims of the present Government that the problem was caused by events outside its control, events with such a minuscule probability that it was reasonable to ignore them, echoing the bankers hauled before the Commons Treasury Committee.
It will hear but it will not be moved. The public sense quite rightly that the debt problems we now have to deal with built up in a period of false political values. They will make an intuitive connnection between politicians boasting of record unbroken growth in spending, ignoring the steady increase in endebtedness and illiquidity, and bankers chasing loan growth and ignoring the quality of their lending and the liquidity of their balance sheets. Bad banking is always bad politics.