Banks double down on risk

The Bank of England estimates governments the world over have spent or committed a staggering $14 trillion (Dh51.38trn) to prop up the financial system following the fall of Lehman Brothers in September 2008.

So, what did we get for all that dough? Unfortunately, more questions than answers.

Indeed, many of the factors that helped cause the previous crisis – a sustained period of low interest rates, high levels of consumer debt in the West and excessive risk-taking by financial institutions – remain in place.

At the same time, supersized government bailouts could have created the conditions for future financial crises that will be larger and even more expensive than the one the world has just suffered.

Despite the protestations by politicians that such a large-scale rescue should never be allowed to happen again, their actions over the past two years suggest the opposite. “Knowing this, the rational response by market participants is to double their bets. This adds to the cost of future crises,” Piergiorgio Alessandri and Andrew Haldane of the Bank of England wrote recently.

“This is a doom loop.”

This, however, is decidedly not the prevailing mood in the banking industry. Following their near-death experience, many bankers have been pleasantly surprised by the industry’s rapid recovery. Markets have stabilised, courtesy of government handouts. Banks’ profits – and their share prices – have recovered.

But all that has come with a price. By cutting interest rates to zero and pumping liquidity into the markets, the authorities risk encouraging a new round of risk-taking by banks and investors. And by loading the bailout costs onto the public sector they have undermined the creditworthiness of large developed nations. This, in turn, has sparked a growing political backlash.

Meanwhile, reforms designed to make the banking system safer – boosting banks’ capital requirements, for example – are still several years away from implementation. And the imbalances in the global economy that contributed to the crisis are far from resolved; they may in fact be worse. This presents policymakers with a nasty dilemma. If they leave support in place for too long, they run the risk of inflating another bubble. But if they withdraw too soon, the danger is of a slide back into recession. That may be enough to send banks back to the blackjack table. “The recovery in financial markets is a welcome development but... if nothing is done to withdraw this stimulus, this search for yield will begin to lead to underpricing of risk,” says Hung Tran, Deputy Managing Director of the Washington-based Institute for International Finance, whose members include most of the world’s large banks.

Pity Goldman Sachs

Judging from the public outrage that has greeted their singular compensation system, the world’s banks seem more vulnerable to pogroms than to another financial meltdown.

In recent weeks large institutions including JPMorgan Chase & Co and Goldman Sachs Group have reported healthy profits, and their counterparts on the other side of the Atlantic are expected to do the same when European banks report their results over the next few weeks. Banks with large investment banking divisions have done particularly well by taking advantage of recent market volatility and heavy trading volumes in bonds, currencies and commodities.

Many have also used the market rebound to rebuild balance sheets. According to the Bank for International Settlements, the amount of capital raised by the world’s banks – which has now exceeded $1trn – has overtaken the write-downs triggered by the crisis.

One major source of profit for banks stems from their ability to borrow at near-zero short-term interest rates, while making longer-term loans at higher rates. In other words, the regulators are allowing banks to earn their way out of trouble. This cannot last for ever. Oliver Wyman, the financial services consultancy, compares these profits to the short-term “morphine high” that patients undergoing medical treatment experience.

Central bank Valentines

As with morphine, the pain is only being masked. Many large banks are still dependent on central bank liquidity facilities and government-guaranteed debt to fund their balance sheets.

The European Central Bank’s Long-Term Refinancing Operation, which allows banks to pledge assets in return for cash, has current loans of €670bn (Dh3.46trn), up from €50bn  before the crisis.

Meanwhile, the Bank of England is currently providing £185bn (Dh1.09trn) of funding to the UK banking sector through its special liquidity scheme. The UK government has also financed a further £134bn of bank funding by allowing them to issue government-guaranteed debt.

“Central bankers have to say: how do I withdraw that without destabilising the system?” said Davide Taliente, head of the public policy group at Oliver Wyman.

Fragile funding

Direct support from the authorities is only part of the problem. The bigger issue is that banks have responded to the crisis and uncertainty by replacing long-term debt with shorter-term maturities when it came due. The average maturity for U.S. banks’ newly issued debt over the past 29 years was 6.6 years, according to Moody’s, the credit rating agency. By 2009 that had fallen to just 3.2 years. This means banks must refinance a large proportion of their liabilities in the next few years.

That could turn out to be expensive for some. For example, if Bank of Ireland replaced its current funding with long-term unsecured debt, the extra costs would wipe out its expected 2012 profits, according to analysts at Barclays Capital. For Commerzbank, the hit would be 20 per cent of profits. But UBS could secure long-term funding by giving up just five per cent of expected profits.

In practice, governments are unlikely to turn off the liquidity tap anytime soon. Oliver Wyman’'s Taliente, who is a member of the advisory team on financial regulation for  Britain's opposition Conservative party, says he expects governments to respond by fully nationalising some institutions or winding them down. “If the central bank lifeline is cut off, we are looking at liquidity shortfalls in the tens of billions. That’s the main worry in the system right now. We do predict that there will be some further casualties.”

Risk-taking on the rise

These concerns have not, however, prevented banks from putting more risk on their balance sheets. Analysts at FBR Capital Markets estimate that up to 40 per cent of investment banking revenue over the last 12 months has come from banks trading with their own funds, compared with a more typical level of about 25 per cent.

All of the top US banks have reported rising value-at-risk levels, signalling that their biggest trading loss on most days is rising.

Take Goldman Sachs, for example. Its biggest possible loss on 95 per cent of the trading days in 2009 was $218m, compared with $180m for 2008. For JPMorgan Chase the largest possible loss for 99 per cent of its trading days in 2009 was $248m, compared with $202m. But value-at-risk is a crude way to measure how much the banks are gambling, in part because it does not specify how big possible losses are on the remaining trading days in a year.

Investors are split about how to interpret banks’ apparent willingness to take increased risk. Some argue that banks are looking to rebuild their capital through reckless trading, safe in the knowledge that the government will bail them out in the worst-case scenario. (Reuters)

 

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