September 8, 2013 7:00 pm

Unfinished business in battle to fix the banks

By Patrick Jenkins, Banking Editor

Ever since Lehman Brothers collapsed almost five years ago the most dramatic event in an unprecedented global crisis that is still reverberating today policy makers have laboured to fix the causes of that disaster and to pre-empt the next. Have they succeeded?
AFP

In an attempt to gauge the merit of the glut of global reforms, the Financial Times has looked back at the 34 main banks and brokers that failed in the crisis, judging the principal reasons for failure from a menu of five low capital; weak funding structures; poor lending; poor trading investments; and misguided mergers and acquisitions. Many failed for multiple reasons, though Royal Bank of Scotland is the only institution to which all five triggers applied.
Workers at Lehman's European Headquarters building in Canary Wharf clear their desks

Any analysis of the precise causes of the global financial crisis, even after five years of reflection, is necessarily subjective. But if there were five main causes of failure, regulators can claim at least partial victory on four of them. Capital levels in the system are more than three times higher than they were before the crisis The Banks at the Nucleus of the as banks pre-empt the requirements of new Basel III global Crisis standards. Financing is more stable, with far less reliance on risky short-term market funding and new incoming rules demanding banks hold minimum levels of cash and safe assets. Big acquisitions are a thing of the past, too, with regulators making it clear such dealmaking is unwelcome. And the kind of complex structured investments that spread the contagion of US subprime mortgage losses around the world are close to extinct, the victim of regulators higher capital charges and banks lower risk appetites. Those successes have emboldened regulators on both sides of the Atlantic. Banks have been chastened and their outspoken executives slapped down, or in the case of Barclays Bob

Diamond, run out of town. The colour has drained from banking, says one top regulator who is close to Mark Carney, the new governor of the Bank of England. Regulators are the rock stars these days. Bankers concede that supervision, after often notoriously lax oversight before the crisis, has clearly improved. Regulation now is rightly much more intensive and intrusive and the supervisory teams are much better, says Richard Meddings, finance director at Standard Chartered in London. The one category of the FTs five triggers of failure that is immune to regulation is bad lending a perennial curse of banking since the Middle Ages and one that in the heat of the crisis, when the focus was on complex collateralised debt obligations, was often neglected. The crisis was overspun as a markets problem, says Robert Law, a former banks analyst and adviser to the UKs recent parliamentary commission on banking standards. There were major problems in traditional lending, too. According to the FTs analysis, this was the single biggest factor in the crisis. Of the 34 big banks that failed, three-quarters succumbed in large part because of the poor quality of basic lending in particular to residential and commercial mortgage customers. There is little that the authorities can do directly in a market economy to curb foolish lending practices by private sector banks. But reformers argue that a laser focus on capital, which can absorb losses, is the essential way to protect the system from further harm. This was the first issue tackled by regulators in the wake of crisis, with big banks today required in practice to hold equity capital equivalent to 10 per cent of their assets weighted for risk. But in recent months reformers have launched another offensive on capital, conscious that risk weightings are fallible and can in any case be massaged to reduce capital requirements. Several countries, notably the US, the UK and Switzerland, have begun initiatives to boost the amount of equity banks hold relative to their overall unweighted assets. This leverage ratio as low as 2 per cent at many banks in the boom years meaning balance sheets were geared 50 times will in future need to be as high as 6 per cent under US reform plans. At the same time, however, politicians, bankers and even some regulators have expressed concern about the economic impact of an alleged regulatory overload, especially amid nervousness about the next challenge for policy makers weaning the world off exceptional central bank liquidity. The expected wind-down of bond-buying under QE has already hurt banks by pushing down the value of bonds on their balance sheets. A secondary threat comes from the prospective end

of cheap central bank funding in the eurozone in a little more than a year. The challenge will be to balance various regulatory initiatives with the realities of unwinding quantitative easing and fostering economic growth, says Jim Cowles, head of Citigroups operations in Europe. In private, unreconstructed bankers go much further in their complaints, arguing that the extent of reforms goes far beyond dealing with causes of the crisis. Many are furious about onerous pay reforms, particularly the incoming EU ban on bonuses that are more than double annual salary. They resent the US Volcker rule and its constraints on using the banks own money for trading purposes. And there is growing irritation about what many see as a series of witch-hunts against banks over past misdemeanours, from insurance mis-selling in the UK to mortgage product mis-selling in the US. Regulators now appear to be on a mission of retribution, says Bill Michael, head of financial services at KPMG UK. All the same, there is still plenty of unfinished business for policy makers to tackle less in dealing with the direct causes of the last crisis and more in terms of preparing to tackle the repercussions of the next disaster, whatever form it takes. In particular, worries persist about the complexity and size of banks nowadays, a problem that has, if anything, intensified. The banks that were deemed too big to fail five years ago are now even bigger, says Richard Portes, professor of economics at the London Business School. JPMorgan Chase, for example has ballooned, boasting assets of $2.4tn following organic growth and crisis-triggered acquisitions of Bear Stearns and Washington Mutual, compared with only $1.6tn in 2007. The UKs Lloyds Banking Group, after its government-sanctioned takeover of HBOS, is more than twice the size it was before the crisis, with a balance sheet of nearly 880bn. In 2007, there were only six banks in the world with assets of more than $2tn. Today there are 13. Plans are afoot to deal with this. The central recommendation of the UKs Vickers commission that big British banks hive off high-street banking activities into safer ringfenced entities should make a wind-down of a large universal bank easier. But the legislation, designed to mitigate the risk of future bank collapses in the vein of RBS and Lloyds, has yet to be passed. In the US, there has been deadlock on many elements of the Dodd-Frank reforms, much to the irritation of President Barack Obama. A campaign to restore Glass-Steagall, the repealed 1930s legislation that barred banks and brokerage houses from combining, has made little headway. In tandem, policy makers in Europe and the US are working on the concept of predefined bailins of bondholders in times of crisis. Optimists cite examples of recent failures, such as the

Netherlands SNS Reaal, which included a bail-in of bondholders alongside nationalisation. Overall, though, progress on the topic is laborious and few believe that banks will shrink much any time soon, whatever reformists might like to think. Size is too simple a metric [anyway], says Douglas Flint, chairman of HSBC. It really doesnt matter from a systemic point of view whether you have four banks or forty banks in a market. Its the systems asset concentration principally in government debt and in mortgage debt that can be dangerous. And this, financiers say, is the eternal rub. Few elected politicians are prepared to shift the focus of debate away from banks size and structure and on to the underlying issue: lenders crucial role in propping up the often excessive debt burdens of governments and households.

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