fter the banking crisis of 2008, equity markets first recovered strongly but have since fallen back as they digest the longer-term implications of events. Some banks’ profits have recovered, in part due to writebacks of excessive provisions and better margins on more conventional business lines. But most of the banking industry is still troubled, and bank stocks lag behind their commercial and industrial peers. This underperformance reflects the continuing poor outlook for banking revenues coupled with liquidity pressures and the impact of higher capital requirements. The malaise is aggravated by the threat of disintermediation as banks struggle with credit ratings inferior to those of some of their major customers. This article explores what went wrong from a Briton’s perspective, and what is still wrong.
The Toxic Mix
One thing that went awry in the run-up to the crisis: The banking sector grew too large as it responded to the huge imbalances in the global economy and the resulting liquidity. At the same time, interest rates were low, so money was not just abundant but also cheap.
The result was that asset prices were chased upward and risk was widely mispriced, particularly in the real estate market. Of course, that market was distorted by something else too: financial engineering. Securitization and derivative “technology” combined to convert highly risky portfolios into allegedly bombproof financial products. Bankers and supervisors alike seemed to believe that judgment was no longer key to running a risk-based banking business.
What the world needed in 2007 was William McChesney Martin, chairman of the Federal Reserve from 1951 to 1970, who famously said his job was to act as party pooper during boom times and “take away the punch bowl.” Instead, we got the legacy of Alan Greenspan’s unshakable belief in the “rightness” of market forces. In the United Kingdom we had “light touch” microsupervision and a near-complete absence of supervision at the macro level.
Where it Hurt the Most
Some countries fared better than others when the problems surfaced. The severity of the experience seems to have been correlated to relative bank sector size and to the extent to which each sector was internationalized. While Wall Street and Main Street might see it differently, the United States didn’t do too badly. Australia, Canada and France (at least until very recently) were hardly troubled. Other countries such as the United Kingdom, Ireland and, of course, Iceland did much worse. As the chart on the next page indicates, the U.K. government now controls a significant portion of the banking sector, whose missteps included poor lending practices, overly aggressive funding and, in two cases, ill-judged acquisitions.
Of course, the story is by no means over. Sovereign debt is still a serious problem, global imbalances persist, and money is still cheap. Legacy financing of the real estate market is still not fully unwound. Salvation for the banking industry will only come as a result of sound political leadership and economic growth, neither of which appears to be in abundant supply, at least currently.
Solutions and Mitigation
Regulators have taken a number of steps to fix the problems and to mitigate the effects of any future downturn.
Capital adequacy and quality. The crisis exposed the defects of Basel II, the attempt to put bank capital, disclosure and supervisory standards on a global footing. Basel III will remedy this by raising so-called Tier 1 core capital requirements and by requiring additional capital buffers in the form of loss-absorbing securities such as contingent convertibles.
Liquidity. Basel II was nearly silent on the need for proper management of bank liquidity. Basel III puts liquidity on the risk-management agenda.
Consumer protection. Among the issues that emerged from the crisis were the extent to which retail deposits were used in risky lending and retail mortgages as raw material for complex securitization and derivative products. In the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act is the result. In the United Kingdom, at least at the time of this writing, the notion of “ring fencing” retail banking operations has considerable support.
Regulation and supervision. In the United Kingdom, the Financial Services Authority, which oversaw regulation, supervision, consumer protection and promotion of the markets, is being dismantled and its functions assumed by three different agencies, the Bank of England assuming most of the prudential work. The Dodd-Frank Act and the conversion of the leading investment banks into bank holding companies will, meanwhile, tighten regulation and supervision in the United States.
What is Still Broken
Capital. Capital requirements are being increased throughout the sector under Basel III. Where will this capital come from? Even if it is raised, the impact on bank profitability will be serious and will likely be transmitted to the wider economy through higher charges. Further, Switzerland and the United Kingdom have tabled proposals that potentially go beyond Basel III, while, on the other hand, the United States may delay implementation. We risk an uneven playing field and, through excessive capital requirements, damage to the banking industry and its customers.
Regulation. Many countries have introduced or are proposing significant new regulations. The interplay between the revised capital requirements and re-regulation of the sector is not well understood. In the United Kingdom an independent commission on banking has proposed “ring fencing” retail banking operations, a measure that will need to be carefully evaluated and executed if it is not to cause unintended consequences.
Disintermediation. We are back to the position we were in during the ’80s, when corporate creditworthiness was superior to that of banks’. That led to the growth of the commercial paper markets. Today we have an even stranger situation in that sovereign ratings can be inferior to that of the banks that they host and to whom they act as lender of last resort. There is a growing likelihood that banks will be taken out of parts of the money flow equation, with unpredictable consequences for the supply of credit.
The economy. Many countries are still struggling to move out of recession. The market for property remains in a state of dislocation in key areas, and there is evidence that loans are being rolled over rather than foreclosed. The same can be said for some sovereign debt. Lending markets will continue to be difficult, and we will continue to see loan charge-offs.
Management stretch. It has not been easy to run a bank over the past four years, and the next two or three years won’t get any easier. Economic growth depends on robust banks, and they need motivated managers.
What Regulators Should Do Now
There is more that regulators and banks could and should do to address the outstanding risks.
In the United Kingdom, more robust supervision. The most obvious failures in the United Kingdom can be blamed on poor management and poor supervision. The remedy: supervisors placing much greater emphasis on management’s ability to run the business and on the effectiveness of the banks’ governance arrangements.
Reward long-term performance. Banks should drop the focus on the short term and on quarterly earnings, and instead link executive pay to earnings quality and risk management.
Macroprudential supervision. The banking sector is the mechanism through which a government’s monetary policy is transmitted to the economy. If that policy allows the party to continue unabated, then, as we have seen, the results can be dire. Each country therefore needs an agency empowered to counter this effect — to play the role of Mr. Martin. A call to stop the party will be seriously unpopular and politically difficult to make. Nevertheless, we need it, particularly because the global imbalances that were present before the last crisis are still there.
It would be good if politicians understood these things and acted accordingly. Let’s hope they do.