We ended the last part of Propaganda Wars with the question,
“So what are the ways the banks ditched safety and robustness in favour of performance, profit and bonus package?”
To answer this we are going to look in more detail at the money banks lend out and are owed back (bank income) which is the Assets side of the balance sheet. Once again we’ll pick on Barclays. First thing to notice is that there are Assets and what is called ‘Risk Weighted’ assets.
The difference? 20 odd years of all expenses paid, Basel I, II and III meetings in which it was decided that not all assets/loans are equally risky, plus the millions in bonuses paid to bankers for them to weigh the risk that any given asset /loan may not quite deliver.
The gap between those two lines is supposed to be what makes modern banking so profitable, efficient and yet still completely safe. In the event it turned out it was actually a direct measure of how much we had to bail them out when all that brilliance and regulation turned out to be bollocks.
The most astonishing thing about this graph is that it clearly claims that as we progressed through the nineties and up to the bubble, banking was becoming less and less risky. The world, according to this graph, was filling up with less and less risky assets. You may balk at this given what we all know happened but that is what the graph says all the same. In 1992 the gap between the face value of the bank’s assets and the fraction of that value that was considered to be risky or at risk was small. The risk weighted total was nearly 3/4 of the actual face value. Which means most assets were risk weighted at one. But as the global volume of debts, of mortgages, securities, derivatives (such as CDS and currency swaps) and bonds of increasingly indebted sovereigns grew and grew, the risk according to the banks became less and less. As the world became more indebted, as banks carried more and more of that debt with less and less equity to support it, the risk of the whole thing became less and less. That is what the graph says at least. Every bank, not just Barclays, carried more and more debt but claimed there was less and less risk in doing so. No where in this graph or in those just like it for the other banks, is there any trace or hint of the vast risk they were all running and which the system as a whole was accumulating.
In 2007, the moment when the first shudders of impending catastrophe ran through the global debt system, Barclays found the risk posed by their assets had plummeted from the 3/4 of face value that it had been in 1992 to less than a third in 2007. And the pattern is the same for all the global banks.
So what had happened in those 15 years? Can we believe the financial world had really become much less risky? Had assets become safer? Were there somehow billions of Dollars and Euros worth of newer, far less risky asset classes in existence than had ever existed before? Well we have four years of incontrovertible evidence that utterly refutes any such rosy notions. And yet, those who claim that there was and is nothing fundamentally wrong with the system, that what happened was just a passing crisis of confidence and liquidity, are in effect asserting that the graph and its claims are absolutely correct. And moreover the defenders of the financial status quo are continuing to assess risk now exactly as they did then. More of the same is what they are lobbying for. Much, much more.
Needless to say I don’t agree.What actually happened, I argue, is that the banks and regulators created the Basel agreements which the banks pretend to hate but in fact largely control. The bankers had decided they understood risk better than anyone else and should therefore be in charge of regulating it, reporting on it and profiting by it. And from this conviction Basel I, II and now III were born as the bastard offspring of the banker’s tumescent avarice and the regulators servile willingness to service them. What ensued was a revolting orgy of rapine excess behind a veil of sober sounding terminology and Basel agreements.
The Basel II agreement ruled that banks didn’t need to hold the same amount of capital against those assets that were considered to be of lower risk – lower risk weighted. This for instance is a typical risk weighting table based on Basel II.
|Cash and equivalents|
|Standby letters of credit|
So for example government securities (the AAA rated kind only of course), because there is obviously zero chance of them not being paid, carry no risk. Thus however many billions of euros worth of those a bank has, the total is multiplied by zero and that big, safe risk weighted zero is the ‘risk weighted’ amount the bank has to hold capital against.
As you can see a bank which chose to buy government securities in 2008 or even 2009 when most European sovereigns were rated as AAA, would be judged to be running zero risk from those securities and would therefore not have to hold any capital against them. Of course it is an oddity of banking logic that not all AAA rated risk-free government securities and bonds are equally ‘risk free’.
Thus it was well known by 2003 at the latest that both Italy and Greece had, since 2001 at least, been making major Currency-swap deals with big US banks whose purpose was to artificially reduce the amount of debt those countries appeared to have. The deals didn’t actually reduce the debt. In fact they increased it. But they did hide some of it long enough to ‘fool’ the regulators.
You remember them? They’re the ones under whose strict supervision the banks were allowed to calculate their own risk weighting on the assets, like government securities, they were holding.
So since 2001 at the latest the major banks would have been well aware that behind the official debt figures of several European sovereigns was a large hidden debt which would make something of a mockery of the AAA rating. So why buy them if the banks knew they were riskier than they appeared? Easy. The key is the lag time between what the official rating agency/government rating says and what the market says.
Once the market (AKA the banks) knew the real risks then the payments demanded on those securities and bonds would go up, making them more lucrative than safer securities and bonds from other countries. BUT because they were still officially AAA rated they could be held as if they were risk free with a risk weighting of zero. This is what we might call rating arbitrage or a case of officially sanctioned having ones cake and eating it as well.
On one side of every bank bankers would hold securities and bonds as risk-free assets while a few yards away on the other side of the bank a whole different bunch of bankers would be busy selling CDS on those same securities at ever higher rates as the ‘market’ judged them to be riskier and riskier. Riskier and riskier in the profit chasing bit of the bank but risk free in Basel and in the office where the bank’s risks were calculated.
In fact Basel II, which took many years of fine lunches and much expert cogitation on the part of the bankers and their regulators, went further. It decided that while some banks and countries (those not so brilliant ones run by foreigners) would be required to follow guidelines like the above chart, for the banks whose brilliance was amply attested to by their enormous…balance sheet, they would be allowed to move on to a new “internal ratings-based” (IRB) system.
In this approach, institutions will be allowed to use their own internal measures for key drivers of credit risk as primary inputs to the capital calculation, …
subject, of course,
to meeting certain conditions and to explicit supervisory approval.
Yes, quite so! They decide their own risk according to their own model… but subject to approval.
All institutions using the IRB approach will be allowed to determine the borrowers’ probabilities of default while those using the advanced IRB approach will also be permitted to rely on own estimates of loss given default and exposure at default on an exposure-by-exposure basis.
Advanced IRB as well! Of course the models being used are proprietary and therefore NOT open to scrutiny by any outside experts. What do you think, if the bank’s experts came up with two possible models one of which gave a lower over-all risk weighted total which do you think the bank would go for? And if another bank came up with a model that shaved just a little bit more off the risk weighting do you think there would be a subtle pressure to match the undoubted brilliance of their competitor’s model? I leave you to decide if such a thing could possibly have happened at any point in any bank some time between the Basel II update in which this idea was enshrined in 2005 and the bank debt crash of ’08.
So on the surface, according to the official story and the banks own figures the bank’s strategy for stellar growth was to vastly increase the volume of assets they held (Loans made) relative to a tiny capital base (the definition of increased leverage) BUT to somehow do this without increasing any risk, in fact managing to lower their risk. And they did it, according to the banks and regulators, by inventing and then buying hundreds of billions of dollars and Euros worth of new kinds of low risk assets. Except that it was the banks who were deciding if an asset was risky or not.
In case you think I am exaggerating or, lacking in a PhD as I am, just not understanding the subtle brilliance of modern banking and its risk management, read what Mr Haldane, Executive Director for Financial Stability at The Bank of England has to say about it (See pages 9- 10). First his over all point about the brilliance of banking.
…virtually all of the increase in the ROE (Return on Equity = Profitability) of the major UK banks during this century appears to have been the result of higher leverage.
For most banks, the story is one of a significant increase in assets relative to capital, with little movement into higher risk assets (unit risk makes a negative contribution for most banks). Those banks with highest leverage, however, are also the ones which have subsequently reported the largest write-downs. That suggests banks may also have invested in riskier assets, which regulatory risk-weights had failed to capture.
May have failed to capture?! That is a polite way of saying the banks lied, the regulators obliged and we carried the can for all of them.
It gets worse. In this period of ‘financial innovation’ the banks had other tricks and articles of faith that allowed them to hugely increase the risks they ran without appearing to do so. One of the most important tricks was and is to trade one kind of risk for another. A mortgage held by a bank is what is called a ‘Credit Risk’. Credit Risk is the risk that the borrower might not pay you back. Market Risk, on the other hand is the risk that the price an asset can be sold for in the market can go down. Of course it can also go up which is negative risk.
It is an article of faith in the financial world that Credit Risk is greater and therefore carries greater Risk Weighting than Market Risk. The logic is that in Credit Risk all it takes is for the one borrower to default and you’re out of money. But if instead of a loan you hold a security made of slices of many loans, then you are not stuck with it even if some of the underlying loans start to default. You can always find a buyer. With a loan, the risk is all yours and depends on one borrower. With a security you can always sell the product and its risk. The risk is therefore often seen as off-loadable into the magic ‘market’.
So what the big banks did, en masse, was to stop holding and making loans to customers (between 2000 and 20007 loans to customers declined from 35% to 29% of total assets) but securities held on the banks trading books almost doubled. In the world of modern bank regulation if two banks each held a loan they could BOTH reduce their risk simply by selling their loans to each other and hold them as securities. As securities they would be lower risk weighted, even though the actual risk and the loans was identical. Where had the risk magically gone? It had been absorbed and guaranteed by ‘the market’.
But risks ‘in the market’ are not accounted for by anyone in any place. There is no measure of it. Like polluters around a lake each flushes their risk away, declares their own site to be compliant with the highest environmental standards and never notices the dying fish or the toxic bloom in the waters off shore.
A further reward of this happy arrangement is that loans are held on the Bank Book where they sit inert as far as market price goes. Even if the value of the house on which the loan is given goes up, the bank sees no benefit. It is simply a loan bringing in a regular payment. The same loan held as a security is held on the Trading book where it has a market price. The value of a security, the price for which it can be re-sold, does benefit from a rise in the value of the underlying house. It is marked at what is called Fair Value or Mark to Market. And what is more that rise in value is marked directly on the banks profit and loss figures.
So in every way the structure of the regulations which the banks worked hard to shape makes it not only very easy to hide risk but to profit greatly by doing so.
What could go wrong? Well when the bubble burst and prices went in reverse, in 2008 alone, the losses on these structured securities was about $210 billion. Risk? What risk!
Of course the banks were insured for this sort of risk. They had thought it all through. That’s why they’re paid so highly. Sadly they had insured …with each other. Insuring risk was one of the bank’s other favourite strategies for seeming to reduce risk and to profit by it. All banks as well as insurers like AIG wrote insurance for ‘risky’ assets, securities, CDOs (Collateralized Debt Obligations) etc. The writing of insurance had a symbiotic relationship with what it was insuring. The more risky the assets, and the more of them to insure, the more lucrative business there was available to any bank wishing to insure it. The more insurers there were the greater the apparent market which underpinned and guaranteed the insurance. The ‘magic’ of the market as absorber of all risk coming in to play again here.
In the end everyone had risky assets they wanted to insure and everyone was keen to profit from insuring them. Do both and you were doubly smart. Your assets were ‘safe’, your bank ran no risks on thoset assets (low risk weighting profile) and you had another whole river of CSDS ‘assets’ that were themselvs considered and rated as ‘low risk’. Derivatives like CDS are generally not seen as high risk because they are tradeable in the market, the risks are seen as remote, the risks can be laid off on other willing market bidders and anyway what they are insuring are reliable produicts from good banks staffed by very clever bankers. All in all a wonderfully sound world build on pure, 100%, leveraged bullshit. As Mr Haldane notes (p.11), AIG from ’03 to ’06 made an operating income of $2.3 billion on its CDS. In ’08 alone it made a loss on these same products of about $40 Billion. Which the tax payer had to pay.
In short these clever ’structured’ products which were the engine of modern banking and still are, were a disaster. A disaster we are still paying for. And they make another appearance in the banks as well. Not the exact same ones, but ‘structured’ products also began to appear in the capital base of the banks as well. ie in the reserve of capital the banks must hold to underpin all the risk they were ‘not’ running. During this same period banks began to replace boring old investor equity with what they called Hybrid capital. The regulators just lay back and thought of England as usual.
Equity is boring like loans are boring. They just sit there. Hybrid capital puts the money back to work. The Capital is put into a ‘product’ that earns an income by being ‘invested’ but then after a certain date also returns the capital. They were guaranteed as a more efficient use of capital, more lucrative and yet also safe and reliable. But as the redoubtable Mr Haldane notes , again,
…such hybrid instruments have shown themselves largely unable to absorb losses during the crisis,..
Now much as I like to quote Mr Haldane and think he speaks more honestly than almost all his colleagues, I feel we are in danger of being sucked into banker-think here, in spite of ourselves, by this phrase “largely unable”. If the brakes on a car were guaranteed to stop it in case of need , but in the event were ‘largely unable’ to do so the manufacturer would be sued into oblivion. If a parachute was found to be ‘largely unable’ to open or slow the fall of the unfortunate who was wearing it, would we shrug and offer to bail out the manufacturer? If aircraft were largely unable to stay airborn would we wish to pay their executives large bonuses to ensure they didn’t go elsewhere to work?
The financial products of the bubble years, in fact the entire market for them, which was made of the very same people who also manufactured them, FAILED. But none of the rules which would apply to any other form of corporate and product failure have been thought applicable to bankers. And who thought they should not be seen in the same way? The people whose utter failure to regulate them was an equal part of the crisis, like Nitro is to Glycerin.
Bankers and their regulators lied about risk. They hid it. They did not think to ask where risk was accumulating but prefered to talk like wide eyed fundamentalist nut balls about the efficiencey of the hidden hand of the market to make all things work out, find their correct price and be honest about risk, as if it was some kind of coke snorting, dick head God-ling of the modern era.
We have to change the terms of the entire financial and political debate and confront the claim that the banks,as they are presently run, are safe and necessary. We need to ask, safe and necesary for whom? It must no longer be what must society do to save the banks but what must be done to the banks to save society from them.
We need to do our own very simple risk benefit analysis of the banks. Do you personally get any benefit from a bank being very large? Do you get a cheaper mortgage from a bigger, risk hiding bank? Answer, NO. Big banks can often borrow more cheaply but they tend not to pass this on to us. On the other hand, is there a risk to you from a bank being very large and hiding all sorts of risks, in order for its bonus pool to benefit? Obvioulsy the evidence from the last 4 years is an unequivocal YES. There is no argument on this point. We have a global crisis entering its fourth year with all central banks still having to keep interest rates near zero, even though doing so cripples pensions and pernsioners, because the banks still can’t fund themselves or pay for their on going losses without free money from Fed and ECB.
The banks, their system and their entire claim to be good at managing risk, have all proven catastrophically wrong. While banking is a necessity, the banks we have and the system they have built and profted from are in fact a massive and expensive systemic risk to everybody and everything else. The analysis is clear. We get no benefit but run huge risks. In short there needs to be a ‘public good and safety’ requirement on banks and banking. They will of course say this is an unwarrented intrusion of government in to private companies. We don’t, after all, tell car companies how big they may become. True. But the banks themeslves have made it very clear that they see themeslseves as a very special case. Banks unlike any other kind of company are so systemically vital they cannot be allowed to fail. That is what they say. All I am doing is using this against them. If they are so systemically vital and different then they cannot complain if we treat them as special. It is utter lunacy to allow them to become a systemic threat to our well-being. So we should accept their special nature and the special threat they become if allowed to grow too large. We should recognize that the nature of market competition for finding loop-holes in regualtions, for ‘regulatory arbitrage’, makes it suicidally stupid to allow banks to self regulate, to set their own risk weighting, to be honest and above all to have any secrets. A secret becomes a lie as surely as a maggot becomes a fly. If a bank needs to keep secrets, we should wonder why and tell it it to go elsewhere. Banks may benefit from keeping secrets from each other. We, however, get no benefit from their secrets but do, self evidenlty, expose ourselves and our children to massive risks if we allow them.
To allow banks to become too large for the needs and good of the society they should be there to serve, is akin to giving planning permission for a massive chemical waste storage or nuclear storage facility to be built next to schools and hostpitals. No one would allow that. No one should allow banks to become unstable, implosive, socially destructive monsters. Especially when their main socially useful function can be done by smaller, safer banks.
Thank you for reading this. There is a lot more I would have liked to include in this but I will save it for the next part. I have two more parts then I will stop bothering you.