The bankruptcy of Lehman Brothers, investment bank, was the business world’s equivalent of comic book characters fall off the cliff moment when it suddenly realizes that it does not have solid ground underneath. For the financial world it discovered the same on that fateful day, warning signs of what is to come were many like, when it was reported (2007) that financial institution account for 40% of corporate profits in US or US national real estate price increase of 100% in less than 5 years!.
Although, world economy has slowly recovered from that body blow and might be on its way back to complete recovery (a big If, it can avoid full blown Euro crisis, once again with European Banks along with its Govt. playing the roles of gladiators). It is definitely past some time to identify the causes for crisis, so that decisions could be taken to re-structure the financial industry otherwise it won’t be long before we have another crisis.
Historically, banking has been recognized as a unique industry with its own structure of ownership, rules for governance and regulations. This has been due to its high risk and high rewards but over a period of time the distribution has changed, thus currently it has privatized returns (profits) and socialised risks (losses). Thus Banking industry as a whole has its incentives horribly skewed towards higher risks this needs to be rectified to ensure that millions do not have to suffer due to the greed’s of few.
Banking at the start of industrilization
In the mid 19th century (Europe & US) banking represented the staid part of the business with a typical firms being unlimited liability partnerships or mutually owned co-operatives (UK building societies). Due to unlimited liability owners and managers were one and the same, having their own personal wealth being at risk. Thus “market” ensured that risk management was exercised with due-diligence and discipline.
Another crucial factor in bringing the market discipline was that most of the banks had equity capital comprising 50% of liabilities while liquid securities and cash comprise almost 30% of bank’s assets. Thus, bank creditors/depositors were comfortable in knowledge that if any losses are to be taken it has to be born first by the owners themselves.
In terms of taxation there was not any differentiation between equity and debt thus dividend and debt payments (principal and interest) were made net of taxes i.e. without any bias towards the structure of financing the business. And of-course, banks at the time did not have such curious things as “cross-border” banking where their liabilities and assets are in different parts of the world.
In mid 19th century UK (it represents a global empire spread across globe) total financial sector assets represented less than 50% of annual GDP and the largest bank had less than 5% of GDP in its assets.
How it we get here?
The change in banking control structure started in 19th century itself as Western world started industrializing it had tremendous requirement to fund its new infrastructure and industries (Railways, Ship-building, and Textiles etc.) and it was felt that unlimited liability was holding back the from wealthy populace to invest in banks.
Thus, to address these issues legal changes were made over a period of time in both UK and US which allowed for banks with limited liability but with a provision for reserve capital (i.e. the capital that could be called in at the time of bankruptcy). Thus, even with limited liabilities bank’s total capital (paid up and uncalled) still represented 50% of its liabilities.
By start of 20th century a major consolidation took place in financial industry which meant that as banks were becoming bigger/larger they could not be managed on earlier partnership model where by owners/managers were one and the same. Hence, with consolidation came in the practice of professional managers separate from owners.
At the start of 20th century laws were changed in terms of treatment of banks capital and thus debt and interest payment were given tax free status which was slowly adopted world over. The rationale behind the move being that for financial industry debt is more akin to a raw material or part of business; slowly this rationale was applied to non-financial industry.
During the depression and previous banking crisis (lots of them in USA during its robber baron era) in early twentieth century, it came to be observed that extended capital was not of much use as it would always worsen the situation by spreading more panic about bank as a going concern.
As a part of policy response to Banking crisis of 1930’s and global depression many steps were undertaken the foremost being the introduction of Federal deposit Insurance which was to assure banks creditors so as to not turn a crisis of liquidity into one of insolvency. To limit the scope of contagion in one part of business causing to other and many bank related governance issues, Glass-Steagall Act 1933 was introduced in USA that ensured a clear separation between different financial institutions.
Due to these changes most of the investment banking was to continued to be a separate entity with partnership structure until late into eighties and would turn into public listed companies as the regulation climate turned business friendly.
The last bastion to fall in this climate of de-regulation was the repeal of Glass-Steagall Act in 1999 combined with very regulation lite for new derivative industry which was argued for in by such worthies as Greenspan and Summers. The former allowed the now too familiar behemoths in the form of Citi, BoA (Bank of America) and JP Morgan to be structured about who it is said that they are not ‘To Big to Fail’ but rather ‘To Big To Save’.
Where are we?
Now past three years from last crisis and probably staring into a new one in Europe which could be dramatically more painful as what was once a private debt on banking/financial institution has now been converted into a public debt crisis.
Today, when we survey the banking landscape it is dominated by “all in one” banking conglomerates, in UK banks have assets more than 600% of its GDP thus representing undue systemic risk in case of financial contagion. In 2007, 40% of US corporate sector profits were from financial sector which earns its income for risk management and transfer, must surely signifies the mis-alignment of the sector. In US on an average, CEO of a large bank earn a compensation of $26 million which is 500 times US median household income while no downside in case of losses indicating malaise called ‘profits are private while losses are public’ helped by ever increasing leverage ratio which was north of 30 before crisis and still is around 25.
The banking crisis has had a huge cost not just economical which is substantial but in terms of cost to society due to huge increase in unemployment, burden of unsustainable debt, in some cases people with no access to savings for their retirement years. In a study it was estimated that total loss due to banking crisis from 2007-2010 is approx. $5000 billion or $1250 billion per year (equivalent to Japanese GDP).
These systemic changes have not happened in ideological vacuum but has helped cult like devotion to Efficient Market Hypothesis (EMH), whereby it has been hypothesized that market are the best regulator thus all public listed companies merely require self-regulation (read Alan Greenspan’s testimony to US Congress one of his gems is “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.”)! Secondly, laissez-faire proponents started justifying it as part of next level of evolution, like earlier one from agriculture to industry, where people argued that finance could exist for finance sake and not exist as an catalyst to real economy need to be discarded where we have UK’s PM Gordon Brown wishing to have everyone in London working financial industry.
We as a society need to go back to basics, that money is predominantly means of exchange (of course beside store of value, a function we tend to forget in an era of fiat currency) and needs to be viewed solely in that context and not as a stand-alone sector on its own, once financial sector activity is cut-off from real economy than its activity starts to resemble gambling casinos rather than one of traditional banks.
Where we want to be?
It is high time that decision makers need to align the interest of broad society with that of banking industry, it cannot be allowed to continue in its existing form of particularly in its perverse risk-reward behaviour.
The recommended changes are:
Increase equity in financial institution: It has been suggested that optimal equity ratio is about 20% of risk weighted assets. This will align the risk of equity holders with that of credit holder and will also provide a much needed buffer in times of crisis but additionally lower the leverage for management to undertake risks.
Introduction of Contingent capital: Banks need to have contingent convertible securities which will be debt instruments in normal times but will convert automatically to equity on predefined thresholds (this to be done pre-crisis thus avoiding Time-inconsistency issues). To avoid gaming possibility these securities should be tradable in market as current crisis experience suggests that market based equity prices were a better indicator of financial health of institutions rather than regulatory/accounting reports.
Re-introduce Glass-Steagall Act or Separation of retail/commercial banking from Investment banking: This is to ensure ring fencing of “every-day” banking which needs to be protected by state for operational reason as well as for the well being of its citizens (no bank runs etc). This need to be further strengthened by imposing lower leverage ratio (lower risks) for retail banks to ensure that state is not require to be bail out.
Introduce Partnership for Investment banking: Investment banking with its huge risk-reward profile has a principal-agent problem where agent (management) has incentives to take huge risks as they do not have to suffer from downsides as oppose to share-holders. Thus, this needs to avoid such problem by having partnership structure as was the case before nineties where a deal has to be signed on by shareholders who were to bear the risk. Also, since this industry is not crucial from every-day banking aspects hence it cannot qualify for state subsidies but needs to be treated on par with hedge-funds or private equity.
Measure performance of Return on Asset (RoA) rather on Return on Equity (RoE): Currently most of financial institutions are measured on RoE which is flawed measure as it does not account for the increase in risk profile in search for higher returns. If the bank CEO’s compensation was to be linked to RoA then their pay would have gone from average of $ 2.8 million in early nineties to $ 3.4 million in 2007 unlike on RoE which will take it to $26 million! If any further proof is needed, in US 2007 top 5 CEO with highest stake in their institutions were Dick Fuld (Lehman Brothers), James Cayne (Bear Stearns), Stan O’Neal (Merrill Lynch), John Mack (Morgan Stanley) and Angelo Mozilo (Countrywide).
Shadow Banking including cross border banking: One of the fallout of introducing measure such as above is that it might push such activities to institutions that are not under regulator’s radar, for e.g. most of the banking regulation is done nationally but banks are allowed to operate globally thus there is serious lacuna where a bank in foreign country might undertake more riskier bet thus causing pain to its tax payer for e.g. in Iceland , Ireland and Spain where most of the private banking bad debt has been laid at the Govt.’s door.
But surely, the most profound learning from this crisis is not of one particular measure but of relaxing the regulatory roles played in finance. Thus, although the changes in banking industry were being made over last century it is only with the coming of laissez-faire ideology that this industry ran amuck at taxpayer’s cost. It is high time where a proactive regulation is brought on with clear separation between those who are regulator to the ones who are regulated and ending the practice of revolving-door particularly in USA between the two. In my opinion finance should be treated on par with pharmaceutical or health industry as any misstep’s cost has to be borne by society at large.