La Der des Ders

Some ninety years ago, World War I ended after causing extraordinary suffering to winners and losers alike.  Survivors swore to do everything in their power to ensure that such a war would be the last of its kind, la der des ders.  This impetus gave us the League of Nations, the Reparations of the Treaty of Versailles and the Maginot Line.  The rest, as they say, is history.

As we are emerging from the worst banking and financial crisis in memory, governments are determined that such a crisis will never happen again.  Parallels between wars and financial crashes can be carried out only so far, but both are rooted in human nature.  The lessons we can draw from the aftermath of WWI are that: as much as it is emotionally satisfying, rushing into action is usually counterproductive; there will be more crises in the future, so that the cost of absolute protection is likely absolute instability or economic stagnation; there are always unintended consequences to seemingly effective new policies; the next crisis will not be a repeat of the previous ones.

We already got a taste of over-reaching with Sarbanes-Oxley, as major foreign multinationals chose to delist their shares from US exchanges and many international companies chose to list in London or Hong Kong rather than in New York.

Today, the legislative ire is turned on the big banks.  In truth, these banks made some horrendous mistakes, such as taking extraordinary risks in order to keep up with the Jones, and some of their high executives showed little sensitivity when the country was reeling.  So the remedy and the punishment are to saddle them with so many regulations and to impose such high capital requirements that they won’t possibly risk to go under again; and they will be made to pay for a long list of safeguards and other measures for the common good.

The truth is that the US economy will not grow without access to credit, and with the demise of securitization, bank credit “is it”.  The other unpleasant truth is that, in a free economy, banks are not obliged to make loans at a loss; in other words, they will pass on their extra costs to their clients.  More pernicious is the apparent belief that erecting a battery of new rules will protect the system, just like the Maginot Line was supposed to protect France from a German invasion.  The real protection will come from vigilant regulators and from enforcing rules that are clear to all and that deal with the fundamentals of banking, such as capital, reserves, proper independence of risk control functions and appropriate incentives.

One of the toxic byproducts of the Great Recession has been the concept of “too big to fail”.  We now have 19 US banks which were designated as too big to fail.  We also have ongoing discussions as to whether they should be downsized enough so as to no longer warrant such classification.  In truth, nobody quite knows what to do about these 19 banks; do they derive an unfair advantage from their new status?  Does this classification strengthen or weaken the US banking system?  Is the state setting itself for a stiffer bill when the next financial crisis erupts?

Historically, it is not the biggest banks that caused financial crashes.  The Knickerbocker Trust which triggered the 1907 crisis was not one of them, but markets worried about it and its affiliates.  Nor was the Herstatt Bank, the bankruptcy of which roiled markets in 1974.  In 2008, Bear Stearns was not one of the largest banks either.  

What these troubled banks had in common were two things: they were big enough and they failed when markets were vulnerable.  A bank doesn’t need to be the biggest to cause concern, but it needs to be big enough for its failure to be noticed and widely reported.  Perhaps more importantly, it very much matters when it fails.  Had Bear Stearns failed in 2006, markets would have shuddered but not gone into a tail spin.  However, if markets are on the edge of panic and a sizeable bank fails, it is only natural for creditors and investors alike to extrapolate and believe that, far from being an isolated accident, this failure is emblematic of the system as a whole.  “If Bank So-and-So had such bad assets, why wouldn’t the others be in the same boat?”

When markets are driven by panic and participants are suddenly unwilling to take on any risk, all bets are off.  Indeed, under such circumstances, whether the US government has the authority to unwind a big investment bank or not, I believe that panic-stricken markets would question which bank was next and if there were sufficient public funds to save the system. 

The 1907 crisis was compounded by the fact that the Federal Reserve Board didn’t exist then, nor did deposit insurance.  The result of the panic was a run on the banks by their depositors.  It is worth noting that the banks that threatened the system in 2008, Bear Stearns and Lehman Brothers, were not deposit takers, as commercial banks are.  Not only did they rely on wholesale borrowings for funding, these borrowings were largely entered on a very short term basis, such as overnight.

Which brings us back to Dodd-Frank and “too big to fail”.  While Citi, Bank of America and others had made shaky loans and poor investments, in 2008 they were not in danger of failing overnight as investment banks were.  They also had intrinsic value, such vast networks of branches and stable deposits; unlike them, investment banks’ most valued assets were staff who could bolt out the door at any time.  Accordingly, it probably makes sense to limit the absolute size of investment banks, and I think that their business models will likely evolve further.

I don’t know how Dodd-Frank will be implemented eventually.  What I do believe is that the biggest universal US banks have gone through massive recapitalization exercises that have endowed them with good quality capital; that they have set up sufficient reserves against bad loans.  They also have gone back to basics, funding loans with deposits unlike some of their bigger international peers that sport ratios of loans/deposits north of 120%. 

Banking crises have always existed, and always will.  They have occurred even in times when debt leverage was much lower than today.  Insufficient capitalization and/or liquidity has often been the cause of bank crises.  But banking is a special activity: what it produces is intangible, invisible; it also deals with money, and not just that of its shareholders, but mostly with that of its depositors and creditors.  For both of these reasons, and unlike any other industry, it relies on trust, or to put it differently, on human emotions. 

For all of the above, a framework based on principles and a reasonable number of clear rules, enforced by willing regulators will achieve better results than one based mostly on thousands of pages of rules.  And rather than avoiding a future big crisis, we should try to set in place a system that will minimize its most adverse consequences.

In the end, those banks that have a strong and positive culture of capital preservation, risk control, client service and where the staff has pride in their institution will not only survive but prosper.  This is difficult to achieve when top performers tend to rotate from bank to bank in search of larger compensation.  Yet as an investor, this is the kind of bank I want to invest in, and there are such banks in the US, Europe and elsewhere.