The next few months will hopefully see an end to panic and crisis, paving the way for numerous changes within the banking industry, writes Charles Pettit...

Fear of the unknown currently stalks the global banking sector. Following the expiry of the United Kingdom’s ban on short selling on 16 January, the share prices of UK financial stocks fell like stones. While markets indicate that investors no longer fear the bankruptcy of these institutions — credit default swap (CDS) spreads have been static for months as default risk has effectively passed to the government — it is the uncertainty of the outcome for shareholders that is driving private capital away from the sector. In the UK, and even the United States, the spectre of nationalisation is the most damaging to share prices.

It is certain that further government intervention will be needed before this banking crisis ends. There are three broad forms that this intervention can take:

• an extension of government and central bank insurance for bank losses;

• full or partial nationalisation; or

• the creation of a 'bad bank' (or aggregator bank) to buy up the bad assets and clean up bank balance sheets.

To date, governments and central banks have tried a patchwork combination of the first two options. The US government has injected in excess of $150-billion of equity into financial institutions via subscription for preference shares and has also begun to guarantee banks against losses on specific portfolios of loans. The government will absorb most of the losses on a $306-billion portfolio of problem assets at Citigroup, while Bank of America (BoA) has received similar assistance for a $118-billion portfolio inherited in the merger with Merrill Lynch. Following the provision of capital to its ailing banks, the UK Treasury has ended up holding 70 percent of the Royal Bank of Scotland (RBS) and 43 percent of Lloyds Banking Group (the combined Lloyds TSB and HBOS), as well as Northern Rock and the asset book of Bradford & Bingley.

The Treasury has also announced an 'asset-protection scheme'. In return for paying a premium — and carrying the first 10 percent of any loss — banks will pass 90 percent of any further write-down to the government.

However, these measures have failed to stem the panic, probably only averting a catastrophe through preventing a large-scale run on the banks or a significant banking failure. This has resulted in growing political pressure for full-scale nationalisation. In Britain, Labour MPs are now calling for the full nationalisation of RBS and Lloyds, but the idea is even gaining increasing traction in America where House Speaker Nancy Pelosi said: "If we are strengthening them (banks), then the American people should get some of the upside of that strengthening. Some people call that nationalisation; I’m not talking about total ownership, but we’re just saying".

'Bad bank'

Despite the risk of being wiped out, there is also a good chance that those buying banking shares now will end up making an absolute fortune. This will be the result if policy-makers end up pursuing the third option — a government-funded 'bad bank' to purchase toxic assets from financial institutions and allow the remaining parts of the bank to operate (almost) as before. Both the Federal Bank and the Federal Deposit Insurance Corporation (FDIC) are currently advocating this approach in the US. The good bank/bad bank terminology dates back to 1988 when America’s Mellon Bank spun off its bad energy and property loans into Grant Street National Bank, which was financed with junk bonds and private equity. However, such purely private solutions are not feasible during crises that encompass the entire banking system, as there is not enough private capital around.

In the early 1990s the governments of Sweden and Finland each nationalised some of their largest banks and set up 'bad banks' to dispose of their assets. Around the same time, America created the Resolution Trust Corporation to sell off the loans and underlying collateral of hundreds of failed savings banks. The aim from the perspective of government is to isolate toxic assets, encourage private money to come in and discourage banks from hoarding their capital.

The attraction for private capital is that, once the uncertainty is stripped from the balance sheets of these institutions, there will be a massive re-rating of share prices. For example, if an investor were to correctly predict that Barclays would not be nationalised and that its balance sheet would be stripped clean of 'toxic' assets then he/she could acquire the shares at valuations that effectively give the investor ownership of large parts of the bank for free. This is evidenced by the fact that Barclays now has a smaller market capitalisation than Absa, of which it owns 59 percent.

A new banking model

Whatever the eventual structure of further intervention, it is clear that governments will do 'whatever it takes' to ensure that the banks survive — their role in the promotion of economic activity is too important to allow them to fail. However, it is also clear that the old model, in which even supposedly staid commercial banks leveraged themselves recklessly, secreted assets off balance sheet and allowed junior traders to bet huge amounts of their capital while being subjected to only limited regulatory oversight, will need to be overhauled radically. Indeed, the vast amount of taxpayer money being deployed to shore up the banking system has created widespread resentment and political pressure, as well as economic common sense, which should provide the impetus for reform.

Perhaps the most important issue is the compensation culture that originated at US investment banks, but became widespread across the Western banking sector. It entailed an asymmetric reward system in which traders and others responsible for lending and investing their bank’s capital receive outsized rewards when their bets go according to plan, but only lose their jobs (at the most) when they don’t. This created a culture of recklessness in which traders took ever bigger and riskier positions in the knowledge that one big payday would be enough to set them up for life, while a wrong bet would rarely cost them personally.

Actions taken at UBS Investment Bank in the second half of 2008 probably point the way forward for the industry, namely the inclusion of a 'claw-back' provision with bonuses. Another approach is simply to pay a larger share of bonuses in bank stock that is 'locked up' for a period of time, say three to four years (while this is already common with managers, it is less so for traders). Over-reliance on mathematical models — such as value-at-risk (VaR) — which assume a normal distribution of returns, will no longer be good enough.

Blindly accepting the default rates predicted by Monte Carlo models, which use historical data to forecast future events, will also no longer be acceptable. Events of the past year have proven this approach fallible because of its inability to factor in changing circumstances such as declining mortgage underwriting standards.

Another area that is certain to see change is the acceptable level of capitalisation for banks. Banks have steadily worn down their capital ratios to the point where banks like Morgan Stanley and Deutsche Bank had balance sheets that were geared by over 40 times the value of their 'core' equity.

Conclusion

The next few months will hopefully see an end to panic and crisis, paving the way for a period in which there will be numerous changes within the banking industry, including an overhaul of the established norms in terms of compensation, risk management and capitalisation. These changes will be driven both by the market and by regulators as the causes of this crisis become clearer. While the details of all of these changes are impossible to forecast at this stage, it is a safe bet to predict that for the immediate future at least, we will see banks that are smaller, better regulated and more conservative than those we have become accustomed to over the past decade.

Published courtesy of Blue Chip magazine

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