Banking: Still crazy five years later

Five years ago yesterday Lehman Brothers filed for bankruptcy. It wasn’t the beginning of the credit crisis, or the end of it, but it was its defining, nameplate event.

The beginning of the crisis can be traced back to June 7, 2007, when Bear Stearns halted redemptions on two of its CDO hedge funds, and it really got underway on August 9 that year when BNP Paribas announced that “a complete evaporation of liquidity” had resulted in the suspension of two of its subprime mortgage debt funds.

Business Spectator launched in late October 2007, a week before the stockmarket peaked, and for the next couple of years Robert Gottliebsen, Steve Bartholomeusz and I worked most nights watching in awe as one of the greatest credit collapses in history unfolded.

Five years later we’re getting more sleep, but the question now is: what, if anything, was learned and has enough been done to prevent the same thing happening again, as it has periodically through history?

The answer is no. It will definitely happen again. The main result of the crisis, apart from the loss of trillions of dollars in retirement savings, is the disappearance of the secondary market in mortgage securities that was so debauched by the bankers who peddled mispriced and mislabelled securities.

The banks themselves are bigger and more powerful than ever; the term “too big to fail” that was coined during the early 1980s credit crisis when Continental Illinois went bust, still applies.

Lehman Brothers was too big to fail, but fail it did after Barclays refused, or wasn’t allowed, to buy it and then Treasury Secretary Hank Paulson, Federal Reserve chairman Ben Bernanke and New York Fed chairman Tim Geithner, meeting over the weekend, decided not to act.

A couple of days earlier they had forced Bank of America to buy Merrill Lynch, two days later they bailed out AIG with a loan of $US85 billion and ten days later the Federal Deposit Insurance Corporation seized Washington Mutual and sold its assets to JP Morgan Chase. But Lehman was allowed to go, and “The Great Recession” was the result.

Five years later the banking industry is even more concentrated (Lehman's ghost haunts banks from beyond the grave, September 13) than it was then, especially in the United States and Australia. That’s partly a consequence of the credit crisis itself – that is, the flight to quality and the demise of a key vehicle of competition – the mortgage securities market.

Regulators have tightened gearing and liquidity requirements so that average bank capital in the US is now double what it was in 2008, but they have failed even to try to break them up. A few months ago the managing director of the IMF, Christine Lagarde, said that “too big to fail” banks had become more dangerous than ever, and needed more controls.

Writing in the Financial Times over the weekend, the former chief of Barclays banks, Bob Diamond, agreed that too big to fail was still a threat: “Without an international plan to wind down an important bank in an orderly fashion, political and regulatory leaders are compelled to create more rules – often to protect national and regional markets and economies.”

Moral hazard and distorted executive incentives still underlie the banking system: banks still have a licence to borrow short and lend long with just a tenth of their loans backed by shareholder capital and they still reward managers for the profit they make rather than the quality of their credit decisions.

The truth is that the monetary system relies on a banking system that is inherently unstable, in which banks are required to take much greater risk than any other corporation.

The roughly 10:1 gearing ratio (or more) on which banks operate is actually the foundation upon which our debt-based system of capitalism rests. The colossal demand for credit from governments, households and companies would be impossible to meet if banks were required to hold as much capital as other businesses.

The whole thing relies on lenders (depositors) being prepared to leave their money with a bank at call, knowing it has been lent out again for 25-30 years.

The reduction in gearing imposed by regulators since the crisis is mere tinkering. Ten to one, twelve to one, it’s all much the same: the system balances precariously on an inverted pyramid of shareholder capital and requires the confidence of at-call depositors to keep going.

As long as bankers are paid according to the size of their assets and profits they will always push the envelope and periodically destroy that confidence and blow their banks up.

Nothing has happened since September 15, 2008 to change that – in fact it has been reinforced by the continuing liquidity operations of central banks, who are still desperately trying to get unemployment down.

In a sense quantitative easing exposes the hopelessly corrupt and circular nature of the problem: the only tool that authorities now possess to increase employment, since governments themselves are too indebted to do anything, is to give cash to banks and hope they lend it, or rather hope that someone borrows it and invests.

In other words the banks that are still too big to fail are being force-fed in the hope that they will once again start doing what causes them to fail.