Rebuilding the banks

A special report on international banking May 16th 2009

BBANKING.inddANKING.indd 1 55/5/09/5/09 14:35:0614:35:06 The Economist May 16th 2009 A special report on international banking 1

Rebuilding the banks Also in this section Exit right The contract between society and banks will get stricter. Page 3

Don’t blame Canada A country that got things right. Page 5

From asset to liability The shifting shape of bank balance•sheets. Page 6

Too big to swallow The future of securitisation is the industry’s most pressing question. Page 9

Opportunity gently knocks Who will gain from the crisis? Page 11

The revolution within A tamer banking industry is already emerging from the debris of the The way banks manage risk will change‹as old, failed one, says Andrew Palmer will the way they reward managers. Page 12 ANKING is the industry that failed. hearing about your annual bonus. Now it B Banks are meant to allocate capital to means getting †red. America’s †nancial• Back at the branch businesses and consumers eˆciently; in• services †rms have shed almost half a mil• More Swedish lessons for the banking in• stead, they ladled credit to anyone who lion jobs since the peak in December 2006, dustry. Page 14 wanted it. Banks are supposed to make more than half of them in the past seven money by skilfully managing the risk of months. Many have gone for good. transforming short•term debt into long• The pain is nowhere near over. The From great to good term loans; instead, they were undone by credit crunch has been a series of multiple Banks will still make money, just less of it. it. They are supposed to expedite the ‡ow crises, starting with subprime mortgages Page 16 of credit through economies; instead, they in America and progressively sweeping ended up blocking it. through asset classes and geographies. The costs of this failure are massive. There are now some glimmers of opti• Frantic e orts by governments to save mism in the investment•banking world, their †nancial systems and buoy their where trading books have already been economies will do long•term damage to marked down ferociously and credit expo• public †nances. The IMF reckons that aver• sures to the real economy are more limited. age government debt for the richer G20 But most banks are hunkering down for countries will exceed 100% of GDP in 2014, more misery, as defaults among consum• Acknowledgments up from 70% in 2000 and just 40% in 1980. ers and companies spiral. In its latest Glo• Apart from the people quoted in this report, the author is Despite public rage over bank bail•outs, bal Financial Stability Report, the IMF esti• grateful to the following people for their help: Viral the industry has also comprehensively mates that the total bill for †nancial Acharya, David Aldrich, Lucian Bebchuk, Markus Brunnermeier, Simon Gleeson, John Grout, Colm Kelleher, failed its owners. The scale of wealth de• institutions will come to $4.1trillion. Naguib Kheraj, Mark Richards, Til Schuermann, Larry struction for shareholders has been With so much red ink still to be spilled, Tabb, Michael Tory, Rick Watson and numerous people at breathtaking. The total market capitalisa• it may seem premature to ask, as this spe• Allen & Overy, the Bank for International Settlements, the Boston Consulting Group, Deloitte, Oliver Wyman and tion of the industry fell by more than half cial report does, what the future of bank• PricewaterhouseCoopers. in 2008, erasing all the gains it had made ing looks like. For most industries, failure since 2003 (see chart 1, next page). on this scale would mean destruction, A list of sources is at Employees have scarcely done better. after all. Banks, notoriously, are di erent. Economist.com/specialreports The popular perception of bankers as The most seismic event of the crisis to date, Porsche•driving sociopaths obscures the the bankruptcy of Lehman Brothers last An audio interview with the author is at fact that many of the industry’s sta are September, demonstrated the costs of let• Economist.com/audiovideo modestly paid and sit in branches, infor• ting a big †nancial institution collapse. mation•technology departments and call• Trust evaporated and credit dried up. ŒOc• More articles about banking are at centres. Job losses in the industry have tober was the most uncomfortable mo• Economist.com/banking been savage. ŒBeing done used to refer to ment in my career, recalls Gordon Nixon, 1 2 A special report on international banking The Economist May 16th 2009

2 the boss of Royal Bank of Canada (RBC). too quickly during this crisis, wiped out by ŒThere was a possibility that the entire glo• Worth less 1 writedowns and by the implosion of busi• bal banking system could go under. Global banking industry, total market capitalisation ness models. ŒThe discounted future pro†t Concerted actions by governments $trn streams of †nancial institutions went from % change on previous quarter since then, †rst in the form of capital injec• quite something to almost nothing in an tions and liability guarantees, and more re• -3.2 -13.2 instant, says Andy Haldane, head of †• cently via schemes to buy or guarantee -10.0 8 nancial stability at the Bank of England. -12.7 loans, have signalled their determination -29.9 Banks recognise this as much as regula• to stabilise and clean up their big banks. 6 tors do. There is a striking degree of conver• Politics notwithstanding, the commit• 4 gence between the thrust of planned regu• ment of governments to defend their latory reforms and the new strategic banking systems removes the existential 2 thinking of many institutions. Greater re• threat to the biggest institutions (or, more silience is a shared objective. Banks are re• precisely, transfers it to sovereign borrow• 0 ducing their dependence on wholesale ers). Bank bosses have learnt not to pro• H12007*H2 Q1 Q2 Q3 Q4 2008* funding and increasing their reliance on 2007 2007 2008 2008 2008 2008 nounce too con†dently about the future. If Œstickier deposits. They are reducing the Source: Boston Consulting Group *Year end the IMF’s loss predictions turn out to be ac• amount of risk they take, which means re• curate, there is still too little capital in the ducing their proprietary trading and con• system. But most think that the chance of counts more slowly. And the assets that are centrating more on clients and activities another Lehman•style blow•up has been now under scrutiny may be much bigger that consume less capital. They are rapidly greatly reduced. than their subprime predecessors but they shrinking their balance•sheets. ŒThe bank• There is still great uncertainty about the are also better understood. ŒThe scale of ing industry got it so wrong and destroyed nature and extent of the support that gov• the recession is unprecedented but it is so much value that it is diˆcult to sit in ernments will end up o ering to their more familiar terrain, says John Varley, front of investors and say we are going to banks. But governments are now deeply the chief executive of Barclays. carry on as before, says Richard Ramsden, embedded in banking systems. They are an analyst at Goldman Sachs. guaranteeing far more retail deposits than The forgotten art The future looks di erent to di erent before the crisis. They are guaranteeing the With government backing assured and im• types of banks. For smaller ones that fall issuance of new debt. They own preferred pending losses somewhat more predict• outside the comforting embrace of the shares in many banks, common equity in able, the big banks are slowly starting to lift state or have less diversi†ed loan portfoli• others and stand ready to inject capital in their heads from the ‡oor. Meetings with os, the outlook is bleaker. American re• others still. Banks that have not taken a investors have been dominated for the gional banks and Spanish savings banks, scrap of government money still bene†t past 18 months by discussions about or cajas, are among those coming under in• from their stabilising presence. ŒWe all ex• banks’ balance•sheets and, in particular, creasing pressure as commercial•property ist at the largesse of the government right the amount of capital that banks had. portfolios su er. Mike Poulos of Oliver now, says a bank boss. ŒThis is my †rst experience of the quarter• Wyman, a consultancy, expects the num• The types of losses that banks now face ly•earnings game where no one has cared ber of banks in America, currently some have also changed. The huge writedowns about earnings, says Bob Kelly, the boss of 8,000 or so, to drop by 2,000 or more as a on trading•book assets that de†ned the Bank of New York Mellon. result of the crisis. †rst phase of the crisis were horribly un• That is changing. Even the biggest vic• Banks in many emerging markets will predictable. The complexity of structured tims of the crisis expect to return to pro†t• su er as the economic climate deteriorates †nance made it diˆcult to know how ability this year. Galling as it may be to con• but they need to deleverage less. There is losses would cascade down the ladder of template the returns that will once again also less need for regulatory change. The investors in securitised assets. The patchy accrue to banks, the rest of us badly need Asian banks kept their exposure to cross• credit histories of subprime and low•docu• them to make money. Just as the prospect border funding ‡ows under control, for ex• mentation borrowers made it hard to mod• of continuing losses is what has stopped ample, unlike their peers in eastern Eu• el default rates accurately. And mark•to• private capital from entering the system, rope. The scale of structural change that market accounting meant that banks were the prospect of future pro†ts is what will these institutions face is relatively limited. valuing illiquid assets at prices which re• lure investors back in to replace govern• But for those banks at the heart of the ‡ected a lack of buyers as much as under• ments. Pro†tability is also critical to the crisis, the household names of Western †• lying credit quality (accounting•standards ability of banks to cover future losses with• nance, the landscape is di erent. Their fu• bodies have since been bullied into allow• out calling on further government cash. ture is secure enough for them to be able to ing bankers to exercise more judgment in The situation is ‡uid but analysts at Bar• plan beyond survival. Their failures have how they classify and value such assets). clays Capital reckoned in March that cum• been big enough for them to know that Although the losses that banks face in ulative pre•tax and pre•provision income everything they do, from the way they their loan books are ugly, they should be at the top 20 American banks for this year, manage their balance•sheets to the way more predictable. Shocks are still likely: for 2010 and 2011 will be $575 billion, just they pay their managers, has to change. instance, the size of the bubble and scale of enough to cover their estimates of losses in But in seeking to work out what the new the bust may overturn historic relation• that period of $415 billion•$560 billion. normality will be for banks, the †rst ques• ships such as that between unemploy• Pro†ts need to be sustainable, of course. tion to ask is how quickly and on what ment rates and credit•card losses. But They may be the †rst line of defence terms governments will disentangle them• losses on loans can be recognised in the ac• against trouble but they disappeared all selves from the industry. 7 The Economist May 16th 2009 A special report on international banking 3

Exit right

The contract between society and banks will get stricter

OTHING highlights the scale of bank• blood, says Bo Lundgren, one of the archi• ingly vocal about their desire to repay Ning’s upheaval better than the inter• tects of Sweden’s vaunted bank•rescue money from the Troubled Asset Relief Pro• vention of governments. An industry that package of the early 1990s, Œand the econ• gramme (TARP). But many bankers also re• embodied the free market turns out to be omy cannot survive without banks. But cognise that they should not be too hasty pathetically dependent on the state for its now that this commitment has been called in their bid for freedom. We are not going survival. In some cases, the civil servants on so dramatically, three questions arise. to pay o TARP money until we are certain are oˆcially in charge. The taxpayer is al• The †rst is how long the state will remain we don’t need it, says a bank boss. ready the majority owner of Royal Bank of so explicitly involved in the industry. The Regulators may not allow relatively Scotland (RBS) and Lloyds Banking Group second is what immediate distortions that strong banks to buy out the government in Britain. The German government is involvement creates. And the third is what early in any case, for fear of a further lurch poised to take control of Hypo Real Estate. additional charges governments will levy downward in the economy and of leaving American taxpayers are set to own the on the industry in future for providing straggling institutions vulnerable to attack largest single stake in Citigroup. In many banks with such a huge safety net today. from short•sellers. ŒThe idea of TARP re• more cases, oˆcials exercise control with• The answer to the †rst question will be payment is a nonsense, steams a Wall out formal representation, imposing pay measured in years. Take Sweden’s bank Street executive. ŒIt all has to be paid back limits and lending targets. The government bail•out. It was more successful than any• at the same time. is the industry’s largest shareholder and one had expected but it still took four years the guarantor of its liabilities. for the liability guarantees to be lifted. Finding a way out Yet the magnitude of this shift can easi• Nordbanken, the seed of today’s Nordea, Even if it is feasible to replace government ly be overstated. Governments routinely was fully nationalised in 1992 and partly equity fairly quickly, most believe that it step in to rescue banks at times of systemic re‡oated three years later but the Swedish will take far longer for governments to exit distress, observes Claudio Borio of the state remains its largest shareholder. their debt guarantees. Banks have lots of Bank for International Settlements. Rating The Swedish policymakers’ task was bubble•era debt to re†nance this year and agencies have long assessed banks’ credit• also less daunting. The bad assets in their next. The coming torrent of government worthiness in part on the likelihood of banks were more homogenous and easier borrowing may make it harder for banks to government support should they get into to value than those currently clogging attract private funding. And the more gov• trouble. Their judgment, as everyone things up. The Swedes intervened at the ernment•backed bank debt is issued, the knows, is not always right. Moody’s was end of a recession, so banks quickly bene• greater the risk of creating another re†• pilloried in early 2007 for awarding gold• †ted from the recovery. Governments to• nancing problem when state guarantees plated AAA ratings to the big Icelandic day have had to step in earlier in the eco• expire. banks on the false premise that the au• nomic cycle, implying a longer period of The second reason why governments thorities in Reykjavik could a ord to res• engagement for two reasons. need to stay engaged is to counter the cue them. But the assumption that govern• First, while loan losses continue to raise banks’ usual instincts during slowdowns. ments will try to help a big bank in crisis is doubts about banks’ solvency, the pres• The obvious thing for banks to do in a re• nothing new. ence of governments will be necessary to cession, let alone one in which trust in This contract to intervene was †rst le• reassure creditors and counterparties. In counterparties has been shattered and a gally recognised after the Depression, America the healthiest banks are increas• credit bubble is de‡ating, is lend less (see when the Glass•Steagall act of 1933 created chart 2). Governments are urging banks to the Federal Deposit Insurance Corporation lend more to prop up the economy, even (FDIC). Since then, similar deposit•guaran• Drying up 2 though in the long term they will want tee schemes have been created around the US commercial-bank credit* them to be more cautious lenders. world to help persuade savers, who are 3-month moving average, % change: The political imperative for govern• otherwise unsecured creditors of their 20 ments to try to make a return on their in• bank, not to remove their money if it gets on previous 3 months, annual rate vestments complicates matters further. into trouble. Indeed, some advocates of 15 Banks will have to look relatively risk• on previous year free markets argue that this guarantee of 10 proof before they can be passed back into compensation helped to cause the current private ownership at a pro†t. All of which 5 crisis, by reducing the incentives for depos• + suggests that governments have to negoti• itors to look closely at their banks. 0 ate a prolonged transition before they will Whatever the merits of that argument, – exit all of their investments in banks or re• 5 it is whistling in the wind to suggest that JASOND JFMAMJJASOND JFM move their liability guarantees. the state should withdraw from its com• 2007 08 09 The longer governments stay involved, mitment to support banks in times of trou• Sources: Federal Reserve; *Excluding Washington Mutual the more they will distort competition. Goldman Sachs; The Economist and money-market assets ble. ŒThe body cannot survive without Normally, private †rms moan about hav•1 4 A special report on international banking The Economist May 16th 2009

tinuing basis is diˆcult because of con• cerns over restrictions on marketing and compensation expenses, says Gary Parr of Lazard, an investment bank. There are also disadvantages to having government•owned rivals. The obvious one is unfair competition. Northern Rock, a British bank which was nationalised in early 2008 and was originally told to shut its doors to new borrowers and shrink its book, abruptly changed course in Febru• ary. It now aims to lend an extra £5 billion ($7.6 billion) in mortgages in 2009, and up to an additional £9 billion in 2010. If gov• ernment•owned banks were to underprice risk for a long period of time in order to meet lending targets, everyone would feel under pressure to respond.

The shadow of the state Let’s be foolhardy and assume the best. Economies start to recover relatively rapid• ly. Governments are able to plot a relative• ly fast exit from their equity investments. And a revival in funding markets allows for a smooth exit from debt guarantees (as happened in Sweden). Even so, the crisis will leave a lasting mark on the terms of trade between banks and the taxpayers who periodically come to their rescue. ŒBanks have to have a licence to operate, which is granted by a common under• standing of what is right and fair, says Hans Dalborg, the chairman of Nordea. Some elements of this new contract be• tween banks and society are already clear. Amendments to bank•capital regimes are certain, although regulators clearly do not want to squeeze banks to raise more capi• tal until credit shortages have eased. There 2 ing to compete with state•backed rivals but you stay with us we will make it up to is now impressive momentum behind the in this case government backing is likely to you’. But eventually competition from idea of a leverage ratio, a measure that puts change from a boon into a handicap. Bank unfettered rivals will tell. a †xed ceiling on the total amount of assets bosses in America who welcomed the ini• Freedom to act on the international that a bank can hold relative to its capital. tial injection of TARP capital have become stage is particularly prized by institutions Some countries, including America, al• progressively less enthusiastic about it. that have not taken government cash. Tax• ready have such a system, and others are Those who have stayed outside the gov• payers have little interest in seeing their fast coming around. The Swiss are intro• ernment net, in terms of equity participa• money used to †nance activities in other ducing just such a ratio for their two big• tion at least, are revelling in their indepen• countries: they want it used for lending at gest banks, which will be phased in by dence. ŒThere is some tactical advantage to home. The dismantling of RBS’s global em• 2013, to sit alongside the international ŒBa• government money but it is deeply politi• pire is the most conspicuous example of sel 2 capital rules. cised, says the boss of a big bank which this type of †nancial nationalism, but pres• Basel 2 takes a di erent approach to has not taken state cash. sure to lend domestically is universal. capital, charging banks on the basis of how Compensation is the obvious example. With many competitors gone, impaired or risky their assets are. These Œrisk weights The top 25 employees at banks that have under the cosh of government masters, will also become far more punitive. Ask su• taken TARP money face tight regulation of banks that have been able to keep operat• pervisors about the biggest ‡aws in the their incentive•based pay until the govern• ing normally in global markets are already previous regulatory framework and many ment has been paid back. Prior bonuses grabbing new wholesale business. Capi• will point to the meagre capital charges are also at risk from punitive tax proposals. tal•raising is easier for independent banks that banks faced in their trading books, That may be sustainable for a while, says too because shareholders and politicians which were based on disastrously optimis• another boss: ŒWe can say for a year or two have di erent priorities. ŒInvesting capital tic assumptions about the liquidity, risk that ‘we value you, you’re a leader and if where government is involved on a con• pro†le and price stability of assets such as 1 The Economist May 16th 2009 A special report on international banking 5

2 mortgage•backed securities. These charges management controls and systems that and what to do about those banks that are are going to be driven higher. banks had in place. That passive approach too big to fail? Both problems have got The liquidity of banks’ balance•sheets will be replaced by a more intrusive and more acute because of the crisis. Deals will also be regulated more intensively. capricious regime, which questions the de• such as the takeovers of Bear Stearns by Britain’s Financial Services Authority cisions of individual institutions. JPMorgan Chase, and of Merrill Lynch by (FSA) has already issued proposed guide• Bank of America, have further blurred the lines on liquidity which will require banks Uncertain times boundaries between retail and investment to hold a greater cushion of liquid assets, Widespread enthusiasm for a more Œmac• banks, not sharpened them. Combina• mainly in the form of government bonds. roprudential approach to regulation‹in tions like those of Wells Fargo and Wacho• The proposals have attracted plenty of crit• which regulators think harder about the via, Lloyds TSB and HBOS, Commerzbank icism but they are indicative of what is stability of the system in addition to the and Dresdner Bank have bloated the big• coming: a more robust approach to liquid• health of individual institutions‹also im• gest institutions, not slimmed them. And ity in general and, in the wake of the Leh• plies a higher level of uncertainty for exec• the trend towards concentration of depos• man bankruptcy and the collapse of the utives. Banks that may be doing a good job its among America’s top banks has acceler• Icelandic banks, greater e orts by national could still †nd themselves subject to high• ated as a result of these deals, for example regulators to safeguard the local opera• er charges if systemic risks are rising. (see chart 4 on next page). tions of foreign banks from the risk of their Countercyclical rules requiring banks to Yet despite some talk about the need for parents getting into trouble. beef up capital in good times and run it a new Glass•Steagall act to separate retail If the regulation of balance•sheets is set down in bad times may well rely on the and investment banking, and for higher to become more prescriptive, other things discretion of authorities. capital charges based on size, the idea of will be designed to increase levels of un• What of the two big structural ques• breaking up institutions does not have certainty. Take the stance of Britain’s newly tions that now dog industry regulators‹ great momentum. No business model has scary FSA. Its previous philosophy meant whether to separate out Œutility retail come through the crisis unscathed and size that the regulator focused primarily on the banks from Œcasino investment banks; is manifestly not the only attribute that 1

Don’t blame Canada A country that got things right

T IS the only time I feel like royalty, it easier for Canadian banks to pull back Perhaps the most striking divergence ŒIsays the boss of a big Canadian bank, when things are getting too risky. between Canada and America is in their describing the reception he now gets in Having a few banks that are clearly too regulation of mortgages. Interest paid on America. He is not the only one basking in big to fail has led to more stringent super• home loans is tax•deductible in America, acclaim. All of Canada’s main banks were vision, including imposing a maximum encouraging people to borrow more; not pro†table in the quarter ending January leverage ratio and a single regulatory re• so in Canada. American mortgages are 31st, when market conditions were at their gime for commercial and investment non•recourse in many states, making it worst. None has needed government in• bankers. Laxer and more fragmented capi• harder for lenders to pursue defaulting vestment. The country’s †nancial system tal regimes allowed the balance•sheets of borrowers; not in most of Canada. (Then has been praised by Barack Obama. banks elsewhere to balloon (see chart 3). again, Britain is like Canada in these re• Trouble is, some di erences between spects but still has soaring defaults). the two countries are culturally ingrained. Canadians taking out mortgages with ŒThe United States has an inherently high• Bank on Canada 3 a loan•to•value ratio over 80% must also er risk appetite, says a banker familiar Banks’ assets, 1997=100, C$ terms take out insurance on them from a federal with both sides of the fence. It is hard to agency called the Canada Mortgage and †nd pre•crisis equivalents in America of 2,500 Housing Corporation (CMHC). The banks the decision by Toronto•Dominion (TD) to Royal Bank of Scotland insure the rest of their portfolios with the exit its structured products business in 2,000 CMHC, which keeps them honest by ap• 2005, or the 20•30% band that RBC im• plying strict standards to the mortgages 1,500 poses on the share of earnings that its cap• they guarantee. Taking out insurance also ital•markets business can contribute. 1,000 brings the risk weighting that regulators Structural di erences matter too. The apply to these mortgages down to zero, Royal Bank Canadian system is an oligopoly of †ve 500 which means that the banks derive no of Canada dominant banks. That dampens price 100 capital advantage from funding them competition: independent brokers origi• 0 through securitisation. Some argue that nate less than one•third of the mortgages 1997 99 2001 03 05 07 08 Freddie Mac and Fannie Mae, America’s in Canada, compared with up to 70% in Sources: Thomson Datastream; The Economist; housing•†nance giants, should likewise America during the bubble. It also makes Royal Bank of Canada; Royal Bank of Scotland guarantee mortgages but not buy them. 6 A special report on international banking The Economist May 16th 2009

2 makes a bank too important to fail. support. Credit•default swaps are vili†ed, Standalone investment banks have Winners take more 4 by contrast, but they serve a valuable func• failed and, as Lehman vividly demon• Top 3 US banks’ domestic deposits, % of total tion. ŒWe will buy credit protection but not strated, were too central to the architecture sell it, buy catastrophe risk [protection] but of global †nance to disappear smoothly. 35 not sell it, says the boss of a bank that has Pure retail banks have imploded too. In• 30 negotiated the crisis successfully. Fine, but vestment bankers archly observe that 25 that implies it is useful for someone to be judgments on which bit of the business is selling these kinds of instruments. Propri• the casino ought to be withheld until the 20 etary trading is harder to defend when it is end of the credit cycle. The woes of Citi• 15 sheltered by a government guarantee but group put paid to the myth of the inde• 10 any bank that acts as a marketmaker be• structible universal bank, even as the suc• tween buyers and sellers will end up tak• 5 cess of Canada’s banks (see box on ing some form of proprietary risk. previous page) showed that a system of a 0 Faced with this untidy set of choices, a few domestic giants can work. 1994 96 98 2000 02 04 06 09* sensible philosophy would not make Source: Goldman Sachs *February Any radical regulatory surgery would hard•and•fast judgments about what busi• also require governments to mark out nesses belong together. Quality of man• some very arti†cial boundaries. Take the unacceptable activities. Peter Sands, the agement, not business models, is better at distinction that some make between de• boss of Standard Chartered, an emerging• explaining the di erence in performance posit•taking institutions, which should be market leader, argues that there are between banks. The right approach con• protected, and wholesale•funded entities, swathes of the industry doing blameless ceptually is a dynamic regulatory regime which should not. With so much whole• but critical things like cash management that looks sceptically at the boardrooms sale funding coming ultimately from indi• and trade †nance for companies that fall and strategies of †nancial institutions and vidual investors in the form of pension outside the de†nition of narrow banking. is capable of intervening e ectively when and mutual funds, that distinction is blur• What is more, any form of lending en• need arises. In any case, systemic changes rier than it †rst looks. tails risk. The extension of credit to a small to institutions’ balance•sheets will have a There are similar problems with de†n• business is one of the riskiest things a bank substantial impact on the types of busi• ing the borders between acceptable and can do, but it wins taxpayers’ unequivocal nesses banks become. 7 From asset to liability

The shifting shape of bank balance•sheets

HE dirty secret of the golden age of †• says a Wall Street veteran. greater cushion beneath them in the capi• Tnance was that it was obscenely easy to Things are somewhat di erent now. If tal structure to protect them against losses. make money. The supply of credit was boardroom discussion in the past decade Shareholders too are belatedly happy to seemingly inexhaustible, so banks could revolved around the asset side of the bal• trade higher returns on equity for a re• fund their expansion at will. Demand was ance•sheet, the next decade will see man• duced chance of being wiped out. So equally insatiable, providing those infa• agers focusing on the liabilities side‹the banks with more equity capital are now mously complex structured products with amount and quality of capital they hold to valued more highly by the market. Be• a stream of ready buyers. The years of protect against losses, and the duration tween 2000 and 2007 there was no corre• plenty disastrously skewed risk models, al• and sources of their funding. Banks will go lation between equity•capital ratios and lowing banks to run with lower capital on from being unconstrained by their bal• the total return on banks’ shares, says Mr the assumption that past performance ance•sheets to being caged by them. Varley of Barclays. ŒNow the correlation is was, contrary to the industry’s standard Start with capital, which has suddenly meaningful. advice, a guide to future returns. And the become the industry’s scarce resource. The amount of capital banks hold is not theory that risk had been dispersed be• That is particularly true today as the pros• the only thing under scrutiny. They also cause of securitisation added to the false pect of further losses continues to unnerve need to have the right kind. Their capital is sense of security. private investors. But it will remain true a mix of common equity, which is †rst in The result for many banks was a strat• after the immediate crisis has eased. The line when losses strike, and various other egy of expanding their balance•sheets by amount of capital that banks have to hold instruments, often hybrids of equity and writing more and more loans and holding will go up, and not just because their regu• debt. A gradual pre•crisis increase in the ever more securities. With risk low, liquid• lators want them to have a bigger bu er proportion of this sort of capital has accel• ity ubiquitous and many institutions un• against losses. erated rapidly in recent months, as com• der †re for appearing to be overcapitalised, The risk weightings on assets are rising mon equity has been eaten up by losses there seemed to be little cost to growth. ŒIf as the e ects of the downturn feed through and governments have largely †lled the we could have an in†nite balance•sheet for into banks’ risk models, forcing them to set gap with preferred shares, which helps to a penny return, we were going to take it, aside more capital. Bondholders want a avoid nationalisation. 1 The Economist May 16th 2009 A special report on international banking 7

2 The curious e ect of this changing capi• debtholders are too exposed to losses. ample. The advantages of running such tal mix has been to bolster banks’ overall Bank debt of all kinds will nevertheless desks have largely gone, says Bill Winters capital bases while disturbing share• be perceived as more risky after this crisis. of JPMorgan Chase’s investment bank. holders, who see common equity as the Investors will not soon forget Washington Finer judgments about the liquidity of only dependable bulwark against losses. Mutual’s failure last September, when as• assets will also come into play. When mar• Thus banks with less of it have been pun• sets and deposits of the Seattle•based thrift kets are less liquid, assets stay on the bal• ished by the markets. ŒIt turns out that hy• were transferred to JPMorgan Chase but its ance•sheets for longer. That exposes insti• brids don’t have much loss•absorbing ca• creditors were left high and dry. Even in tutions to greater risk and ties up capital pacity and are not much use in a period of countries that do not formally prioritise that could be better deployed elsewhere. stress, concludes Mr Ramsden of Gold• depositors over other creditors, as Ameri• Credit Suisse is planning to continue to op• man Sachs. That realisation helps to ex• ca does, the political necessity of reimburs• erate in American residential mortgage• plain why American commercial banks, ing taxpayers before anyone else has be• backed securities (RMBS), for example, despite appearing well capitalised com• come crystal clear. Thanks to Iceland’s where markets are deeper and more liq• pared with their European peers ahead of crisis the creditworthiness of banks will uid, but exit the sludgier European RMBS the crisis, have still had a capital problem. also be far more closely tied to the credit• market, where the bank is forced to hold It also helps to explain the banks’ rush to worthiness of the countries in which they assets for longer. buy back hybrid debt at discounted prices: are headquartered. Businesses that throw o plenty of they can book the gains as pro†ts and use The primary e ect of all these changes earnings without absorbing much capital these to beef up capital where it counts. will be to make it more expensive to ex• or running great risks are naturally in de• Holders of hybrid instruments, as well pand the balance•sheet. Scared bank mand. Take the advisory businesses of in• as of other forms of junior debt, have been shareholders will now demand a higher vestment banking, an area in which plenty given their own reasons to re‡ect. The Brit• risk premium, as will debtholders. Compe• of boutiques make a decent living without ish government’s decision in February to tition for capital and safer forms of debt having a balance•sheet at all. Or custody amend the terms of subordinated debt is• will be greater, as investors demand for• businesses, where banks look after the as• sued by Bradford & Bingley, a nationalised tress•like balance•sheets. And equity will sets of other †nancial institutions. Or asset bank, spooked European markets, for ex• go less far in a world where banks are more management, where someone else’s mon• ample. Bondholders were locked in when constrained in the amount of assets they ey is at risk. The two remaining indepen• Deutsche Bank decided in December not can support with each unit of capital. dent investment banks, Goldman Sachs to redeem a ¤1billion ($1.3 billion) subordi• All this in turn will lead banks to think and Morgan Stanley, have both signalled nated bond at its †rst opportunity. John harder about where they deploy capital. greater emphasis on less capital•intensive Raymond of CreditSights, a research †rm, Executives will ask tough questions about businesses. says investors used to like buying debt activities that absorb lots of capital but lower down banks’ capital structure be• have lower returns now that leverage is Debt dilemmas cause they thought its higher yield over• lower, the risks are clearer and cost of fund• Capital is not the only bit of the balance• compensated for a marginal increase in ing is higher. ŒSome banks’ balance•sheets sheet that will get a lot more attention in risk. Now their thinking has changed. could be expanded inde†nitely in the future. Executives (and regulators) will Senior debtholders, who rank †rst in past, says Paul Calello, the boss of Credit also focus more on the funding pro†le of the hierarchy of unsecured creditors if a Suisse’s investment bank. ŒNow that capi• their businesses in light of the crisis, as the bank is liquidated, have less to worry tal is more scarce the banks have to be even costs of borrowing rise, lenders demand about. In general regulators have stuck to more eˆcient in their balance•sheet and greater security and keener awareness of the standard script of bank bail•outs, in capital usage to maximise pro†tability. liquidity risk informs behaviour. which shareholders take the pain and Dedicated proprietary•trading desks, They will pay greater attention, for ex• bondholders are protected. And a bigger where a group of traders put the bank’s ample, to whether assets can be used as equity cushion should help to reduce the own capital at risk, look much less attrac• collateral for further borrowing. Huw van cost of debt by counteracting fears that tive in this changed environment, for ex• Steenis, an analyst at Morgan Stanley, says 1 8 A special report on international banking The Economist May 16th 2009

2 banks will divide activities between those have exposure to many of these institu• generating collateral that can be placed Wholesale disaster 5 tions anyway. Securitisation markets are with central banks (high•quality mort• Northern Rock’s liabilities, £bn badly damaged (see next section). gages, for example) or is otherwise decent Loan from Covered bonds The second option, and the more im• enough to be used as security (shares, say), Bank of England portant shift, is for banks to increase their Retail and those that do not throw o any collat• Securitised dependence on more stable deposits. The eral at all and therefore consume unse• notes Wholesale most dramatic volte•face has been that of cured funding. The cost and scarcity of this 120 the surviving investment banks, Goldman type of funding means that these business• 100 Sachs and Morgan Stanley, which became es‹equity underwriting is an example‹ bank holding companies in September, will command higher margins. 80 making it easier for them to take deposits. Above all, banks will have a deeper 60 The upheaval in funding pro†les is ar• awareness of funding risk‹their ability to guably greater for retail banks, however. roll over debts as they come due. Institu• 40 Just as capital ratios are now strongly corre• tions that keenly exploited the pricing dif• 20 lated with share prices, so too are loan•to• ferences between long•term assets and deposit ratios (LDRs). Among emerging short•term liabilities paid heavily when li• 0 European countries, where cross•border quidity dried up and they were unable to June 2007 December 2007 capital ‡ows were critical and have now re†nance fast•maturing debts or sell the as• Source: Hyun Song Shin, Princeton University dried up, those with higher LDRs (ie, fewer sets that they held. deposits) have seen their banks’ share To be more precise, the weakness re• curitisation really be blamed for the with• prices dive the most (see chart 6). vealed by this crisis has been in short•term drawal in funding. Northern Rock’s securi• Retail•bank bosses who had †nanced wholesale funding, which rolls over quick• tisation vehicle issued relatively long•term loan growth by tapping wholesale sources ly but does not have the government• notes to investors, so it did not face the of funding are now targeting lower LDRs. backed guarantees that help to keep retail threat of massive redemptions from this Before it was snapped up by Lloyds TSB, depositors quiescent. This type of funding particular quarter. The †rst and most da• HBOS, another stricken British lender, was has been at the heart of the crisis. maging run on the bank took place in its trying to dispose of businesses that were Many subprime mortgage•backed secu• other short• and medium•term wholesale dependent on wholesale funds and there• rities were held in o •balance•sheet vehi• liabilities (see chart 5). fore increased the group’s LDR. Many cles that funded themselves by issuing Faced with this stress fracture in their banks have now imposed limits on asset short•dated, asset•backed commercial pa• funding structures, banks have two obvi• growth, requiring that loans do not expand per to money•market funds and other in• ous ways to respond. The †rst is to length• more quickly than deposits. vestors. When those funds suddenly en the maturity of the wholesale debts A perennial industry debate, on the stopped buying paper, the banks’ liquidity that they have. Some institutions have less merits of bank branches versus other cus• lines to these vehicles abruptly came into far to go than others: the unsecured debt of tomer channels, has been given fresh pi• force. Similarly, the amount of funding that Goldman Sachs already boasts an average quancy by this need to gather in deposits‹ investment banks were doing through maturity of eight years, for instance. But and the branch is likely to emerge strength• overnight repo agreements surged be• when markets get back to normal, funding ened. Studies consistently suggest that tween 2004 and 2007; they were rolling maturities are likely to rise. branch networks with a strong local pres• over one•quarter of their balance•sheets There are limits to issuance of longer• ence are the most e ective way to win de• every day prior to the crisis, making them dated liabilities. A big rise in the propor• posits. Mr Shin’s analysis of Northern Rock vulnerable to a sudden loss of con†dence. tion of long•term bond funding across the contains some fascinating detail on the re• Short•term wholesale funding also industry is bound to be costly, especially tail•deposit run. Despite those snaking helped to sink Northern Rock, one of the since banks will have to compete to attract queues, customers with branch•based ac• earliest victims of the crisis. The bank’s interest from bond investors who already counts were stickier than many others. failure in September 2007 is indelibly asso• Online account•holders ‡ed in roughly ciated with images of Britain’s †rst retail similar proportions to branch customers. bank run since 1866 and is often blamed on LDRs of the pack 6 Holders of postal accounts and o shore its enthusiastic use of securitisation to ex• Emerging European countries’ banks accounts were ‡ightier. pand its mortgage book. Yet a 2008 paper In truth, banks need to have a diverse by Hyun Song Shin of Princeton Universi• ar 100 set of funding sources and maturities, Bulgaria Latvia ty, dissecting the bank’s implosion, sug• Russia whether wholesale or retail. Relying on de• 80 gests that neither the run nor securitisation Baltics posits alone still entails risk. Deposits can n previous ye Romania Hungary was the principal culprit. l o 60 be withdrawn at a moment’s notice, after The retail run on the bank came in mid• fal Turkey Poland all, and government guarantees do not September, when news broke that the 40 stop depositors from discriminating be• Bank of England was providing it with Czech Republic tween institutions: companies and indi• 20

emergency support. Yet Northern Rock hares, 2008, % viduals alike want to avoid the hassle of had been experiencing funding problems 0 having to retrieve deposits from a failed since mid•August. The retail run came after Bank s 0 40 80 120 160 200 240 bank. There will be a bigger question to the bank had already been destabilised by Loans as % of deposits, 2007 consider as well. Are there enough depos• Source: Citigroup wholesale•funding problems. Nor can se• its to go round? 7 The Economist May 16th 2009 A special report on international banking 9

Too big to swallow

The future of securitisation is the industry’s most pressing question

NE of the canards of the credit crisis, in 2007 was just $850 billion. Otrotted out regularly by politicians Supposing for a moment that the banks and pundits, is that banks have stopped actually wanted to take on the credit risk lending. It is a charge that bankers vehe• associated with these assets, the sums sim• mently reject and the data largely back ply do not add up for two reasons. First, them up. It is true that overall ‡ows of cred• taking securitised assets back on to bank it have fallen steeply. Yet analysis by Oliver balance•sheets implies extra demand for Wyman, a consultancy, suggests that net capital that would be very hard for banks lending by American banks, for example, to meet in benign circumstances, let alone has contracted by amounts that are broad• these ones. ly in line with previous recessions, when Second, plenty of banks depend on se• demand for credit naturally diminishes curitisation for a big chunk of their own and lending standards inevitably tighten. funding, so they would have to replace this Indeed the worry of some observers, giv• source of †nance with deposits. In most en that easy credit got us into this mess, is mature markets, savings penetration is al• that banks are still lending too much. ready relatively deep, so there are limited The really precipitous contraction in options for driving deposits higher still. credit has come from non•bank lenders‹ There is greater capacity to increase depos• the array of money•market funds, hedge its in emerging markets, where there is funds, former investment banks, ex• more cash under the mattress (see chart 8, change•traded funds and the like that is when the Long•Term Capital Management next page), but doing so takes years. ŒYou sometimes called the Œshadow banking hedge fund failed in 1998. cannot be disintermediated over ten years system. These capital•market lenders are Some of these things happened this and then reintermediated in a month, especially important in America‹banks time too. Liquidity lines from banks to o • says Mr Nixon of RBC. Hence the near•uni• have supplied only 20% of total net lend• balance•sheet entities such as conduits versal agreement that securitisation needs ing in the country since 1993 (see chart 7, and structured investment vehicles (SIVs) to be revived. left•hand side)‹but they play an increas• were activated as securitisation markets ingly important role elsewhere too. evaporated. Bank executives report heavy Resuscitation procedures In particular, non•bank lenders have loan demand as a result of the collapse in If only it were that simple. The intellectual been buyers of securitised products, loans non•bank credit. Some savings ‡owed into case for securitisation certainly remains that are bundled together into securities banks too. The problem is that the amount strong, and not just because without it, de• and sold on to investors. An estimated $8.7 of money needed from the banks this time leveraging will be even more painful. trillion of assets worldwide are funded by around is so vast. Oliver Wyman calcu• Banks that have concentrations of risk in securitisation. More than half of the credit lates that in the †rst three quarters of 2008, their portfolios can reduce them by selling cards and student loans originated in lending via capital markets in America assets to other investors. Those investors America in 2007 were securitised. Many shrank (on an annualised basis) by $950 who cannot extend credit directly to indi• European banks used securitisation to billion. In contrast, banks’ total net lending viduals or small businesses can get expo•1 fund the expansion of their loan books in the boom (see chart 7, right•hand side). There is a stylised model of what is Out of the shadows 7 meant to happen when the shadow bank• US banks’ net lending, % of total credit European bank system, loans as % of deposits, Dec 2008 ing system contracts, in which banks act as Œlenders of second•to•last resort. Borrow• 80 140 AVERAGE 1952- ers who can no longer get money from cap• 1992=39% 60 130 ital markets can call instead on contingent AVERAGE 1993- funding commitments made by the banks. 2008=20% And banks can fund their expanded asset 40 120 base because at the same time deposits are 20 110 attracted into the banks by the comfort of + deposit insurance. A 2005 paper from Evan 0 100 Gatev and Philip Strahan of Boston Col• – lege and Til Schuermann of the Federal Re• 20 Britain France Euro Spain Italy Germany serve Bank of New York showed how this 1952 60 70 80 90 2000 08* area Sources: Oliver Wyman; Citigroup *Q3 ‡ight to traditional banking operated 10 A special report on international banking The Economist May 16th 2009

2 sure to these assets via securitisation. ŒWe troubled o •balance•sheet assets to help their balance•sheets. European banks didn’t come out of the internet bubble and their clients. That reputational exposure which operated only under a risk•weight• say that we should give up on venture cap• will surely attract a more explicit cost in fu• ed capital regime were able to buy those ital, says a regulator. ture. Coming changes to FAS140, an Ameri• very same assets because they attracted a Optimists point out that some of the can accounting rule for o •balance•sheet low capital charge. With risk weightings on worst excesses of the market have already assets, will also mean that banks can no the rise, and leverage ratios all the rage, the gone. Ludicrously complex securitised pro• longer claim capital relief by securitising capacity of European banks to purchase ducts, the CDO•squareds and •cubeds, assets through special•purpose vehicles. these assets is shrinking. have gone forever. Greater emphasis on Second, many buyers of securitised Money•market funds, which invested the quality of borrowers will mean that products are also likely to be more con• heavily in securitised products, will also risk should become more predictable. strained in future. Leveraged investors, be more constrained. One of the most un• ŒThe problem comes when you start secur• such as some hedge funds, are going to †nd nerving moments of the crisis was the itising things for which you cannot com• it harder to gear up, making the returns on massive out‡ow of cash from these funds pute the odds of default, says Stephen securitised products less attractive. after the announcement by one of them Cecchetti, chief economist at the Bank for Banks themselves, also important buy• last September that it had Œbroken the International Settlements. Even if those ers of securitised products, will have less buck, meaning that its net asset value had predicted default rates are high, the risk room for manoeuvre too. Matt King, an an• fallen below $1 a share and investors were can be mitigated by techniques such as alyst at Citigroup, believes that the surge in going to get less back than they had put in. overcollateralisation, where there is an ex• securitisation during the bubble can partly With $3.4 trillion of assets under manage• cess of loans to cover losses. be explained by a massive mismatch be• ment, allowing a run on money•market There is also an emerging consensus on tween the regulatory regimes of American funds was unthinkable. The American how to †x securitisation’s biggest ‡aw, the and European banks. Those American government stabilised the market with a moral hazard which meant that origina• banks whose regulator imposed a leverage temporary guarantee that investors would tors had less incentive to care about the ratio had an incentive to move assets o not lose money. quality of the business they wrote because The issue is what kind of quid pro quo they thought the risks were someone else’s money•market funds will now face. There problem. By making issuers take the †rst Banking on the unbanked 8 is a particular focus on their break•the• loss on any defaults in the securitised pool Savings and investments as % of GDP, 2007 buck commitment, which means that they of assets (and stipulating that they cannot mimic a bank by engaging in maturity hedge that exposure away), regulators will 0 25 50 75 100 125 150 transformation while promising share• give them a clear incentive to think about Switzerland holders that they can get all their money asset quality. Japan back whenever they want it. A choice is This goal of aligning the interests of is• Belgium looming for the industry‹either to keep suers and investors also explains oˆcial South Korea this commitment and submit to greater enthusiasm for covered bonds, a type of regulatory oversight, potentially including Italy secured•funding instrument in which capital charges, or to drop it and make Canada creditors have recourse to both assets and shareholders understand the risk. the issuing bank. By keeping all the assets United States Neither outcome is great for securitis• on the balance•sheet, however, a surge in China ers. If money•market funds keep the break• covered bonds would still require banks to Ireland the•buck promise, they are likely to move †nd a lot of additional capital. That cost is Austria into more liquid asset classes than securi• more manageable if banks keep some ex• Germany tised products. If they abandon it, they will posure but sell most of the securities to Britain demand even higher yields on securitised other investors who have no recourse. As• Australia assets or even greater amounts of credit sume a risk•weighting of 20% on a portfo• Netherlands enhancement, which inevitably means lio of high•quality mortgages, calculates Ja• Greece higher borrowing costs for issuers. (On the mie Dimon, JPMorgan Chase’s boss, and ‡ip side, if funds produce lower yields or Spain retaining a 10% slice of a $50 billion pool of more risk in future, that could lead inves• mortgages would imply a capital charge of Denmark tors to keep more of their money in banks). $80m. ŒThat’s doable, he says. India Even for long•term investors‹think of There is broad agreement on how a re• Finland pension funds and insurers with long•dat• vived securitisation market would work Sweden ed liabilities of their own‹likely levels of (high•quality assets, simple products, France demand for securitisation are horribly some retained risk on the part of the issu• Poland murky. Rating agencies are going to be far er). But big worries remain. First, regulators Norway more wary of giving AAA ratings for struc• may impose higher capital charges on Indonesia tured products. Since many of these inves• banks for the contingent risks they run as a Russia tors have to put their money into top•rated result of securitisation. Banks were not just Brazil products, that implies a smaller market. undercharged for the formal liquidity lines When AAA ratings are awarded, inves• Turkey they o ered to conduits and SIVs; they Savings tors will in any case derive less comfort were also undercharged for reputational Mexico Investments from them. That is partly because of the risk, the informal obligation to reabsorb Source: Oliver Wyman high•pro†le failures of rating agencies and 1 The Economist May 16th 2009 A special report on international banking 11

2 partly because investors are rethinking Government intervention in America and years but two assertions look pretty safe. their assumptions about the supposed di• elsewhere to ease homeowners’ repay• The †rst is that the market for securitisa• versi†cation bene†ts of securitised pro• ment diˆculties will shake investor con†• tion will shrink substantially. Borrowers ducts. A large portfolio of securities clearly dence in future income streams. The pros• are scaling back, buyers are thinner on the o ers greater protection against idiosyn• pect of court•ordered reductions in ground, risk aversion is up and banks are cratic risk‹the chance that a particular bor• mortgage principal‹or Œcramdowns‹is in any case under pressure to improve rower will get into trouble‹than buying a particularly alarming. According to Anna their loan•to•deposit ratios. The second is single•name corporate bond, say. But as a Pinedo of Morrison & Foerster, a law †rm, that the extent of banks’ continued deleve• paper by Joshua Coval and Erik Sta ord of there is also fogginess around the tax status raging depends to a large extent on the Harvard Business School and Jakob Jurek of securitisation trusts, the entities into scale of that drop. of Princeton University argues, a diversi• which securitised assets are placed. For tax The wild card, of course, is the degree of †ed portfolio o ers far less protection purposes, they are structured as Œpass• long•term support that governments are against systemic risk such as a general eco• through entities, meaning that the servic• willing to provide to buttress the market, nomic downturn. The chance of losses on ing †rms that administer mortgage pay• whether through guarantees, loan pro• securitised products increases as the econ• ments have little scope to modify the terms grammes for investors or future incarna• omy worsens; for single•borrower bonds, of loans if borrowers get into diˆculty. tions of government•sponsored enter• †rm•speci†c factors are more important With servicers now given greater leeway prises such as Freddie Mac and Fannie than the economic climate. Growing to intervene, questions about how far they Mae. Whisper it softly, but one of the last• awareness of this disproportionate expo• can go without compromising trusts’ tax ing e ects of this crisis could end up being sure to systemic risk may reduce investors’ status hang over the industry. institutionalised guarantees for buyers of appetite for securitised products. How these various uncertainties re• securitised assets to sit alongside guaran• The uncertainties do not end there. solve themselves will not be known for tees for retail depositors. 7

Opportunity gently knocks Who will gain from the crisis?

ESTRUCTIVE? Absolutely. But will interest rates are encouraging savers to tomers are low, because they already have Dthe †nancial crisis also be creative? seek better returns elsewhere. Zopa, a Brit• millions of shoppers passing through When incumbents disappear and estab• ish website that pioneered the concept, their stores. Their brands are trusted. And lished business models no longer work, says the number of lenders joining it has those who have seen how retailers work that is usually good news for up•and•com• soared. For borrowers spurned by their with banks in joint ventures consistently ers. The massive disruption in banking banks, low•cost and unleveraged social note how much more focused grocers are has members of the industry’s fringe rub• lenders are an attractive alternative. on the customer’s needs. ŒRetailers think bing their hands. They include: Zopa’s boss, Giles Andrews, says new en• †rst about the customer, banks about the Advisory boutiques. ŒLike gnats is trants like his should gain from how the pro†t, says an executive. Britain’s Tesco how an executive at a big investment crisis has undermined customers’ faith in announced an ambitious expansion of its bank describes boutiques. Without †• banks’ solidity and intensi†ed their banking activities in March. nancing capacity, a global presence or big doubts about whether the banks have Just how capable non•banks are of tak• capital•markets businesses, they lack the customers’ best interests at heart. ing big chunks of the market is unclear. †repower of bigger rivals. But the crisis Islamic †nance. This was booming The downturn is hitting most institutions, has nevertheless increased their capacity before the crisis, thanks to oil•fuelled li• retailers included. Regulators will also to irritate the giants. Clients’ faith in the quidity in the Gulf, rising devoutness have a big say. The rules may have been advice of the industry’s big names has among Muslims and a fast•developing tweaked to make it more attractive for been badly dented by their conspicuous market infrastructure. But its emphasis on private•equity †rms to invest in American inability to manage their own businesses. risk•sharing and prohibition of specula• banks, for example, but Douglas Landy of Many banks have damaged client rela• tion has a fresh resonance given the fail• Allen & Overy, a law †rm, expects con• tionships more directly, by skimping on ures of Western †nance. Its backers stress tinuing hostility to the idea of non•banks credit as they slim their balance•sheets. the ethical side of sharia•compliant †• owning banks. And serious questions Con‡icts of interest for large banks are nance. However, the Middle East is su er• hover about whether it makes sense to en• also more common now that their ranks ing its own economic headwinds and the courage more competition in banking. have thinned. And boutiques have lots of industry’s fundamental problems, includ• ŒAnything that smacks of loosening regu• high•quality job•hunters to choose from. ing an over•reliance on short•term fund• latory standards is going to be politically Peer•to•peer lending platforms. ing, have yet to be solved. hard, says Andrew Schwedel of Bain, a These websites, through which savers Supermarkets. They see the crisis as consultancy. There are great opportunities pool money and lend to borrowers, have an opportunity to push further into †nan• lying among the debris of the banking in• also been boosted by the crisis. Derisory cial services. Their costs of acquiring cus• dustry but reaching them may be tricky. 12 A special report on international banking The Economist May 16th 2009

The revolution within

The way banks manage risk‹including how they reward managers for taking it‹will change greatly

HE changes to the environment in cut their proprietary activities in illiquid McKinsey, Œas managers see real detail on Twhich banks operate‹tougher regula• markets and focus on high•volume Œ‡ow who is making money and how. tion, higher capital requirements and businesses: for example, helping clients to The mechanics of risk management are scarcer funding‹will have a dramatic im• manage exchange•rate and interest•rate also in upheaval. Articulating how much pact on the way that banks are managed. risk. That means leaving some money• risk to take or deciding how much to But banks are also re‡ecting hard on some making opportunities on the table, a most charge internally for a certain activity is fundamental internal questions, such as unbubble•like thing to do. ŒWe could have less clear now that many banks’ risk mod• how to manage risk, compensation and held on to certain assets and made money els have proved unreliable. (The impres• growth itself. Too many bosses and share• now but we cannot have this kind of risk sion of additional uncertainty is itself holders accepted years of double•digit re• irrespective of future potential, says Josef partly illusory: the clarity models provid• turns without probing the sources and sus• Ackermann, the boss of Deutsche Bank. ed during the bubble was misleading.) tainability of those pro†ts. ŒNo one was In truth, the crisis will make models asking the ‘Columbo’ questions, says Fireproo†ng more useful. They will be using data from a Toos Daruvala of McKinsey, a consultancy. Banks are also taking measures to ensure whole economic cycle rather than looking The most basic of these questions, par• that a poor year in more volatile business• myopically at a period of exceptionally ticularly for banks with large wholesale es cannot overwhelm a decent year in high returns. The improved risk pro†le of operations, is what kind of businesses steadier ones. And they are reviewing the banks’ borrowers also means they will they want to be. The bubble was character• appropriate mix of earnings between divi• have better data to work with. Method• ised by a game of copycat, in which banks sions, given the capital•intensity and risk ological improvements will capture the re• strove to match the returns of their most pro†le of some activities. The †rewalls be• lationships between institutions‹the ef• pro†table rivals by piling headlong into as• tween businesses are being forti†ed, too, fect on its peers of Lehman Brothers going set classes where they were lagging, irre• so that managers have a clearer idea of the bust, say‹as well as their independent risk spective of the risks. ŒThe securities indus• standalone pro†tability of each division. pro†les, which are commonly assessed by try was based on revenue, not on UBS was especially guilty of underpric• a measure called Œvalue at risk (VAR). To• risk•adjusted returns, says a bank boss. ing its internal funding, letting its invest• bias Adrian of the Federal Reserve Bank of Consultants armed with league tables ment bank take advantage of the bank’s New York and Markus Brunnermeier of and presentations full of Œgap analysis in• cheap overall cost of funds without paying Princeton University have proposed a creased the pressure on sluggards to catch an appropriate premium for the risks it measure called CoVAR, or Œconditional up. Mr Winters of JPMorgan Chase recalls was taking. The Swiss bank has reorgan• value at risk, which tries to capture the how executives at the bank worried about ised itself to ensure that businesses are risk of loss in a portfolio due to other insti• its underperformance in †xed•income more autonomous and are funded at mar• tutions being in trouble. Taking account of markets. ŒWe used to beat ourselves to ket rates. Such changes arguably have such spillover e ects greatly increases death about it and wonder ‘what aren’t we more impact than any regulatory reforms. some banks’ value at risk (see chart 9). getting right?’ Now we know. For the fore• ŒThe real revolution will be within the Despite such improvements, risk man• seeable future, managers will think harder businesses, says Charles Roxburgh of agers are well aware of the need to beef up about where they have a competitive ad• their qualitative controls too. Stress tests, vantage over rivals, not where they don’t. designed to think through how institu• Besides working out what they are Even more at risk 9 tions cope with periods of pressure, will good at, banks must decide how much risk Selected British banks, post-2007 crisis, %* become more important to boards as they they want to take. Helped along by the seek to de†ne institutions’ risk appetite. Value-at- VAR conditional on ratcheting•up of capital charges in trading risk (VAR) other institutions being They will also become more important to books and other planned regulatory in distress (CoVAR) shareholders. Bank of New York Mellon changes, a sweeping shift in risk appetite is 20 has started to include †gures in its earnings already under way. There are obviously statements showing what could happen to distinctions between †rms: Goldman 15 its capital under various scenarios. Sachs has maintained a stronger bias to• Stress tests will also become more de• 10 wards risk exposure than Morgan Stanley, manding. Take the assumptions about for example. But in general proprietary 5 how long liquidity can disappear for. Mea• risk•taking is being scaled back drastically. sures such as VAR seek to capture the ef• 0 Risk capital will reside outside the banking 1 2 3 4 5 6 7 8 9 fects of a single explosive event within a system, in hedge funds and private•equity Banks (names withheld) relatively short period. This crisis, says †rms, much more than before. *The return on the bank’s share price relative Koos Timmermans, chief risk oˆcer of The likes of Deutsche Bank, UBS and Sources: Bank of to the risk-free return has a 10% chance of ING, a Dutch bank, has been Œmore like Credit Suisse have all unveiled strategies to England; Bloomberg suffering a fall at least this great slow death by torture. Peter Neu of the 1 The Economist May 16th 2009 A special report on international banking 13

2 Boston Consulting Group says stress tests ther to calculate the size of their bonus must also become more Œcoherent. Too Risk-free returns 10 pool or to allocate it. That will change (see many banks de†ned stress events in isola• Banks’ use of risk adjustment in bonus calculations chart 10). Economic•capital models, which tion‹asking what kind of losses they % of total respondents calculate the use of capital based on as• might sustain in the event of, say, a 20% sumptions about expected losses, will be stockmarket fall without asking what sorts 0 10 20 30 40 more widely used to set bankers’ pay in fu• of changes in the economic climate would Not used, plans ture. The bonus/malus structure intro• to implement prompt a fall that big. duced by UBS in 2008, whereby a cash por• Used in generating and Even Goldman Sachs, widely regarded allocating bonus pool tion of a bonus award is held back at the as the best manager of risk in the industry, Used in generating or end of a †nancial year and reduced if tar• did not foresee quite how bad things could allocating bonus pool gets are not met in subsequent years, will get. The bank’s most demanding pre•crisis Not used also become more common as institutions stress test‹known as the Œwow, or worst seek to track and reward the performance Source: Institute of International Finance, survey of the worst, test‹took the most negative of senior managers over time. events to have happened in each market Some banks will be more sophisticated since 1998 and assumed that they got 30% touchstone issue of the †nancial crisis, vil• still. With costs and capital under so much worse and all happened at the same time. i†ed both as the incentive that drove bank• pressure, the incentive for executives to That still wasn’t pessimistic enough. ers to take foolish risks as well as the most identify those who add genuine value to a Banks must revisit their assumptions inequitable feature of an industry that bank has rocketed. A few banks already try about how e ective their defences are makes obscene pro†ts in the good times to adjust, when calculating bonuses, for against multiple risks. The crisis will live and comes crawling to the taxpayer when franchise value‹the advantage derived by long in the collective memory for showing it gets into trouble. From the bonuses paid employees from the bank’s brand value, that all markets can become illiquid and all to executives at AIG, a monumentally league•table positions and other institu• risks are correlated, removing many of the failed insurer, to the expensive tastes of tional strengths. An industry veteran says bene†ts of diversi†cation. ŒThe fourth John Thain, a former head of Merrill that more managers of big banks will quarter of last year was remarkable for Lynch, and the huge pension granted to Sir come to realise that they do not need to showing how fragile the system has actu• Fred Goodwin, a former boss of RBS, pay pay twice over for the same bit of business, ally turned out to be, says Wilson Ervin, has captured the public’s attention, far †rst by building a global infrastructure and chief risk oˆcer of Credit Suisse. more than the banks’ many other failings. then by rewarding an investment banker. The inadequacy of speci†c hedges, Managers admit privately that things ŒThey would get one in †ve calls for big something known as Œbasis risk, also got way out of line. ŒIt was better to be an projects anyway, he says. came as a shock to many. A corporate bond employee than a shareholder, says a Other ideas in the vanguard of design• and a cash•collateralised credit•default bank’s chief executive. The traditional ar• ing pay structures include ŒS•curves, swap written on the same company ought gument against changing pay structures which pay less below a certain threshold to o set each other‹if the company looks has been that no institution could move of pro†t so as not to reward employees for likely to default, the bond will fall and the unilaterally without competitors poaching market conditions and franchise value, but swap rise. In late 2008 the system•wide its best people. Now, no bank can fail to al• also pay out less above a certain threshold, evaporation of liquidity meant that banks ter its compensation policy without hav• to discourage excessive risk•taking. These could lose money on both. ing its executives publicly humiliated by types of thinking are likely to become A degree of calm has returned to the politicians and the news media, and more prevalent. markets since then, reversing some of the frowned upon by regulators. Many of these changes are welcome, losses banks su ered from basis risk. The The broad thrust of the coming changes with two caveats. First, no system can be amount of counterparty risk in the system on pay is clear. Banks will tie compensa• foolproof. Risk•adjusted measures of com• will be reduced greatly by central clearing• tion more closely to performance and pensation work only if risk is being mea• houses for credit•default swaps. But con†• spread rewards over longer periods. It sured properly, for example, and the indus• dence in hedges and market liquidity as a should be said that neither idea is foreign try has proved how unsafe an assumption way of mitigating risk has been badly to the industry. Bonus pools based on pro• that is. And attempts to control pay in one damaged. In response, banks will use a †ts (though not revenues, an indefensible area tend to in‡ate it in another. As bonus• simpler set of palliatives. They will take practice) may be seen as a problem now es fall, pressure on banks to increase basic greater account of their gross as well as net but are clearly more closely tied to perfor• pay is already rising. That pressure will exposures. They will charge more for tak• mance than a †xed base salary. Awards of grow as the industry recovers and compe• ing on risk on clients’ behalf. And to the ex• shares were common within the industry tition for the best sta increases. ŒAt some tent that they continue to package and sell before the crisis and caused employees, point in the next few years, the industry is securitised assets to investors, they will re• those of Lehman Brothers included, to suf• going to have an absolutely stellar year, duce the amount of inventory they hold. fer vast losses when share prices dropped. says a pay consultant who predicts that What the industry as a whole did not do †rms with clawback policies will have to A game of pay sense well enough was to design pay so that it o er more in upfront pay to attract recruits. All of these aspects of risk management, better re‡ected long•term risk. The second caveat is that some employees from models to hedges, are important. But According to a survey of industry prac• really are worth lots of money. Asked to another risk•related question‹bankers’ tices published by the Institute of Interna• defend levels of pay prior to the crisis, pay‹has dominated the public debate on tional Finance (IIF) in March, many banks many in the industry would reach for the the industry’s failures. Pay has been the still fail to use risk•adjusted measures ei• analogy of †lm or sport, two other indus•1 14 A special report on international banking The Economist May 16th 2009

More Swedish lessons for the Back at the branch banking industry

F A bank posts record results during the principle‹namely, that you should do environments like this one. There are no Iworst quarter in living memory for †• business only as far you can see from the formal budgets or projections for the year nancial markets, it could be a quirk. When local church tower. Responsibility for all ahead, on the principle that customer the same bank has produced higher•than• credit decisions rests with the branches. needs, not product targets, should deter• average returns on equity compared with No loans can be extended over the heads mine growth. Handelsbanken eschews its peers for a number of years, it deserves of branch managers (larger sums also re• bonuses too, on the grounds that they a closer look. And when it has a business quire approval from higher up). work against long•term relationships model that appears to answer some of the The bank is unimpressed by the idea of with customers and employees. If the main governance concerns a‰icting the selling loans on to other investors. Ulf bank meets its return•on•equity goals, industry, it repays much wider attention. Riese, the bank’s chief †nancial oˆcer, however, a portion of the pro†ts goes into The bank is Sweden’s Svenska Han• says 30% of credit losses can be traced to the bank’s pension scheme, which is its delsbanken, a retail bank with operations the initial decision to extend credit but largest shareholder. in Scandinavia, Britain and elsewhere. 70% come from changes in borrowers’ cir• Is Handelsbanken just a Scandinavian Handelsbanken posted a 39% quarter•on• cumstances and the way banks respond oddity or can it teach others something? quarter jump in operating pro†ts in the to them. Banks need to have deep custom• Its approach works in part because it is se• fourth quarter of 2008. It has gobbled up er relationships to spot and respond to lective about the types of customers it great chunks of market share in deposits these changes, he says. If loans do sour, takes on. A mass•market bank would †nd and new lending in the past year. The Handelsbanken has no specialist central it tougher to copy its model and be pro†t• worst of the economic downturn is yet to workout team, like those at many other able. Mr Riese reckons that the bank’s ini• come in Sweden but the bank has good banks, to come in and sort out the mess. tial shift to a decentralised model was reason to believe it can navigate stormy The job is left to branches, which similarly helped by the fact that lending growth waters, since it sailed through the coun• have responsibility for cost management, was very tightly regulated in Sweden at try’s 1990s banking collapse unscathed. salary levels and product o erings. A tier that time. Handing full control to The bank’s managers put its success of regional management makes the deci• branches would lead to more missteps in down to an extremely decentralised man• sions on where to open new branches. a deregulated market. But the bank’s core agement model, introduced in 1972 after a The e ects of making branches re• philosophy‹a focus on customers, not period when Handelsbanken had got into sponsible for their own fate run deep. The products; on pro†tability at the level of trouble. Branch managers are the banks’ bank’s credit culture is consistent through• each operating unit; and on long•term re• main decision•makers, following what is out the cycle, meaning that it loses market lationships, not short•term gains‹is clear• known internally as the Œchurch•tower share in boom times and wins business in ly of its time.

2 tries where talented individuals are critical result, for example, will be that lenders de• And that raises a bigger management to success and are richly rewarded as a re• mand more data on customers, leading question‹how institutions can resist the sult. The trouble with this defence is that it borrowers to concentrate more of their pressure to grow when a boom is in pro• was not just the big•name stars who got business on particular institutions. But the gress. Such pressure comes from all quar• really rich in †nancial services; the extras basics of credit•risk management have ters: from shareholders who want growth, did too. Lower pro†ts and more sensitive been reinforced rather than overturned. from analysts who want to see higher re• pay structures will mean that most jobs are There is a problem with this picture, turns on equity, from sta who want bo• repriced across the industry but the best however. Retail banks may have less to nuses, from managers who want to keep people will still be the subject of frenzied change operationally (their funding pro†le their jobs, and from politicians who want competition and will still command huge is the obvious exception) yet they still got higher employment and tax takes. One sums. That may be distasteful to many out• into a ton of trouble. The worst mistakes of way of getting around this is to operate in siders but if pay structures better re‡ect in• this crisis were arguably made in relatively markets that o er high growth without re• formation about the risks such star bank• simple areas of retail and commercial quiring great risks. ŒWe run a boring busi• ers are taking and if their pay levels do not banking‹from the concentration of risk in ness model in exciting markets, says Mr in‡ate the compensation of everyone the corporate•loan book of HBOS to Wa• Sands of Standard Chartered, which is around them, it ought to be defended. chovia’s kamikaze acquisition of Golden headquartered in London but operates in The biggest upheavals in pay and in risk West, a Californian lender stu ed full of developing countries. ŒThe problem was management will be in wholesale bank• mortgage•shaped grenades. Complexity is that others were running exciting business ing. The assumptions that underpin the not much of an excuse here. For many models in boring markets. way retail banks manage risks and pay banks, the crisis re‡ects a simpler tale of Industry bosses agree that saying Œno have withstood the crisis better. There are frenetic asset growth and the inevitable to opportunity is one of their most impor• still lessons to be learned, of course. One turn of the credit cycle. tant jobs and among their most diˆcult. 1 The Economist May 16th 2009 A special report on international banking 15

2 Those who did sit out some of the boom management, a job for bank executives. als can avoid being obsessed with short• were heartily criticised for doing so. Ed ŒDirectors do not design aeroplanes for term growth targets and can live with peri• Clark, the boss of Canada’s TD, recalls the Boeing or make the food for Taco Bell, ods of reduced pro†ts. Then again, Nation• heat he got from analysts for exiting the says Mr Dimon of JPMorgan Chase. wide has spent much of the crisis snapping structured•products business. Ulf Riese of But it does mean that they can do a bet• up other mutuals that have got into trou• Svenska Handelsbanken (see box on previ• ter job of vetting key executive appoint• ble, so the model is not infallible. ous page) remembers the pressure that the ments‹for example, the rise of Chuck With quality of management being bank resisted to join its peers in the Baltic Prince, a lawyer, to head Citigroup and of both the best defence against bank failure lending boom. Mr Timmermans, the risk Andy Hornby, a youthful former retailer, to and something that can change with the chief at ING, points to the problem of get• lead HBOS should have prompted more appointment of a new chief executive or a ting out of positions at the right time. ŒIt is searching questions. It means dedicating rush of empire•building madness (step for• relatively easy to get discipline into the more time to reviewing the business, ward the managers of Bank of America process of putting assets on to the books. which implies a limit to the number of di• and Lloyds TSB), regulators are likely to ad• The problem is when you have held them rectorships that board members hold. It dress the problem of governance in two for two years and think it may be time to means separating risk and audit commit• di erent ways. The †rst will be to cushion o‰oad, he says. tees. It ought to mean dividing the role of the impact of those bank failures that do chairman and chief executive. And it occur by creating better resolution regimes The governance gap means asking more robust questions for large institutions and for non•banks. The memory of this most painful of epi• around such things as Œkey person risk, in There are also proposals for banks to buy sodes should make it easier for bosses to which only a few employees really under• an option on capital via a kind of disaster• shake their heads, at least for a few years. stand what is going on in a particular line insurance scheme, paying out premiums Private capital will be more patient and of business. to long•term investors in return for dollops managers will be more focused on sustain• Profound questions are also being of equity when crisis strikes. able growth rather than short•term returns asked about the right model of bank own• The second direction of policy will be on equity. Wrong•headed assumptions ership. Some fondly remember the old to intervene more forcefully to prevent fail• about risk dispersion will be less easily days of private partnerships on Wall Street. ures in the †rst place, stepping in whenev• made. But there is an increasing recogni• But for banks that need lots of money to er asset growth accelerates, demanding a tion that the governance of †nancial insti• operate, that is not an option. ŒCapital is greater say in board appointments and ve• tutions needs to be reviewed carefully (the like heroin, says an investment banker. toing dodgy acquisitions on the grounds of British authorities have already initiated ŒOnce you go down the capital•intensive †nancial stability as well as competition just such an exercise). route, you cannot go back. Others pro• concerns. More daring voices are even sug• One obvious area of scrutiny will be mote the merits of mutuals, banks that are gesting that there may be a case for an oˆ• the quality and composition of bank owned by their customers. Tony Prestedge cial presence at board meetings. There is at boards, which were found sorely wanting of Nationwide, a British building society least time to get all of these things right. It in many cases. That does not mean that di• that has come through the crisis relatively will be a long time until anyone has to rectors should take responsibility for risk well so far, says that being unlisted, mutu• worry about the next bubble. 7 16 A special report on international banking The Economist May 16th 2009

From great to good

Banks will still make money, just less of it

UNDING markets are damaged. Bor• that banks enjoyed in recent years (see Frowers have to recover from the biggest Globalisation halted? 11 chart 12) were largely created by leverage, credit bubble in history. Bankers’ reputa• Wholesale bank revenues, % of total the ability to increase the amount of assets tions are mud. Regulators are not just read• Asia-Pacific* Americas they held relative to their equity, and by ing riot acts, they are rewriting them. Yet Europe†, Middle East and Africa Œasset velocity, which let banks reuse cap• many industry executives are surprisingly ital multiple times during the course of a 100 bouncy about the future. Investment year as assets were originated and speedi• bankers in particular have been sounding 80 ly moved o balance•sheets through se• brighter, thanks to a healthy start to the curitisation. The new emphasis on stabil• 60 year. Are banks in denial or do they have ity of capital and funding ensures that genuine cause for optimism? 40 neither source of pro†ts will be readily The answer is obscured by a couple of available to banks in the future. The banks’ 20 big unknowns. One is the length and hope is that they can compensate by in• depth of the recession. A depressing analy• 0 creasing their unleveraged returns, which sis by Citigroup looks at what happened to 2001 02 03 04 05 06 07 08 means grabbing higher volumes of busi• banks in four previous episodes of ex• *Including Japan ness and repricing their products. Source: Oliver Wyman †Including eastern Europe treme stress, including the Depression, Ja• They do have some cause for optimism. pan’s Œlost decade in the 1990s and the The structural potential of developing Swedish banking crisis of the 1990s. Loan proportion of revenue at the big banks (see markets remains intact. And in mature books collapsed in all cases (by 50% from chart 11). Returns will drop if banks have to markets, banks’ †nancing and risk•man• peak to trough in America, 30% in Japan set aside more capital at the national level, agement capabilities are arguably in great• and 25% in Sweden), greatly reducing earn• or fund themselves from domestic depos• er demand than ever. Lots of companies ings even before credit losses were taken its. Big customers may take things into their still need to raise capital, for example, as into account. own hands if the system gets too fragment• evidenced by the rush of bond issuance in Direct comparisons are dangerous. ed. ŒIf international banking gets more dif• the †rst two months of the year. The advi• Banks have fewer loans as a percentage of †cult, multinationals will end up doing sory business is ticking over too, as waves total assets nowadays (because they hold things like cash management themselves, of companies seek to restructure debts. more securities) and they also have the says Mr Sands of Standard Chartered. chance to gain business that had been go• Let us again make some non•apocalyp• Still hedging ing to the shadow•banking system. But the tic assumptions: that the business of inter• Many expect clients to demand more dynamics that operated in earlier periods national banking is less pro†table but sur• hedging because of the crisis. ŒThere are of stress are also present now‹falling de• vives broadly intact and that the recession companies that cannot continue operating mand, pressure to deleverage to meet new reaches a bottom in the relatively near fu• today as a result of a failure to hedge, says capital rules and reduce loan•to•deposit ra• ture. That still leaves many banks with the Mr Winters at JPMorgan Chase, who also tios, and dipping asset values. European task of †nding a new set of pro†t drivers to reckons that clients will ask for more pre• banks look especially leveraged in com• replace the old ones. cise, and therefore expensive, forms of pro• parison with their American counterparts. The extraordinary returns on equity tection given the inadequate performance If things turn out anywhere near as badly of some hedges through recent months. ŒIf as before, says Simon Samuels of Citi• you are exposed to real estate in the [Eng• group, banks’ pre•provision returns have a Nice while it lasted 12 lish] Midlands it is no good being hedged lot further to fall. European banks’ return on equity, % with a European property index, he says. Another important unknown is the ex• A heightened awareness of risk will af• tent to which globalisation unravels. The 25 fect clients’ relationships with the banks threat of †nancial nationalism, sparked themselves. Banks are supposed to worry initially by political pressure on lenders to 20 about borrowers going bust. Now the re• focus on domestic markets and reinforced 15 verse is also true. Mergers and acquisitions by the likely tightening of rules on liquid• mandates often require companies to pay ity and capital for any bank operating 10 banks a fee even if they are no longer in• within a country’s borders, is arguably the volved at the time a deal is done, for in• biggest long•term worry for international 5 stance. Some clients now want engage• banks. (Local banks, by contrast, should ment letters for the services of banks to †nd it easier to win more business.) 0 spell out what would happen if the banks Business volumes are likely to fall in 1995 97 99 2001 03 05 07 08* failed in the interim. The bankruptcy of Source: Citigroup *Estimate markets that have been producing a rising Lehman Brothers gave a harsh lesson to 1 The Economist May 16th 2009 A special report on international banking 17

2006, according to estimates by Oliver Wy• man. These sources of revenue will not easily be replaced. The goal of many retail customers, meanwhile, will be to deleverage. The fact that households, not businesses, have so much debt to unwind is something that marks this episode out from many previ• ous banking crises. According to McKinsey, American consumers have accounted for more than three•quarters of the country’s GDP growth since 2000 and for more than one•third of worldwide growth in private consumption since 1990. Although deleve• raging can also occur through income growth, the immediate response of con• sumers has been to save more, depressing demand for credit (see chart 13). That is like• ly to continue for the foreseeable future. (The situation in emerging markets is dif• ferent: assets there will probably grow rap• idly again once the economic cycle turns, although the need to reduce loan•to•de• posit ratios will weigh on several eastern 2 hedge funds about the dangers of doing all ŒThe change in the competitive landscape European markets.) of their borrowing and saving with a sin• has been absolutely brutal but for the win• The ability of retail banks to make mon• gle prime broker. Custody banks are win• ners, volumes are up, margins up and mar• ey from those customers who do still need ning lots of hedge•fund business as a result ket share up, says Mr Varley of Barclays. to borrow is also more constrained than it of this. Tri•party collateral management, Survivors of the crisis will also be pro• may appear. The politics of ramping up whereby a third bank acts an intermediary tected by higher barriers to competition. lending rates to taxpayers is sensitive, to between a buyer and seller, is another Regulators are going to be nervier about say the least. As Andy Maguire of the Bos• growth area for custodians. Bank of New letting new entrants into the †nance indus• ton Consulting Group points out, there is York Mellon is currently servicing $1.8 tril• try and allowing foreign banks free rein in also an adverse•selection problem. Bor• lion of tri•party collateral a day, up from their markets. Many of the most important rowers who are applying for credit right $1.2 trillion in 2007. sources of earnings in the new banking now are likely to be the ones that are hav• landscape, such as cash•management ser• ing trouble getting loans elsewhere. Mov• Trend•watching vices and ‡ow businesses, are gigantic, ing existing customers on to higher•priced Changes in consumer behaviour can also technology•heavy operations that are diˆ• loans prematurely can strain relations. create opportunities for retail banks. A cult to replicate. Economies of scale will shift towards saving is one trend to capital• also count for more in areas such as depos• Nightmare scenario ise on. Retail bankers are already thinking it•gathering, risk analysis, cross•selling and Low interest rates have steepened the about structured savings products that of• wholesale•debt issuance. Although there yield curve, the di erence between short• fer consumers the chance to start putting is much talk about constraining banks that and long•term rates, but they also make money back into shares while protecting are too big to fail, the smallest institutions this a terrible environment for deposit their principal. Given worries about the are the ones that will su er most in this margins, which banks calculate as the dif•1 stability of the dollar, says David McKay of changed environment. RBC, there will also be greater demand for All of these factors help to explain why products denominated in other currencies banking will continue to be a highly attrac• Hitting the credit limit 13 such as the euro. tive business. But they do not make up for US households’ net new borrowing as % of GDP More important is the fact that competi• what has been lost. Huge swathes of the tion has fallen sharply in many markets, ei• wholesale industry’s product o ering (in• 12 ther because banks have disappeared or cluding some of its most pro†table areas) 10 because they are †nancially and politically have disappeared. So have many of its 8 constrained. The credit environment has newer customers‹analysts at Morgan changed from being demand•driven to Stanley reckon that hedge•fund assets fell 6 supply•constrained, which means that by around 40% in the second half of 2008 4 market share is up for grabs and pricing alone, and that a further 15•30% of assets 2 power has increased markedly. A recent re• will be redeemed this year. The contribu• + 0 port on the future of wholesale banking tion that prime brokerage, structured credit – from Morgan Stanley and Oliver Wyman and private•equity activities made to pro• 2 reckons that bid•o er spreads have in• †ts in wholesale banking rose from ap• 1952 60 70 80 90 2000 08 creased by anything from 50% to 300%. proximately 20% in 2000 to around 35% in Sources: Federal Reserve; Bureau of Economic Analysis 18 A special report on international banking The Economist May 16th 2009

2 ference between what they pay for depos• cause now urge, it may even be a more will manage risk, not assume it away. Sta its and what they make by putting them to pro†table one than before. But masters of and lines of businesses will have to show work in money markets. With interest the universe it ain’t. they add value to a bank, not just increase rates so close to zero, banks are having to It is possible to glance at the emerging its revenues. Regulators will bare their cut their lending rates but have no room to landscape of banking and think that not teeth more, and look away less. And tax• drop their deposit rates further. Spreads an awful lot is going to change. Aside from payers, whether explicit owners or implic• compress as a result. ŒThe nightmare sce• a few tweaks to capital here, some tougher it guarantors, will peer at the industry and nario is a period of extended low interest rules on liquidity there, and the disappear• its leaders with hostility, not admiration. rates like Japan, says Mr Clark of TD. ance of a handful of badly•run institu• As dramatic as these changes will be to There is another threat to pro†ts. Banks tions, the same big names dominate the in• those inside the banks, they will be just as make money not just from the spreads dustry. And yes, banks will make less striking for banks’ customers. During the they can command on lending but also money than before but the industry will bubble and during the crisis, credit was tid• from fees. The politicisation of banking still return decent pro†ts and still pay its al. It swept in, buoying everything from could easily mean that the fairness of bank people well. Their †rst•quarter earnings subprime mortgages to leveraged buy• fees comes under closer scrutiny. Britain’s showed that they can generate huge outs. And then it swept out again, strand• Oˆce of Fair Trading has already ruled amounts of money in even the most diˆ• ing everyone from investment•grade com• some bank charges unfair. American law• cult times. With so many assets trading at panies to emerging•market oligarchs. In makers are taking aim at credit•card fees in such distressed levels, many expect the the future, credit will be riverine. It will a proposed law. With voters, ie, consumers, wholesale side of the industry to record stream towards more creditworthy bor• now in charge of the industry, other fees massive gains when sentiment properly rowers. It will follow a more de†ned such as overdraft charges may also fall un• turns around. course, constrained by embankments of der the spotlight. O shore banking secrecy Regulators themselves wonder wheth• capital, funding and risk management. Its is an example of something that did not er the measures now being discussed go ‡ow will be more domestic, less global. cause the crisis but has been vigorously tar• far enough. As Mr Borio at the Bank for In• Above all, it will be scarcer. geted in its aftermath. ternational Settlements points out, many Given what has gone before, that may Wealthier clients are also likely to be of the ideas around countercyclicality (set• seem like no bad thing but it will entail less inclined to pay fat fees in such busi• ting aside more capital in good times) and costs. No one knows exactly what the right nesses as asset management, as falling macroprudential regulation (safeguarding balance of debt and equity is in an econ• markets, frauds such as the Bernard Ma• the stability of the whole banking system omy, but the shrinkage of securitisation in do scandal and broken promises of abso• as well as of individual banks) were oven• particular makes it more likely that the pro• lute returns make investors question the ready, having been worked on by a coterie cess of deleveraging will overshoot. Cus• value they are getting. As the full e ect of of central bankers, academics and regula• tomers, such as new businesses or immi• the crisis on savings and pensions be• tors for a number of years. Calls to disman• grants, who lack a credit history but could comes clearer, consumer activism is likely tle the biggest institutions and split up uni• well be terri†c economic bets will †nd it to rise. versal banks have not got far. tougher to raise money. Emerging markets Yet the scale of the change sweeping that need to wean themselves o cross• A glistering era ends over banking should not be minimised. border capital will grow more slowly than Add to this picture the drag of continuing Banks will seek to conserve capital, not their potential. For borrowers such as losses from toxic assets and souring loans, †nd ways to run it down. They will cut these, the failure of the banks will not be and it is clear that as an industry, banks are their dependence on wholesale funding, measured in periods of a few dramatic going to †nd it much tougher to make mon• and grow more slowly as a result. They months. Its legacy will last years. 7 ey than before. Clearly, costs, particularly those related to pay, will fall as well as rev• O er to readers enues. But there seems to be broad consen• Future special reports Reprints of this special report are available at a Countries and regions sus among industry observers that average price of £3.50 plus postage and packing. Texas July 11th returns on equity through the economic A minimum order of †ve copies is required. The Arab world July 25th cycle will be in the low• to mid•teens September 12th Corporate o er Indonesia henceforth, well down on the 20%•plus Customisation options on corporate orders of 100 achieved before the current crisis. or more are available. Please contact us to discuss Business, †nance, economics and ideas Another way of looking at the industry your requirements. Business in America May 30th is to compare its growth with GDP growth. The euro area June 13th Send all orders to: In emerging markets, the industry should Global greying June 27th still be able to grow faster than GDP as the The Rights and Syndication Department use of †nancial products spreads. In ma• 26 Red Lion Square WC1R 4HQ ture markets, with the turbo•boost of lever• London Tel +44 (0)20 7576 8148 age gone and bank balance•sheets still to Fax +44 (0)20 7576 8492 be slimmed, a growth rate in line with GDP e•mail: [email protected] is probably as much as can be hoped for. That would still make banking a decent For more information and to order special reports Previous special reports and a list of business, comparable to many other in• and reprints online, please visit our website forthcoming ones can be found online dustries. And if you look at returns on a Economist.com/rights Economist.com/specialreports risk•adjusted basis, as some converts to the