Tuesday, Nov 17, 2009

It's official: Banks' only strategy is to fleece the taxpayer

Bank of England Report: Banking on the State

This BoE report argues that over the decades the state's support for banks has simply encouraged greater risk-taking by the latter. The banks have learned that their gains will be privatised, and losses socialised, so they have adapted their strategies accordingly. They have learned that greater risk means a greater upside and a greater downside, but with the state at their backs they know they can harvest the upside (an Alice in Wonderland world where "everybody wins, everybody gets a prize") and export the downside to the state. High leverage (risk) fully accounts for banks' return on equity to 2007, and for the subsequent collapse of those returns..

Posted by icarus @ 05:58 PM (800 views)
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1. icarus said...

The gist of the problem is spelled out on pages 3-13 of the report. The rest of the report discusses what to do about it. For those who don't want to read the report a summary of these pages might go as follows

:Banking history has evolved to the point at which it pays banks to take big risks because they know the state will bail them out.

Once a bank's biggest risk was lending to the sovereign,usually to wage a war, a risk that was reflected in higher interest rates to states than to commerce. Since the mid-19th century governments have gradually become last-resort financiers of banks and now we've seen the complete turnaround - the biggest risk to the state comes from underwriting banks' losses.

Banks have been encouraged to take risks because they are in the position of a gambler who ups his stakes to cover previous losses, comes out with a profit and then re-starts the sequence. We all know that the danger in such a strategy is the inevitable long losing streak. But if the losing streak is underwritten by the state the danger disappears. (This analogy is in the BoE report – it's not mine.) This is what has happened with banks and the implicit or explicit state guarantees to them (originally just liquidity insurance and later deposit and capital (equity) insurance, debt guarantees and, to complete the full house, asset purchases).

Part of this problem stems from the increasingly lower liability of bank owners and their consequent greater risk-taking. In 1360 a Barcelona banker was executed in front of his failed bank pour encourager les autres to desist from excessive risk-taking. Then there were debtors prisons and 'double liability', where shareholders were liable for losses on the purchase price of shares and on their par value at issuance. The mid-19th century saw the institution of limited liabilty and the taking shape of state support for banks, under the banner of attracting risk capital into banks to finance economic growth. Since then there has been both greater risk-taking and a racheting up of the scale and scope of state support to banks, a 'safety net' that suddenly grows in a crisis and is slow to contract afterwards.

The banks, knowing this, have gamed the state (that's the authors' word - it's also the meaning of the report title). UK banks have expanded their balance sheets relative to GDP (Chart 1). For a century until 1970 their combined balance sheets were 50% of GDP, now they're 500%. So the state's insurance liability has gone up 10-fold relative to GDP. Have the banks offset this by holding larger buffers of capital and liquidity? No, the opposite has happened. Since 1880 capital ratios in the UK and US have fallen from 17% and 24%, respectively, to 5% (Chart 2). The combination of balance-sheet and leverage expansion has caused the potential need for a state backstop to rise exponentially. This huge rise in risk has also meant that bank shareholders have required greater returns on equity. Before 1970 this was about 10%, with little volatility year-to-year (similar to non-financials). Since then it has gone up to 20%, with high volatility (Chart 4). A vicious circle of balance sheet fragility, higher returns required by shareholders, progressive risk in the system and the expansion of the state safety net has led to greater risk-taking by bankers. What's happened over the last few years was waiting to happen.


With the state at their backs the bankers ensure great gains for shareholders and execs when things are good and minimise losses when things go wrong. Losses tend to be borne by non-equity parts of the capital structure – the wholesale and retail depositors, who are in turn insured by the state via, respectively, liquidity insurance (last-resort lending) and deposit insurance. This privatisation of gains and the socialisation of losses has become a repeated historical pattern.

Knowing that they are backed up by the state the bankers have adapted their strategies accordingly. In the UK and parts of Europe they have relied on leverage focussed on trading assets, while those trading assets have made up an increasing proportion of the total book. When asset prices rise there are huge wins, then the taxpayer steps in when it all goes into reverse. The banks have done nothing clever. They haven't made money apart from the taxpayers' money - high leverage fully accounts for UK banks' returns on equity to 2007, and for the subsequent losses.

In the US banks have not been allowed to use as much leverage so they game the state in other ways: (1) originating high-risk loans (securitised exotica and sub-prime) which have high payoffs at the front end because of the high risk (private gains) but horrible losses at the back end (socialised losses) and (2) out-of-the-money options like AIG's writing CDS insurance, collecting premia in the good times and getting rescued by the taxpayer when loans go bad and AIG can't pay out.

One can see why Mervyn was so concerned last year about 'moral hazard' until Brown-Badger told him to shut it.

The report goes on to discuss how to reduce this moral hazard in future. But the Barcelona Solution isn't considered.

Tuesday, November 17, 2009 06:19PM Report Comment
 

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