Today, the UK financial system is in a crisis. Northern Rock – a small regional bank has already collapsed, the interbank market is frozen and the spectre of higher loan defaults threatens the entire system. Far too many banks are under-capitalised and excessively dependent on wholesale funding. After a decade of reckless lending, the banks are looking for an exit strategy, and the taxpayer has deep pockets.
Unfortunately, the banks might have some justification for looking towards the government for a bailout. Successive governments created the enabling environment that allowed the banking sector to go mad with credit. Competition was encouraged; supervision was relaxed and banks always knew that if things became sticky, the Bank of England would come to the rescue as the lender of last resort.
Financial sector deregulation – competition without failure
It was not always like this; back in the 1960s, banking was a low-risk business. A handful of large banks dominated the high street; while small building societies provided a regional flavour and looked after the mortgage market. The city of London handled the capital and equity markets. At the centre of the system was the Bank of England, who determined interest rates and watched over the banks, ensuring that everyone behaved. It was a business where everyone knew their place.
There was also an element of self-regulation. Banks formed a cartel that ensured that there was no competition over interest rates. The elimination of competition ensured a reasonable level of profitability for all. No banks ever failed and no new banks entered the market. While the lack of competition was not great for the customer, it did make for a stable banking system.
This happy state of affairs could not last. Starting in the early 1970s, successive governments became bored with financial sector stability and wanted to liven things up with more competition. The sector was progressively deregulated. The government dismantled the cartel and removed the distinction between the banks and building societies. Supervisory norms were simplified and liberalized. Over time, the government got what it wanted; banks began competing over interest rates.
The increased competition may have pushed down rates, but was a contradiction with deregulation that no government ever considered properly. Highly competitive markets need smooth exit procedures for failing firms. In the rest of the economy, this exit procedure is called bankruptcy. However, banks hold deposits and if people think they might lose their cash, they pull it out. Since the failure of one bank might provoke a complete loss of confidence in the financial system, bankruptcy for banks was not an option. The bank of England would always be there as the lender of last resort.
Originate and Distribute
Over time, competition became increasingly vicious, with UK banks biting pieces out of each other. Competitive pressures forced banks to narrow interest rate spreads sharply; a process that accelerated over the last five or so years. As spreads compressed, it became extremely hard work turning a profit in banking.
Banks adapted to this new environment of increasing competition and a near certain guarantee of a bailout in the event of failure. With competition pushing down spreads and no means of exiting the market, banks needed a new way of doing business to boost profitability. They found it with something called “originate and distribute”.
Under this new business model, banks would take on more risk through increasing lending volumes and then redistribute the risk through out the wider financial system. At the same time, banks reduced costs. More risk and lower costs compensated for lower spreads and maintained profitability.
Reducing costs was a straightforward matter. Banks would focus on originating loans. The marketing business farmed out to a network of hungry brokers, who worked on a commission only basis. Banks also downsized their high cost branch networks. Instead of raising money the traditional way by attracting retail deposits, banks raised funds in the wholesale money market. This combination of freelance brokers and wholesale funding gave many smaller banks the ability to project their products on a national level.
The Sleepy Supervisor
While finding customers and funding was easy, getting around prudential banking regulations was more difficult. Over the years, governments had eroded prudential norms. Nevertheless, no government was stupid enough to deregulate completely the financial sector. Banks had to keep a minimum level of capital that should provide a buffer should a large amount of loans go bad.
Eventually banks found an answer to regulatory capital requirements. Any bank closing in on their minimum capital requirements could “distribute” some of their loans off their balance sheets. Banks created virtual banks, which they called structured investment vehicles (SIVs). Since these SIVs did not have any retail depositors, they evaded the normal regulatory framework. These SIVs could have minimal levels of capital, obtain funding from the wholesale market and then buy loans from their mother banks. These loans were bundled together as asset-backed securities, typically with mortgages or credit card loans. Today, most banks work with the "originate and distribute" business model. Moreover, it could all be justified because banks were simply ensuring that “their regulatory capital worked more efficiently".
While this was happening, what were the UK’s financial supervisors doing? In theory, capital adequacy standards should have put a break on “originate and distribute”. Unfortunately, the UK became an experiment in a new form of financial sector oversight, called “principles based” supervision. However, the Financial Services Agency was also quite happy when others described it as the FSA’s “light touch”.
With the FSA’s light principles, the banks ran amok. In an accounting sense, banks never broke capital adequacy rules. In a financial stability sense, they ran a steamroller through them. The SIVs offloaded risk, credit default swaps lowered risk weightings on assets, and all the time, banks were increasing their leveraging. While this was going on, the FSA was asleep.
If this criticism seems a little harsh, consider this telling fact. Over the last two or so years, Northern Rock was the largest single issuer of asset backed securities in the UK. In the 18 months up to the day it failed, the FSA did not conduct a systematic investigation of that bank’s business activities. There were plenty of warning signs about Northern Rock. From January onwards, the share price fell dramatically while at the same time, Northern Rock mortgage brokers were selling 125 percent LTV mortgages. This should have been enough for the FSA to take the train up to Newcastle and see what was going on.
The rise of the debt-soaked economy
At first sight, the “originate and distribute” business model squared the circle for the banks. Despite the dog-eat-dog competition, banks kept making money. In reality, banks replaced one problem with another. Banks may have learned to live with lower spreads, but at the expense of larger and weaker balance sheets.
The problem with “originate and distribute” is that the numbers do not quite add up. Economies do not grow quick enough to ensure that lending volumes increase fast enough to keep profit continuously high. To see why assume that an economy grows in real terms at 3 percent while inflation is 2 percent; this gives a nominal GDP growth rate of approximately 5 percent.
With spreads approaching zero, a five percent growth rate in lending volumes is simply not fast enough. In order to generate profits while spreads are compressed, bank lending must growth significantly faster than nominal GDP. In order to maintain profitability, banks need to increase lending volumes at rates closer to 10 t0 20 percent, which was much faster than the growth rate of the economy.
This could mean only one thing; sectors outside the financial system needed to take on more debt. In the last ten years, that is exactly what happened in the UK. At the risk of being tautological, the huge increase in lending volumes translated directly into higher personal indebtedness. It was low interest rates and “originate and distribute” that provided the rocket fuel for the UK’s housing bubble. Today, UK personal sector indebtedness is 160 percent of personal disposable income. This is a crushing level of debt. Behind this ugly number is a huge mass of potential default risk.
Of course, it is the crushing levels of personal debt that now threaten the banking system. If the economy slows, people will stop paying their debts, and this will reduce bank profitability. So far, the economy has kept growing, but the years of over-consumption are now threatening a correction. The banking sector is living on borrowed time, and hence, the desperate preparations for a taxpayer financed bailout.
If the banks come to the public sector for help, it can argue with some conviction that the deregulation, poor supervision and perverse incentives contributed to the current lamentable state of affairs. However, should the taxpayer step in and pay up?
Fundamentally, this crisis will come down to a distributional question. Someone somewhere must pay. The difficulty is designing a policy response that ensures that the right people take out their purses. Top of the list must be bank shareholders. Notwithstanding all the mistakes of the government, shareholders could have reigned in bank management and controlled the level of risk-taking. Here, the Bear Stearns example is a model of bank resolution. Within just three short days, the Fed wiped out virtually all shareholder value. Bear Stearns will never threaten the US financial system again.
Despite the lower levels of capital, banks still have plenty of room to absorb losses. Furthermore, banks must also adjust their balance sheets; reduce the overall level of risk, and find new capital. Much of this can be done without any money from the Bank of England.
Finally, the mistakes of the past need to be corrected. This does not mean a return to the 1960s, but will demand that the government realigned incentives within the financial sector. Banks should be allowed to fail along the lines of the Bear Stearns elimination. Capital adequacy standards must be improved and oversight strengthened. Supervisors should be able to distinguish between higher risk taking and genuine financial innovation. At a minimum, this will require the abolition of the FSA and the Bank of England again becomes the sole institution for overseeing the financial system.
There may come a day when the taxpayer may have to pick up the tab for this mess, but we are not at that point yet. In the meantime, policy makers should work hard to shift the losses back onto the financial system. The banks will fight and plead, but we should wait and see real pain from banks before any public money goes into rehabilitating the system.