It’s roughly ten years since the Global Financial Crisis started to gather steam. By the summer of 2007 it was clear that something serious was going on, although the crisis wouldn’t reach its worst point for at least another year. Many banks went bust and had to be bailed out. A handful were allowed to fail. Banking systems will never be risk free. But the good news is that steps taken after the crisis have made the system much safer than a decade ago.
Long time readers know I used to work at a huge (and subsequently less huge) investment bank and wealth manager, now going by the name of UBS Group (SIX:UBSG / NYSE:UBS). I was there for 15 years in all, working around the world but mostly based in London and Hong Kong.
People have different ideas of when the Global Financial Crisis started. As for me, still labouring at UBS in London, I became aware that all was not well in February 2007. On the 7th of that month, HSBC Holdings plc (HK:0005 / London:HSBA / NYSE:HSBC) – a huge global bank headquartered in London – was the first major operator to report a significant writedown in its US sub-prime mortgage loan business.
The amount in question was $1.8 billion (US dollars). At the time that was considered scandalously large, especially for a supposedly prudent outfit like HSBC. As it turned out, it was just the first droplet in a very big and rough ocean of losses.
According to a recent report by James Ferguson of The Macro Strategy Partnership, a UK-based research outfit, US banks went on to lose around $830 billion from the crisis, spread across many years. On top of that, as the tide went out and regulators realised that bankers had been frolicking naked beneath the surf (please don’t try to visualise…), the banks had to pay fines totalling a massive $280 billion.
I don’t have the equivalent figures for European banks but I imagine they’re in the same ball park. If memory serves, my erstwhile employer, UBS, alone took asset hits of around $60 billion and had to be bailed out (several times). It also paid some huge fines in subsequent years.
Not bad for the supposedly safe and conservative flagship of the allegedly staid Swiss banking industry. But it was far from alone. European commercial and investment banks imploded in the UK, France, the Netherlands, Greece, Italy, Spain, Portugal…you name it. At least they would have done if central banks and governments hadn’t propped them up.
Of course it was the same story in the US, as many of the most famous names on Wall Street hit the wall.
Bear Stearns – an investment bank set up in 1923 – went down in March 2008 and was rescued by J.P. Morgan Chase. Merrill Lynch (established in 1914) would have folded, until Bank of America announced it would step in on 14th September. Lehman Brothers (established in 1850!) went bust the very next day.
Lehmans was the one big player thrown to the wolves by its peers and regulators. US Treasury Secretary Hank Paulson said at the time there would be no more bailouts. The very next day the Federal Reserve bailed out AIG, a huge insurance company.
It’s said that AIG was saved because it would have defaulted on tens of billions of dollars owed to Goldman Sachs, the investment bank with a revolving door between itself and the US government (“Government Sachs”). So, if AIG had folded, Goldman Sachs would have gone down too. As a matter of pure coincidence, Goldman Sachs happened to be the investment bank that US Treasury Secretary Paulson had run previously…
In the run up to the crisis, banks became more and more leveraged. Assets were 20 times the capital cushion, then 30 times, then 50 times…
Add to that the lax lending practices of “liar loans”…some liberal dashes of financial alchemy that purported to convert junk into jewels…hubris of the highest order (“these derivatives make the financial system safer by spreading risk around”)…and a general orgy of credit, egged on by government…it really is no surprise that it ended badly.
A lot of people got hurt financially. These were the same people that had heard all the stories about the massive bonuses that bankers and fund managers had pocketed in previous years – or the vast golden parachutes paid out to the people that caused the crisis. (Note: Pay at investment banks has halved since those days. See here for more, and why it could affect you.)
Stan O’Neal – under whose watch as CEO, Merrill Lynch was brought to its knees – reportedly received $91.4 million in pay in 2006. He left the firm in October 2007, once it was in deep trouble, taking with him another $161.5 million of stock and options as reward. This extreme example always stuck in my mind, but I’m sure there were plenty of other people that were rewarded for failure.
Unsurprisingly, the mob wanted blood. And the politicians and regulators – desperate to deflect blame from their own part in stoking up the boom – were happy to go after the banks.
What happened next…
Thus followed a massive tightening of regulations designed to reduce (but never eliminate) the risks of a repeat. There are many finer points to this area, but only two things that really matter. As compared with early 2007:
- Solvency: Banks must be far less leveraged, meaning they have more high quality capital (mainly equity) in relation to assets
- Liquidity: Banks must carry much larger amounts of highly liquid assets – deposits at the central bank, physical cash and government bills or bonds – meaning they are much less likely to struggle to cover a sudden funding shortage, such as a bank run (sudden withdrawal of customer deposits)
Back in 2007 a typical commercial bank might have been 25 times leveraged. By that I mean its assets were 25 times its net assets. Net assets are also known as shareholders’ equity or book value. This is the bulk of the high quality (“tier 1”) capital of the bank.
That meant a bank only had to lose 4% of its assets to become insolvent, reaching the point where liabilities were greater than assets and hence net assets were negative. Which, clearly, isn’t the kind of place you want to deposit your hard earned money. (Note: a bank “deposit” is really just a loan to a bank, being your asset and the bank’s liability.)
Nowadays, that ratio of assets to net assets (equity) is more likely to be around 12.5, which is to say leverage is half as much as before. Now it would take write downs of 8% of assets before all the equity capital (net assets) disappears.
The following chart clearly shows how, for large US banks, the ratio of equity (net assets) to assets was around 4% in 2007, having fallen from closer to 5% earlier in the decade. It then fell further during the crisis, as asset write downs began to hit. But subsequently it doubled from the pre-crisis level to around 8%, as stricter regulations have been put in place.
If 8% still sounds low to you, just remember this: the losses from a crisis usually get phased in over several years. During those years the bank will still be making profits on all its good assets. Along with certain other actions available to management, this means that the hit to capital in any one year can usually be contained.
After all, in the chart above the equity never dipped below 3% of assets, which was reached in late 2008. That’s despite US banks having to eat cumulative losses over time that were equivalent to 10% of 2007 assets, according to estimates made by Macro Strategy Partnership’s James Ferguson.
From solidity to liquidity
It’s clear that banks are more “solid” than before, but they’re also more “liquid” at the same time. Such contradictions are perfectly possible in the jargon-infested world of finance, and both enhanced states are a good thing.
Again based on Ferguson’s figures, banks’ total “risk free assets” have gone from 31% of assets in 2007 to 39% of assets today. “Risk free assets” are made up of deposits at the central bank, treasury bills and bonds and physical cash notes. Taken together they make up a bank’s “liquidity reserves”.
The bigger these highly liquid assets are in relation to the balance sheet, the better a bank can cope with a sudden loss of funding. A funding crisis could include things like a bank run (depositor panic) or lack of interbank lending (loss of confidence between banks, as happened during the last crisis).
I’ve now explained the two main things that have made US banks much safer than they were before. Both high quality capital and liquid assets are far larger in relation to the overall bank balance sheets than they were a decade ago. Banks are both far more solid and far more liquid, and both are a good thing.
What should you still be worried about?
Of course, it’s possible to make the banks even safer, with even higher capital and liquidity requirements. The problem is that both would act to reduce banks’ ability to grow their lending, placing a huge drag on the debt dependent economy. (This doesn’t stop certain influential voices within central banks and academia from arguing for it, exposing their lack of financial understanding in the process.)
There are still things to worry about in the financial system – like more and more zombie companies (see here) or the stock bubble (see here) – and banks will never be 100% safe. But if you’re looking for something to keep you awake at night, it should no longer be the risk of widespread failures in the US banking sector. By and large, the banks are a hell of a lot safer than they were in the past.
Stay tuned OfWealthers,