Totally addicted to debt

11th July 2012

Squeezed Addicts

Predictably the recent set of rating agency downgrades caused squeals of anguish from top tier banks, expressing outrage that their efforts to make themselves less risky aren’t being treated with the respect they think they deserve. Or perhaps their executives are simply angry that their bonus-justifying profits are being squeezed?

Their real problem, though, is that the world has changed. Their debt fuelled addiction to old-style business models is under threat of extinction. Those last century profit margins are gone for a generation or more: it’s time to go cold turkey, whether they want to or not.

Discounting Debt

The problem with addicts is that they can’t control themselves. An addict has reduced control over their behavior, is frequently in denial about their problem and will continue to pursue the object of their addiction despite adverse consequences. Typically addicts tend to live in the present and heavily discount the future because they want their fix now, and don’t really care about what happens next, an idea developed in Becker and Murphy’s Rational Theory of Addiction.

Banks, or at least their leaders, seem to have a similar problem with debt. Debt is the lifeblood of these companies, and has been the driver of their outsized profits, and their executives equally outsized compensation plans, over the past few decades. This addiction has been pursued in a quest for short-term profit, with no regard for the longer-term economic consequences, discounting future impacts close to zero. Now the banks being systematically cut-off from their chosen substance of abuse and are reacting as you might expect: they want it, and they want it now.

Risk is not Rewarded

The latest decision of the credit rating agency Moody's to cut the ratings of a raft of banks has provoked outrage amongst them. Similarly the Swiss National Bank has demanded that UBS and Credit Suisse build up their capital base more quickly, a move that the latter has rejected – at least until the regulators catch up.

RBS, for instance, responded thus:

“The group disagrees with Moody's ratings change, which the group feels is backward-looking and does not give adequate credit for the substantial improvements the group has made to its balance sheet, funding and risk profile.”

The problem, though, is that the banks are responding to the wrong issue. Regulators want banks to reduce their gearing, to force them away from riskier forms of lending and to make them less adventurous. This, in turn, makes them less profitable, which impacts profits and bonuses; so naturally the banks resist. The credit rating agencies are only reacting to the risks they see in the new global environment, where governments are determined to reduce their exposure to their maverick banks, and are intent on forcing them into a diet of debt reduction.

The Pain in Spain

To understand why this is necessary we need look no further than the benighted state of the Spanish banking industry. A recent independent report suggests that the banks are in a property-bubble induced hole that means they need anything up to €62 billion ($78 billion) of additional capital to stay solvent . In the supposed worst case the Iberian financial institutions could be looking at total property losses of €420 billion; a staggering 14% of Spanish bank assets. That’s what letting bank executives loose with debt brings you.

Andrew Haldane, of the Bank of England, has published several illuminating explanations of why this matters. In The Contribution of The Financial Sector –Miracle or Mirage he points out:

“According to data compiled by the Banker, the balance sheets of the world’s largest 1000 banks increased by around 150% between 2001 and 2009 … This rapid expansion of the balance sheet of the banking system was not accompanied by a commensurate increase in its equity base. Over the same 130 year period, the capital ratios of banks in the US and UK fell from around 15–25% at the start of the 20th century to around 5% at its end… In other words, on this metric measures of balance sheet leverage rose from around 4-times equity capital in the early part of the previous century to around 20 times capital at the end.”

Why? Well, as Haldane explains, banks can boost their return on equity by taking on more leverage, and risk:

“Taken together, this evidence suggests that much of the “productivity miracle” of high ROEs in banking appear to have been the result not of productivity gains on the underlying asset pool, but rather a simple leveraging up of the underlying equity in the business”

Gaming the Systems

What’s happening now is that governments and regulators are reacting to this by imposing more and more restrictions on bank lending. One simple way of doing this is to insist on higher and higher levels of capital, which is exactly what the Swiss National Bank is demanding. Of course, the net result of this is to make the banks less risky, to reduce gearing … and reduce profits. Unsurprisingly bank executives hate this, and the reaction to the recent downgrades, which are directly caused by the credit rating agencies’ recognition of this global regulatory environment, is the result.

Unfortunately for them this wave of regulation isn’t likely to subside soon. Despite Jamie Dimon’s bravura performance in front of US lawmakers, the net result of risk management failures such as JP Morgan’s recent credit derivatives trading disaster only reinforces efforts by regulators to ring-fence banks. Exactly what went wrong there might never be understood, but there’s a suspicion that it was an attempt to game the risk management models imposed under the new Basel requirements:

“In December 2011, as part of a firmwide effort in anticipation of new Basel capital requirements, we instructed CIO to reduce risk-weighted assets and associated risk. To achieve this in the synthetic credit portfolio, the CIO could have simply reduced its existing positions; instead, starting in mid-January, it embarked on a complex strategy that entailed adding positions that it believed would offset the existing ones. This strategy, however, ended up creating a portfolio that was larger and ultimately resulted in even more complex and hard-to-manage risks.”

The problem is that no regulatory model can cover all the risks, so banks will be tempted to look for solutions that the model thinks are low risk, but actually aren’t. This kind of problem is implicated in the sub-prime banking crisis when heavily incentivized sales agents figured out how to game the automated risk management models by entering the right combination of figures to escape the dreaded application rejection.

Cold Turkey

Given all of this hi-tech, hi-finance jiggery-pokery it’s no surprise that the regulators are looking for structural reforms that reduce risk across the whole industry, rather than relying on technical and complex new rules that simply pose a new opportunity for financial wizards to exploit. The UK, for instance, is proposing new rules for its banks, ring fencing retail banks from their rumbustious investment banking cousins. The net result of this will be to push up the cost of banking: that’s the alternative to waiting until they fail, bailing them out and paying a whole heap more.

As the FT’s Lex column has pointed out, the credit rating agencies are now distinguishing those banks with riskier business models and downgrading them accordingly. This is the new world, where a debt addiction is going to be an increasingly expensive habit:

< p>“Reports of the death of global banks are exaggerated; the global economy needs them (although it would not invent them if they did not already exist). But they have a lot of work to do to create a less leverage-dependent business model. It is taking a long time for bankers to get that message.”

Maybe, just maybe, our next generation of smart kids will figure out that the rewards of a career in pushing money about in socially pointless ways have migrated elsewhere and go and get themselves real jobs in the real economy. Now that would be of real benefit to humankind.

More on Mindful Money

A womans place is in the money

On the corrosion of moral leadership 

Facebook friends can make you poor

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