Commentaries

What banks can learn from hedge funds

Should the banking industry look more like the hedge fund sector? That’s the surprising suggestion made last week by two Bank of England officials.

In a fascinating paper, Piergiorgio Alessandri and Andrew Haldane explore the level of public support given to banks in the crisis and the problem of institutions that are too big too fail. Their main point is that if this issue is not addressed it will lead to new crises and even bigger bailouts in the future – a state of affairs they describe as a “doom loop”.

But the most eye-catching passage is a suggestion that banks have a lot to learn from hedge funds:

It may be coincidence that the structure of the hedge fund sector emerged in the absence of state regulation and state support. It may be coincidence that the majority of hedge funds operate as partnerships with unlimited liability. It may be coincidence that, despite their moniker of “highly-leveraged institutions”, most hedge funds today operate with leverage less than a tenth that of the largest global banks. Or perhaps it might be that the structure of this sector delivered greater systemic robustness than could be achieved through prudential regulation. If so, that is an important lesson for other parts of the financial system.

This is quite a change of heart. Until a few years ago, regulators viewed hedge funds as the main threat to financial stability. These fears have proved unfounded. Though plenty of hedge funds have blown up – or turned out to be massive frauds – none has so far threatened to drag down the system.

Some things that currently take place in banks are probably better suited to hedge fund structures. Proprietary trading is a prime candidate. There is also a strong case to be made for private partnerships. Would investment banks have grown so large if they were owned by partners who were exposed to any losses?

Even so, it seems fanciful to suggest that the hedge fund model is better. Banks fund themselves by taking retail deposits that customers believe to be safe. That precisely the reason they are so heavily regulated. Hedge funds raise money from institutional investors and wealthy individuals who – in theory at least – realise they could lose it all. Without deposit insurance, the failure of a bank can spark a loss of confidence across the industry. The failure of a hedge fund is less likely to have systemic consequences.

Do banks really need to hoard liquidity?

That’s the provocative question posed by Willem Buiter. His latest, characteristically lengthy, blog post tackles the regulatory vogue for forcing banks to hold much greater reserves of liquid assets – in practice, government bonds.

Buiter’s missive follows new rules from Britain’s Financial Services Authority, which will force banks to increase their reserves of government bonds by more than a third. The rules have been met with predictable bleating from the industry, which accuses the regulator of undermining Britain’s competitiveness and promoting the fragmentation of the global financial system. Another concern is the FSA’s handling of the transition.

Buiter’s objections are more fundamental. He’s not convinced banks should be preparing to deal with a seizure in the markets. That, he argues, is the job of central banks:

It may be possible for private banks to hold enough liquid assets (government debt, effectively) on their balance sheets to survive even a major liquidity crunch without recourse to the central bank.  But that would be socially inefficient.  Banks are meant to intermediate short liabilities into long-term assets, and frequently into long-term illiquid assets.  It’s what their raison d’être is.

By contrast, Buiter says: “Providing liquidity is what God made central banks for.”

It’s an argument which deserves to be explored further, though it does raise some practical concerns.

The first is whether central banks are able to prop up individual lenders without making matters worse. After all, the run on Northern Rock started after  the Bank of England announced it was providing support to the mortgage bank. The Bank of England has since installed a permanent discount window similar to the one used by the Federal Reserve. But it remains to be seen whether banks will dare use it once markets have returned to normal.

RBS issue must be on commercial terms

Britain’s state-controlled banks appear to be playing a game of tit-for-tat. Lloyds Banking Group last week admitted it was looking for ways to reduce its exposure to the government’s insurance scheme for toxic assets. Now it turns out that Royal Bank of Scotland is also sounding out investors about tweaking its own involvement in the scheme.

That is where the similarities end, however. RBS is being much less ambitious than Lloyds. It still wants the government to insure all of the assets it agreed to put into the scheme in the winter. It just wants to pay some of the premium in cash rather than its own equity. This may look a superficially attractive way to de-risk the tax-payer’s huge exposure to bank equity, but the government should think hard before accepting.

Unlike Lloyds, RBS is not proposing to scale back its use of the government’s asset protection scheme (APS). Instead, the Scottish bank is considering raising at least 3 billion pounds, about a tenth of its market value, from shareholders to help fund the 6.5 billion pounds it has agreed to pay (but not yet coughed up) in order to participate in the scheme.

When the APS was negotiated in February, RBS offered to pay this fee by issuing the government with `B’ shares that convert into ordinary stock at 50 pence. At the time, when RBS shares were changing hands at around 20 pence, that looked like a pretty good deal for the bank. But the recovery in RBS’s share price now means it can contemplate raising cash privately at a similar price.

The key question is how RBS’s fundraising is structured. The bank’s shareholders have given it the green light to issue up to two-thirds of its share capital, but any issue that involves selling more than 5 percent of its share capital must be offered to all shareholders, including the state.

In practice this means that the government, which already owns 75 percent of RBS, will have to decide whether or not to take up its rights. If it chose not to, the dilution from the rights issue and the reduced issue of `B’ shares would keep the government’s shareholding below 80 percent.

On the face of it, any move that replaced state funding with private capital should be welcomed. But it is also important that taxpayers do not lose out. UK Financial Investments, custodian of the government’s stake, should insist that it will only stand aside if a rights issue is priced at a modest discount to RBS’s share price, which on Monday already slipped almost 5 percent to 53.65 pence.

The Fed’s phony war on bonuses

Any attack on bank bonuses is going to be a reliable crowd pleaser. So a Federal Reserve proposal to meddle in Wall Street pay would make a good deal of political sense.

But Fed officials are almost certainly aware that this populist flourish will do little to control risk-taking or stabilize the financial system. There are far simpler and more effective ways to clamp down on reckless bank behavior than seeking to micro-manage bank pay structures.

First, the Fed is certain to be outmatched.

In one corner you have a central bank that has been notoriously spineless on regulatory matters. The institution is crammed with officials who have traditionally seen themselves as defenders of the banking system and advocates of laissez faire.

Even some top Fed officials admit they would need a culture shift in order to take on more regulatory responsibility.

In the opposing corner you have heavy-weight Wall Street institutions with armies of lawyers dedicated to gaming the regulatory system.

There is a deeper objection to the Fed’s effort. The real problem is not the structure of bank pay but its scale.

Banking? Keep it simple stupid

In 1873, Walter Bagehot wrote that “the business of banking ought to be simple; if it is hard it is wrong.” He would have struggled to recognize today’s banking system.

It is not just ever more ornate derivatives that bend the mind. Financial firms themselves have become fabulously complicated. Citigroup lists 2,061 subsidiaries and affiliates while the institutional chart of JPMorgan Chase is 267 pages long.

Complexity — as Bagehot predicted — has become a curse. If nobody can understand financial firms, they will become ever more accident prone.

The crisis that exploded a year ago offered a salutary lesson in the dangers of complexity. Many shareholders and creditors simply did not fully comprehend their investments. Instead they were forced to trust managers and the rating agencies.

Regulators too could be forgiven for scratching their heads.

“Supervisors are at a decided disadvantage in understanding risk-taking and compliance for firms that might involve dozens of jurisdictions, hundreds of legal entities and thousands of contractual relationships,” former Fed official Vincent Reinhart has written.

Indeed Basel II — the international capital code — was an admission of defeat by regulators. The message from the banking accord was that institutions had become so convoluted that only they were able to understand the risks they were taking.

The social cost of runaway bank pay

If only the economy were bouncing back as fast as banking compensation.

Even as the first anniversary of the collapse of Lehman Brothers draws near, bankers and traders are now grabbing a larger share of their institutions’ net revenue than they did during the boom years. The leading U.S. banks are on track so far this year to pay their employees $156 billion — more than in sunny 2006.

Politicians have focused mostly on whether the bonus structure can be changed to discourage bankers from making reckless bets with their shareholders money. But a bolder solution to excessive banking pay is necessary. It starts with a simple question: Are bankers paid too much? The answer is a resounding yes.

Everybody enjoys a bout of cathartic outrage over the pay of reality TV personalities and sports stars. At root, however, we must accept that these salaries are determined by the free market. The same is not true of investment banking.

Even those banks not currently financially dependent on the largesse of the federal government clearly benefit from an implicit guarantee. Governments of every political hue have clearly demonstrated that they are unwilling to let large institutions fail. This enables financial institutions to take risks that a toothpaste manufacturer could not. Bankers took full advantage of this subsidy before the crisis and are starting to do so again.

A report by London-based Smithers & Co., while issued before the crisis, shows how that dynamic continues to work. Smithers found that the median nominal return on equity in banks towered above those in other sectors.

“With higher leverage than other industries they could achieve 20 percent returns compared to an average of 8 percent elsewhere,” Andrew Smithers said in a telephone interview. The downside of the banks’ high returns is high risk, much of which is born by taxpayers. This has become more dangerous since offsetting regulations limiting risks were dismantled.

from Margaret Doyle:

Lloyds calls bottom of loss cycle – early?

Lloyds Banking Group's outgoing chairman, Victor Blank, foretold "exciting prospects [and] long-term success" as the bank wrote off 13.4 billion pounds in bad debts, contributing to an overall 4 billion pound loss. The group's assertion that its loan impairments have peaked -- well ahead of when historical precedent suggests -- may also prove a hostage to fortune. Blank's remarks and chief executive Eric Daniels' thanks to him for his "significant contribution" had an air of surrealism about them. Blank, after all, cooked up the hasty takeover of HBOS that scuppered the formerly cautious Lloyds last autumn, forcing it into government arms. Daniels did nothing to stop him. Blank is bowing out after losing the confidence of UK Financial Investments, the body that looks after the government's 43 percent stake in the bank. However, UKFI's boss, John Kingman. still defends Daniels, whose old-style banking skills are seen as key to digging Lloyds out of this mess. The extent of the damage of the HBOS deal is evident from the numbers. No less than 80 percent of the impairments come from its book, which was laden with overvalued real estate, both commercial and residential. Indeed, the cost of bad HBOS loans in the first six months of the year exceeds the amount it spent buying the bank. In Lloyds' defence, it is dealing aggressively with Blank's unfortunate legacy. It is working through the loan book and identifying the real dross that will go into the Government Asset Protection Scheme (GAPS). Three quarters of the assets affected by the impairment charge are ear-marked for the GAPS. Moreover, all of the group's new lending (which is significant -- gross mortgage lending, for example, is 18 billion pounds, maintaining its market share at 27 percent), is now done under Lloyds stricter criteria. The group is winding down the "specialist", e.g. self certified, and buy-to-let mortgage categories that proved so tempting to amateur property barons. Lloyds is also crunching through the integration at top speed. It has always been known for being tight on costs. Indeed, it is a bitter joke in the industry that it drip-feeds job losses -- rather than declaring its target for cuts -- in an effort to avoid political fall-out. Staff numbers fell by 2,619 in the first half, to 118,207. More are surely to come with the group targeting an annual improvement of a full 2 percentage points in its cost income ratio for the next few years. On the funding side, Lloyds is increasing the maturity of its funding -- despite the higher costs -- though are still concerns the enlarged bank remains overly dependent on wholesale funding which is currently being supplied by central banks and government guarantees. So far, each of these initiatives has been dwarfed by the sheer scale of HBOS losses. Normally banking losses peak a year or so after the trough of the recession, which suggests any turning point is at least twelve months away. Lloyds reckons that the property focus of the HBOS books means that losses have peaked much earlier than they would otherwise have done. The GAPS should also help shield Lloyds from mounting losses. However, general corporate defaults are likely to rise, as are nemployment-related defaults on unsecured debt. If Lloyds' prediction proves correct, it will have taken a step towards rebuilding its battered credibility. Who knows? Daniels may be able to keep his job after all.

Time for Britain to close the GAPS

Britain’s asset protection scheme, invented to protect the banking system, is morphing into a bureaucratic monster. It’s time to kill it off. Though state support is still needed, there are simpler ways for the government to prop up its ailing lenders.

More than seven months after it was conceived, and five months after Royal Bank of Scotland and Lloyds Banking Group signed up to use it, details of the APS have still not been agreed. The sheer task of sifting through 585 billion pounds worth of loans to be insured by the government means any final agreement is months away.

The only winners from this mess are investment banks, accounting firms and the public sector, which has spawned another quango. The Asset Protection Agency is supposed to monitor the assets in the scheme and make sure that the banks — which are on the hook for only 10 percent of losses on insured loans above a “first-loss” portion — do not diddle taxpayers.

The APA has found an acting chief executive in Jeremy Bennett, a former Credit Suisse banker. But Bennett has let it be known he does not want the job on a permanent basis — hardly a ringing endorsement for the APA as it hunts for recruits.

The uncertainty is undermining the banking sector and delaying the economic recovery. Companies that have borrowed from RBS and Lloyds are struggling to renegotiate their debts because the banks want to know which loans will qualify for the scheme. Even once the scheme is up and running, the APA’s involvement could delay decision-making, forcing companies that might otherwise have been saved out of business.

Indeed, the entire concept of the APS as an insurance policy for banks is false, because insurance only makes sense if there is a reasonable chance it will not be claimed. Both Lloyds and RBS are rapidly burning through the 20-plus billion pounds in “first loss” buffers they negotiated in the spring and are likely to start demanding government cash some time next year. This will reveal the real function of the APS, which is for the government to recapitalise RBS and Lloyds through the back door without resorting to full nationalisation.

Enough. The government should scrap the APS and adopt a different approach. One far simpler option would be for the state to promise that it will maintain the capital ratios of RBS and Lloyds at a certain minimum level. As losses on existing loans were realised, the government could inject fresh capital in return for shares. This approach would guarantee the future viability of RBS and Lloyds, while sidestepping the complexity involved in setting up the APS. It would also have a similar effect on the public finances, because the government would only have to put up cash as it was needed.

Starting small

At least one country is grabbing the bull by the horns and pledging a radical overhaul of its financial system.

“The world is asking for more transparency, higher standards, more controls, more precise rules, “ notes the chairman of this nation’s central bank.

Alas, the country is the tiny, landlocked tax haven of San Marino (population: 30,792)

Biagio Bossone, chairman of the republic’s central bank, said in an interview with Deepa Babington of Reuters that changes are coming to the San Marino financial system as it copes with pressure from the Group of 20 Nations to help stop tax evasion, as well as a money-laundering scandal.

“The real issue is to be ready to overcome this phase of emergency. … with a financial model that is transparent and offers value-added services,” Bossone told Reuters.

Well, it’s a start.

from Margaret Doyle:

HSBC tortoise will outpace Barclays hare

Barclays’ and HSBC’s interim results are a study in contrasts. Barclays has used the credit crunch to make a bet-the-farm move into the investment banking big-league, a bet that has so far paid off. HSBC, in comparison, chastened by its flawed move into the US subprime market, has returned to its conservative roots.

John Varley, Barclays’ chief executive, gives the usual guff about “staying close to our customers and clients”. In truth, Barclays’ 3 billion pounds of profit in the first half owes much more to its investment banking division, enlarged by its opportunistic acquisition of Lehman Brothers’ North American business last autumn, than to its traditional banking businesses.

Barclays Capital (BarCap) more than doubled revenues to 10.5 billion pounds, and doubled pre-tax profits to 1 billion pounds. As with rivals, the star performer was the fixed income, currencies and commodities areas where banks are profiting thanks to their access to very cheap central bank funding.

This is just as well, because Barcap is still carrying plenty of toxic assets left over from the credit boom. These cost it £4.7bn in gross writedowns and impairments in the first half. Given that it still has other dodgy exposures, including assets worth more than £7bn guaranteed by ailing monoline insurers, further losses seem likely. Barclays cannot rely on other parts of the bank to come to its rescue: profits in traditional retail and commercial banking businesses all collapsed as impairments soared.

HSBC’s global banking and markets (GBM) division also delivered a record performance,more than doubling its first-half profits, to $6.3 billion. However, HSBC has long resisted the charms of investment banking, and runs GBM as a complement to its existing global commercial banking franchise. Despite the juicy returns currently on offer, this is unlikely to change.

HSBC has its own sizeable bit of historical baggage in the form of Household, the US consumer lender that is now being expunged from the record, though not without considerable additional losses.

Many suspected that HSBC would use its bumper $17.8 billion rights issue this spring to acquire divisions of ailing rival banks at bargain basement prices. So far, it has resisted, instead bolstering its tier 1 capital ratio to 10.1 percent.