15 Min Read
DAVOS, Switzerland (Reuters) - The Bank of England estimates governments the world over have spent or committed a staggering $14 trillion to prop up the financial system following the fall of Lehman Brothers in September 2008.
So, what did we get for all that dough?
Unfortunately, more questions than answers.
Indeed, many of the factors that helped cause the previous crisis -- a sustained period of low interest rates, high levels of consumer debt in the West and excessive risk-taking by financial institutions -- remain in place.
At the same time, supersized government bailouts could have created the conditions for future financial crises that will be larger and even more expensive than the one the world has just suffered.
Despite the protestations by politicians that such a large-scale rescue should never be allowed to happen again, their actions over the past two years suggest the opposite.
"Knowing this, the rational response by market participants is to double their bets. This adds to the cost of future crises," Piergiorgio Alessandri and Andrew Haldane of the Bank of England wrote recently.
"This is a doom loop."
This, however, is decidedly not the prevailing mood in the banking industry. Following their near-death experience, many bankers have been pleasantly surprised by the industry's rapid recovery. Markets have stabilized, courtesy of government handouts. Banks' profits -- and their share prices -- have recovered.
But all that has come with a price. By cutting interest rates to zero and pumping liquidity into the markets, the authorities risk encouraging a new round of risk-taking by banks and investors. And by loading the bailout costs onto the public sector they have undermined the creditworthiness of large developed nations. This, in turn, has sparked a growing political backlash.
Meanwhile, reforms designed to make the banking system safer -- boosting banks' capital requirements, for example -- are still several years away from implementation. And the imbalances in the global economy that contributed to the crisis are far from resolved; they may in fact be worse.
This presents policymakers with a nasty dilemma. If they leave support in place for too long, they run the risk of inflating another bubble. But if they withdraw too soon, the danger is of a slide back into recession.
That may be enough to send banks back to the blackjack table. "The recovery in financial markets is a welcome development but ... if nothing is done to withdraw this stimulus, this search for yield will begin to lead to underpricing of risk," says Hung Tran, deputy managing director of the Washington-based Institute for International Finance, whose members include most of the world's large banks.
Judging from the public outrage that has greeted their singular compensation system, the world's banks seem more vulnerable to pogroms than to another financial meltdown. In recent weeks large institutions including JPMorgan Chase & Co and Goldman Sachs Group Inc have reported healthy profits, and their counterparts on the other side of the Atlantic are expected to do the same when European banks report their results over the next few weeks.
Banks with large investment banking divisions have done particularly well by taking advantage of recent market volatility and heavy trading volumes in bonds, currencies and commodities.
Many have also used the market rebound to rebuild balance sheets. According to the Bank for International Settlements, the amount of capital raised by the world's banks -- which has now exceeded $1 trillion -- has overtaken the write-downs triggered by the crisis.
One major source of profit for banks stems from their ability to borrow at near-zero short-term interest rates, while making longer-term loans at higher rates. In other words, the regulators are allowing banks to earn their way out of trouble.
This cannot last for ever.
Oliver Wyman, the financial services consultancy, compares these profits to the short-term "morphine high" that patients undergoing medical treatment experience.
As with morphine, the pain is only being masked. Many large banks are still dependent on central bank liquidity facilities and government-guaranteed debt to fund their balance sheets.
The European Central Bank's Long-Term Refinancing Operation, which allows banks to pledge assets in return for cash, has current loans of 670 billion euros, up from 50 billion euros before the crisis.
Meanwhile, the Bank of England is currently providing 185 billion pounds of funding to the UK banking sector through its special liquidity scheme. The UK government has also financed a further 134 billion pounds of bank funding by allowing them to issue government-guaranteed debt.
"Central bankers have to say: how do I withdraw that without destabilizing the system?" said Davide Taliente, head of the public policy group at Oliver Wyman.
Direct support from the authorities is only part of the problem. The bigger issue is that banks have responded to the crisis and uncertainty by replacing long-term debt with shorter-term maturities when it came due.
The average maturity for U.S. banks' newly issued debt over the past 29 years was 6.6 years, according to Moody's, the credit rating agency. By 2009 that had fallen to just 3.2 years. This means banks must refinance a large proportion of their liabilities in the next few years.
That could turn out to be expensive for some. For example, if Bank of Ireland replaced its current funding with long-term unsecured debt, the extra costs would wipe out its expected 2012 profits, according to analysts at Barclays Capital. For Commerzbank, the hit would be 20 percent of profits. But UBS could secure long-term funding by giving up just 5 percent of expected profits.
In practice, governments are unlikely to turn off the liquidity tap anytime soon. Oliver Wyman's Taliente, who is a member of the advisory team on financial regulation for Britain's opposition Conservative party, says he expects governments to respond by fully nationalizing some institutions or winding them down.
"If the central bank lifeline is cut off, we are looking at liquidity shortfalls in the tens of billions. That's the main worry in the system right now. We do predict that there will be some further casualties."
These concerns have not, however, prevented banks from putting more risk on their balance sheets. Analysts at FBR Capital Markets estimate that up to 40 percent of investment banking revenue over the last 12 months has come from banks trading with their own funds, compared with a more typical level of about 25 percent.
All of the top U.S. banks have reported rising value-at-risk levels, signaling that their biggest trading loss on most days is rising.
Take Goldman Sachs, for example. Its biggest possible loss on 95 percent of the trading days in 2009 was $218 million, compared with $180 million for 2008. For JPMorgan Chase the largest possible loss for 99 percent of its trading days in 2009 was $248 million, compared with $202 million.
But value-at-risk is a crude way to measure how much the banks are gambling, in part because it does not specify how big possible losses are on the remaining trading days in a year.
Investors are split about how to interpret banks' apparent willingness to take increased risk. Some argue that banks are looking to rebuild their capital through reckless trading, safe in the knowledge that the government will bail them out in the worst-case scenario.
Other investors argue that banks are sitting on bigger inventories of securities to provide liquidity to capital markets, and that otherwise, investors could have much more trouble buying and selling securities.
Perhaps the greatest concern, however, is that banks are hoarding government bonds.
According to the BIS, banks are buying government bonds for two reasons: because of lower demand from consumers and companies for loans; and because they want to reduce the riskiness of their balance sheets.
Another factor is that regulators, in an attempt to ensure that banks are better able to withstand a sudden freeze in the capital markets, are demanding that they hold greater reserves of liquid securities. In practice, these are likely to be government bonds.
In the United States, holdings of government bonds by banks fell from 16 percent to around 10 percent in the decade up to 2007, according to the Federal Reserve, but have increased again since the crisis struck.
Some bankers believe this is a significant issue.
Historically, banks' risk models have tended to assume that the bonds of developed countries were close to risk-free assets. No longer. The government finances of peripheral countries such as Greece and Ireland are already creaking. And many investors believe it is only a matter of time before ratings agencies lower the UK's credit rating. A downgrade -- or, heaven forbid, a default -- could leave banks exposed.
"Banks are filling their books with long-dated government paper, funded with short-term government funding," said a senior executive at a large UK-based bank, who asked not to be named. "It's the biggest carry trade in the world."
Apart from creating systemic risks, however, large-scale purchases of government bonds by banks are also failing to fix the paltry flow of credit. Despite the liquidity being pumped into the economy, lending to consumers and small- and medium-sized businesses has not yet picked up.
It is not entirely clear banks should be blamed. One explanation is that demand for credit has fallen as consumers and companies decided they had too much debt. The moribund state of the securitization market has also crimped lending, as has the burden of badly performing commercial real estate loans in the U.S. on medium and small-sized banks.
Bankers also point out that some people who took out loans during the boom should never have been allowed to borrow so heavily.
Even so, this situation contributes to the widespread public perception that bailing out banks has been of no benefit to the broader economy. The longer this continues, the more likely it is that governments will interfere in banks' affairs.
Indeed, it is perhaps surprising that government interference has been so limited to date. Since the crisis erupted, governments have upheld a fragile consensus that any financial reform should be implemented on a global basis.
Naturally, that's made this process slow and time-consuming. Though regulators have made progress in drawing up new rules dictating how much capital banks should hold, these will not be finalized until the end of the year, and will probably not be in force before 2012.
"Because the crisis was so big and because the capital markets are so rich, you can't have three or four central bankers sitting in a room and deciding," said a European central banker who asked not to be named. "That means the technocratic debate takes a lot longer."
In recent weeks, political pressure has spilled over as countries -- particularly the United States -- have unilaterally introduced new taxes and regulations. President Barack Obama wants to tax banks' wholesale funds and has promised "a fight" with Wall Street if it resists his proposal to stop investment banks from engaging in proprietary trading. The United Kingdom has introduced a 50 percent windfall tax on banks who pay their employees bonuses of more than 25,000 pounds. Faced with a combination of fiscal pressures and profitable but unpopular banks, other countries are bound to attempt similar moves.
These moves may make political sense. But some investors fear that overt bank-bashing by politicians will undo much of the benefit of the bailout.
"Political interference could derail all the efforts made so far in restimulating the economy," says Davide Serra, co-founder of Algebris, a London-based hedge fund that specializes in financial stocks. "If you crack confidence because you see fights between financiers and governments, these actions have a massive cost to the economy."
Any discussion about the response to the crisis must acknowledge the need to reduce the levels of debt that have been built up. A study by McKinsey, the consultancy, found that previous deleveraging episodes have generally taken four forms: a period of belt-tightening, in which credit growth lags behind economic growth for many years; massive defaults; high inflation; or a period of rapid GDP growth as a result of a war effort or an oil boom.
The most likely outcome is that deleveraging will lead to a long, slow slog. Indeed, falling property prices in the developed world mean many consumers are now more leveraged than they were before. According to Oliver Wyman, the ratio of household liabilities to financial assets in the U.S. is now 40 percent. Two years ago, it was 29 percent.
Another big concern is that the global economic imbalances -- whereby Western economies import and consume and Asian economies export and save -- have not yet been addressed. China's foreign currency reserves are now $2.4 trillion. Japan has reserves of about $1 trillion.
Mervyn King, the governor of the Bank of England, likens this buildup of international assets and liabilities to adding blocks to a tower.
"With skill, it can be done for a surprisingly long time. But eventually the moment comes when adding one more causes the tower to fall down," he said in a recent speech. "If countries do not work together to reduce the 'too high to last' imbalances, a crisis of one sort or another in financial markets is only too likely."
For central bankers, politicians and policymakers, then, the challenges are immense. They must withdraw the financial support that has been provided to the financial sector without triggering a collapse, but before new risk-taking creates the conditions for another collapse. They must overhaul regulation to make banks safer while reversing the moral hazard that has characterized the current round of bailouts. They must manage a controlled reduction of government debt. And they must attempt to rebalance the world economy without withdrawing into conflict and protectionism.
There is little doubt that the authorities' swift response to the crisis prevented an even more severe economic collapse. But the global financial system is far from being fixed.
Additional reporting by Lisa Jucca, Daniel Wilchins and Martin Howell; Editing by Jim Impoco and Sara Ledwith