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THE dirty secret of the golden age of finance was that it was obscenely easy to make money. The supply of credit was seemingly inexhaustible, so banks could fund their expansion at will. Demand was equally insatiable, providing those infamously complex structured products with a stream of ready buyers. The years of plenty disastrously skewed risk models, allowing banks to run with lower capital on the assumption that past performance was, contrary to the industry's standard advice, a guide to future returns. And the theory that risk had been dispersed because of securitisation added to the false sense of security.
The result for many banks was a strategy of expanding their balance-sheets by writing more and more loans and holding ever more securities. With risk low, liquidity ubiquitous and many institutions under fire for appearing to be overcapitalised, there seemed to be little cost to growth. “If we could have an infinite balance-sheet for a penny return, we were going to take it,” says a Wall Street veteran.
Things are somewhat different now. If boardroom discussion in the past decade revolved around the asset side of the balance-sheet, the next decade will see managers focusing on the liabilities side—the amount and quality of capital they hold to protect against losses, and the duration and sources of their funding. Banks will go from being unconstrained by their balance-sheets to being caged by them.
Start with capital, which has suddenly become the industry's scarce resource. That is particularly true today as the prospect of further losses continues to unnerve private investors. But it will remain true after the immediate crisis has eased. The amount of capital that banks have to hold will go up, and not just because their regulators want them to have a bigger buffer against losses.
The risk weightings on assets are rising as the effects of the downturn feed through into banks' risk models, forcing them to set aside more capital. Bondholders want a greater cushion beneath them in the capital structure to protect them against losses. Shareholders too are belatedly happy to trade higher returns on equity for a reduced chance of being wiped out. So banks with more equity capital are now valued more highly by the market. Between 2000 and 2007 there was no correlation between equity-capital ratios and the total return on banks' shares, says Mr Varley of Barclays. “Now the correlation is meaningful.”
The amount of capital banks hold is not the only thing under scrutiny. They also need to have the right kind. Their capital is a mix of common equity, which is first in line when losses strike, and various other instruments, often hybrids of equity and debt. A gradual pre-crisis increase in the proportion of this sort of capital has accelerated rapidly in recent months, as common equity has been eaten up by losses and governments have largely filled the gap with preferred shares, which helps to avoid nationalisation.
The curious effect of this changing capital mix has been to bolster banks' overall capital bases while disturbing shareholders, who see common equity as the only dependable bulwark against losses. Thus banks with less of it have been punished by the markets. “It turns out that hybrids don't have much loss-absorbing capacity and are not much use in a period of stress,” concludes Mr Ramsden of Goldman Sachs. That realisation helps to explain why American commercial banks, despite appearing well capitalised compared with their European peers ahead of the crisis, have still had a capital problem. It also helps to explain the banks' rush to buy back hybrid debt at discounted prices: they can book the gains as profits and use these to beef up capital where it counts.
Holders of hybrid instruments, as well as of other forms of junior debt, have been given their own reasons to reflect. The British government's decision in February to amend the terms of subordinated debt issued by Bradford & Bingley, a nationalised bank, spooked European markets, for example. Bondholders were locked in when Deutsche Bank decided in December not to redeem a €1 billion ($1.3 billion) subordinated bond at its first opportunity. John Raymond of CreditSights, a research firm, says investors used to like buying debt lower down banks' capital structure because they thought its higher yield overcompensated for a marginal increase in risk. Now their thinking has changed.
Senior debtholders, who rank first in the hierarchy of unsecured creditors if a bank is liquidated, have less to worry about. In general regulators have stuck to the standard script of bank bail-outs, in which shareholders take the pain and bondholders are protected. And a bigger equity cushion should help to reduce the cost of debt by counteracting fears that debtholders are too exposed to losses.
Bank debt of all kinds will nevertheless be perceived as more risky after this crisis. Investors will not soon forget Washington Mutual's failure last September, when assets and deposits of the Seattle-based thrift were transferred to JPMorgan Chase but its creditors were left high and dry. Even in countries that do not formally prioritise depositors over other creditors, as America does, the political necessity of reimbursing taxpayers before anyone else has become crystal clear. Thanks to Iceland's crisis the creditworthiness of banks will also be far more closely tied to the creditworthiness of the countries in which they are headquartered.
The primary effect of all these changes will be to make it more expensive to expand the balance-sheet. Scared bank shareholders will now demand a higher risk premium, as will debtholders. Competition for capital and safer forms of debt will be greater, as investors demand fortress-like balance-sheets. And equity will go less far in a world where banks are more constrained in the amount of assets they can support with each unit of capital.
All this in turn will lead banks to think harder about where they deploy capital. Executives will ask tough questions about activities that absorb lots of capital but have lower returns now that leverage is lower, the risks are clearer and cost of funding is higher. “Some banks' balance-sheets could be expanded indefinitely in the past,” says Paul Calello, the boss of Credit Suisse's investment bank. “Now that capital is more scarce the banks have to be even more efficient in their balance-sheet and capital usage to maximise profitability.” Dedicated proprietary-trading desks, where a group of traders put the bank's own capital at risk, look much less attractive in this changed environment, for example. The advantages of running such desks have largely gone, says Bill Winters of JPMorgan Chase's investment bank.
Finer judgments about the liquidity of assets will also come into play. When markets are less liquid, assets stay on the balance-sheets for longer. That exposes institutions to greater risk and ties up capital that could be better deployed elsewhere. Credit Suisse is planning to continue to operate in American residential mortgage-backed securities (RMBS), for example, where markets are deeper and more liquid, but exit the sludgier European RMBS market, where the bank is forced to hold assets for longer.
Businesses that throw off plenty of earnings without absorbing much capital or running great risks are naturally in demand. Take the advisory businesses of investment banking, an area in which plenty of boutiques make a decent living without having a balance-sheet at all. Or custody businesses, where banks look after the assets of other financial institutions. Or asset management, where someone else's money is at risk. The two remaining independent investment banks, Goldman Sachs and Morgan Stanley, have both signalled greater emphasis on less capital-intensive businesses.
Debt dilemmas
Capital is not the only bit of the balance-sheet that will get a lot more attention in future. Executives (and regulators) will also focus more on the funding profile of their businesses in light of the crisis, as the costs of borrowing rise, lenders demand greater security and keener awareness of liquidity risk informs behaviour.
They will pay greater attention, for example, to whether assets can be used as collateral for further borrowing. Huw van Steenis, an analyst at Morgan Stanley, says banks will divide activities between those generating collateral that can be placed with central banks (high-quality mortgages, for example) or is otherwise decent enough to be used as security (shares, say), and those that do not throw off any collateral at all and therefore consume unsecured funding. The cost and scarcity of this type of funding means that these businesses—equity underwriting is an example—will command higher margins.
Above all, banks will have a deeper awareness of funding risk—their ability to roll over debts as they come due. Institutions that keenly exploited the pricing differences between long-term assets and short-term liabilities paid heavily when liquidity dried up and they were unable to refinance fast-maturing debts or sell the assets that they held.
To be more precise, the weakness revealed by this crisis has been in short-term wholesale funding, which rolls over quickly but does not have the government-backed guarantees that help to keep retail depositors quiescent. This type of funding has been at the heart of the crisis.
Many subprime mortgage-backed securities were held in off-balance-sheet vehicles that funded themselves by issuing short-dated, asset-backed commercial paper to money-market funds and other investors. When those funds suddenly stopped buying paper, the banks' liquidity lines to these vehicles abruptly came into force. Similarly, the amount of funding that investment banks were doing through overnight repo agreements surged between 2004 and 2007; they were rolling over one-quarter of their balance-sheets every day prior to the crisis, making them vulnerable to a sudden loss of confidence.
Short-term wholesale funding also helped to sink Northern Rock, one of the earliest victims of the crisis. The bank's failure in September 2007 is indelibly associated with images of Britain's first retail bank run since 1866 and is often blamed on its enthusiastic use of securitisation to expand its mortgage book. Yet a 2008 paper by Hyun Song Shin of Princeton University, dissecting the bank's implosion, suggests that neither the run nor securitisation was the principal culprit.
The retail run on the bank came in mid-September, when news broke that the Bank of England was providing it with emergency support. Yet Northern Rock had been experiencing funding problems since mid-August. The retail run came after the bank had already been destabilised by wholesale-funding problems. Nor can securitisation really be blamed for the withdrawal in funding. Northern Rock's securitisation vehicle issued relatively long-term notes to investors, so it did not face the threat of massive redemptions from this particular quarter. The first and most damaging run on the bank took place in its other short- and medium-term wholesale liabilities (see chart 5).
Faced with this stress fracture in their funding structures, banks have two obvious ways to respond. The first is to lengthen the maturity of the wholesale debts that they have. Some institutions have less far to go than others: the unsecured debt of Goldman Sachs already boasts an average maturity of eight years, for instance. But when markets get back to normal, funding maturities are likely to rise.
There are limits to issuance of longer-dated liabilities. A big rise in the proportion of long-term bond funding across the industry is bound to be costly, especially since banks will have to compete to attract interest from bond investors who already have exposure to many of these institutions anyway. Securitisation markets are badly damaged
The second option, and the more important shift, is for banks to increase their dependence on more stable deposits. The most dramatic volte-face has been that of the surviving investment banks, Goldman Sachs and Morgan Stanley, which became bank holding companies in September, making it easier for them to take deposits.
The upheaval in funding profiles is arguably greater for retail banks, however. Just as capital ratios are now strongly correlated with share prices, so too are loan-to-deposit ratios (LDRs). Among emerging European countries, where cross-border capital flows were critical and have now dried up, those with higher LDRs (ie, fewer deposits) have seen their banks' share prices dive the most (see chart 6).
Retail-bank bosses who had financed loan growth by tapping wholesale sources of funding are now targeting lower LDRs. Before it was snapped up by Lloyds TSB, HBOS, another stricken British lender, was trying to dispose of businesses that were dependent on wholesale funds and therefore increased the group's LDR. Many banks have now imposed limits on asset growth, requiring that loans do not expand more quickly than deposits.
A perennial industry debate, on the merits of bank branches versus other customer channels, has been given fresh piquancy by this need to gather in deposits—and the branch is likely to emerge strengthened. Studies consistently suggest that branch networks with a strong local presence are the most effective way to win deposits. Mr Shin's analysis of Northern Rock contains some fascinating detail on the retail-deposit run. Despite those snaking queues, customers with branch-based accounts were stickier than many others. Online account-holders fled in roughly similar proportions to branch customers. Holders of postal accounts and offshore accounts were flightier.
In truth, banks need to have a diverse set of funding sources and maturities, whether wholesale or retail. Relying on deposits alone still entails risk. Deposits can be withdrawn at a moment's notice, after all, and government guarantees do not stop depositors from discriminating between institutions: companies and individuals alike want to avoid the hassle of having to retrieve deposits from a failed bank.