Message to politicians everywhere: remember there’s no such thing as a safe bank

With a banking crisis in full swing, the US Congress futzes around as if it has all the time in the world to come up with a solution.  Perhaps the demise of Washington Mutual – the largest ever failure of a US deposit bank, will motivate the Congressional sloths to move forward. Populists  will have to put their desire for bankers’ blood on hold.  Libertarians will have to swallow hard and think of Ayn Rand.  Unless you really want to be able to tell your grandchildren stories of how you coped with the hardships of the Great Depression of the 2010s, the TARP proposal should be passed.

UK prime minister Gordon Brown believes that the financial crisis that now threatens to destroy the UK banking system is just the spill-over of the residential mortgage financing crisis in the US and is manageble with the existing institutions, arrangements and policies. According to the prime minisnter, the UK banking sector and financial system are sound. He sees no need for a US style TARP or similar facility, let alone for further radical proposals for recapitalising the banking system through the injection of capital by the government, in exchange for a government equity stake, or through a mandatory conversion of bank debt into equity.  With Bradford and Bingley about to share Northern Rock’s fate (unless a private solution can be found at the last minute), one hopes prime minister Brown may exit from his state of denial.

In the rest of Europe, the financial crisis is considered an essentially Anglo-American problem, whose spillovers to the euro area and other parts of the European continent are limited to some careless exposures on the asset side of the balance sheet to the US subprime markets.  With a number of large banks domiciled in small continental European countries tottering near the edge of the abyss, one hopes that the public protestations of confidence are not preventing the preparation of emergency rescue plans to prevent a financial meltdown.

Fundamentally, any institution that is highly leveraged and has serious asset-liability maturity mismatch and/or liquidity mismatch is vulnerable to runs or market strikes.  This is true even if the institution is sound, in the sense that its assets, if held to maturity, would yield cash flows sufficient to cover all the financial obligations of the institutions.  Regardless of the soundness of the assets they hold, they can be brought down by a sudden drying up of funding liquidity and market liquidity.  The set of inherently unsafe institutions includes all banks – deposit-taking banks, investment banks (if any are left), universal banks, the shadow-banking institutions that have grown up during the latest round of ‘Evade the Regulator’) – , hedge funds, other investment funds, including money market funds, private equity firms and the AIG’s and GE’s of this world, some of which may not even be classified as financial enterprises).

The notion that universal banks with a large deposit bank are safe  from funding liquidity and market liquidity crunches is an illusion.  Even if a bank were 100 percent funded from deposits, whatever security it has is due to the presence of deposit insurance, which is ultimately underwritten by the tax payer.  And no deposit scheme, even if government guaranteed for retail deposits up to $100,000, as is the case in the US, is fully credible.  This is obvious from the example of Washington Mutual, which lost billions of US dollars in deposits in the days since September 15.  In the UK, the problem is worse, with individual deposits per person per bank guaranteed only up to £35,000.  In addition, in the past it has taken UK depositors as long as six months to get their insured money back.  Withdrawing one’s money from a bank that may be at risk of failing therefore remains the individually rational thing to do.  On the European continent, deposit insurance is a country-specific affair, with the EU mandated minimum guarantee at just  20,000.

More to the point, all systemically important deposit-taking banks have the international and domestic financial wholesale markets as their marginal source of funding.  Even if your funding base has a share of deposits of 80 percent, the problem with deposits is that even if they are a stable source of funding (which they may not be in a crisis), they are not a flexible source of funding.  Were the 20 percent wholesale market funding stream to dry up, a bank that funds itself 80 percent through deposits could as readily be pushed into insolvency as a bank funding itself 100 percent in the wholesale markets.

So, unless they fund themselves 100% through deposits and long-term instruments and facilities,  deposit-taking institutions need deposit insurance and, if that fails to stop a run, a central bank willing and able to act either a lender of last resort or a market maker of last resort to provide funds against illiquid collateral.  In this they are not qualitatively different from the investment banks of old and from AIG.  The central bank as lender of last resort and market maker of last resort, backed by the Treasury in case the collateral accepted in exchange for central bank funds turns out to be a dud, is central to the viability of the banking system, even if every bank is sound.

The easily manageable condition where the banks are illiquid but solvent is not, I would argue, any longer the relevant one in the US, the UK and continental Europe  (for simplicity I lump Ireland and Iceland with continental Europe in what follows).  Everyone is familiar with the dire straits the US banking system is in.  The system is now so fragile that, if no TARP-like plan in approved before the markets open on Monday, virtually every bank in the US could be at risk and many would fail.  I cannot believe that Congress would be so irresponsible and stupid that it would risk a re-run of the Great Depression.  The TARP is just the first step in a sequence of measures necessary to maintain a functioning financial system in the US.   Steps to recapitalise the banking system have to be implemented immediately, as without it banks are unlikely to be willing and able to provide funds to households and non-financial enterprises.

But the UK too needs a TARP-like arrangement, that is, a market maker of last resort capable  of buying toxic assets outright, and willing to do do so.  The toxic assets (assets whose fundamental value or hold-to-maturity value – the present discounted value of their expected future cash flows if the assets were held to maturity,  discounted using the discount rates of a non-liquidity-constrained investor – is impossible to ascertain with any degree of confidence)   that should be taken off the banks books are not just residential mortgage-backed securities backed by US subprime mortgages.  They include a large stock of derivatives backed by and based on UK assets.  There has been an explosion of irresponsible and reckless mortgage borrowing and lending in the UK also.  In the last 3 or 4 years before the start of the crisis in August 2oo7, growing numbers of mortgages were approved without  verification of the borrowers’ ability to service the mortgages; mortgages were approved that equaled or (together with further unsecured loans bundled with the mortgages) exceeded 100 percent of the collateral.  Mortgages provided at rates that implied a loss to the mortgage lending company (in the name of gaining market share); mortgages with teaser rate features – perhaps not as extreme as the American examples, but still pretty bad.

US house prices peaked and started falling more than a year before UK house prices did the same.  If UK house prices fall from peak to trough by 25 to 30 percent, as I consider quite likely, then a growing number of UK home borrowers will find themselves with negative equity.  It is true that, while most US mortgages  are non-recourse  (if the borrower defaults, the lender has no claim on the resources of the borrower, including his future income, other than the property against which the mortgage was secured) ,UK mortgages tend to have recourse by the lender.  But many UK mortgage borrowers appear not even to be aware of this.  In any case, the combination of a sharp further fall in UK house prices and a large increase in unemployment will increase arrears and defaults on residential mortgages significantly, further weakening the balance sheets of the banks.

Gordon Brown argues that things will be different in the UK because houses are scarce there, unlike in the USA.  Certainly the effective land to people or land to GDP ratios  are lower in the UK than in the US.  Why that (plus perhaps the existence of tight planning and other regulatory constraints on UK housing construction) would make a sharp decline in house prices either less likely or less dangerous to banks’ balance sheets is not obvious to me.

And the excesses of the past are not confined to residential housing and its financing.  UK households are more indebted (relative to their disposable incomes) than US households.  UK banks are exposed to the excessively leveraged UK consumer through a range of instruments other than mortgages, including unsecured credit card debt.

The UK residential construction sector is gasping for air, and UK banks are highly exposed to that sector.  UK-based but strongly internationally diversified banks, such as HSBC, were able to offset large losses in the US with large profits in emerging markets.  With the financial storm hitting the BRICs and the other emerging markets (other than, so far, Brazil) head-on, the days that the profits from the East could balance the losses from the West are likely be gone, at least for the time being.

So I view the UK banking sector as systemically weak and vulnerable – much of it not just unsafe, but also unsound.  The government has to engage in the kind of contingency planning required  to bring the fiscal resources of the state into play at a moment’s notice.  Why, more than a year after the Northern Rock debacle, we still don’t have a Special Resolution Regime for banks at risk of failing is a deep mystery.  An SRS would be the right way to deal with the Bradford & Bingleys of this world.  Instead we will either see B&B sold off in a shambolic manner to another bank, thus distorting the future competitive playing field, or nationalised (possibly through a take-over by Northern Rock!). With nationalisation, it is likely that virtually all the creditors of B&B (not just the insured depositors) will be made whole.  That creates dangerous incentives for future lending to banks engaged in risky behaviour.

Except for the creation of the SLS, which was a fine if insufficient thing, the UK fiscal, monetary and regulatory authorities have responded late, reluctantly and   timidly to each new  phase of the crisis.  It would be great if they could be ahead of the game for a change.

In the euro area and in the other continental European countries, fiscal support for ailing banks at risk of insolvency presents less of an ideological embarrassment for the authorities than in the US and the UK.  There already appear to be intense discussion and even signs of cooperation between the Dutch and Belgian regulatory and fiscal authorities to address the problems of Fortis.  Switzerland faces the unique problem of having large internationally active banks but not having a strong central fiscal authority capable of recapitalising  its banking sector.  It is hard to visualise a rescue effort being mounted, if one were to prove necessary, by one of the cantons.  Effective support would have to involve cross-border-co-operation.  The same applies to Iceland.

Continental European banks, regulated and supervised by a wide range of often highly idiosyncratic national regulators and supervisors, have thus far on the whole provided much less useful information about their balance sheets and their off-balance-sheet exposures than US and UK banks.  The suspicion is widespread, that there may be significant amounts of as yet undeclared toxic waste, of both US and domestic origin, held by the continental European banks, insurance companies, pension funds  and other financial institutions.  The magnitude of the property and construction boom and bust in Spain and Ireland suggests the presence of a large financial black hole in some banks’ balance sheets.  Until all these losses are declared and the assets marked to market, there can be no normalisation of financial relations between banks and between banks and their non-financial customers.

Even during the heat of the crisis, it is not necessary to lose track of moral hazard.  The TARP should be used to get the toxic waste off the banks’ balance sheets and with it the uncertainty about who holds what and what it’s worth.  The TARP should not be used to recapitalise the banks to any significant extent.  That means that the prices offered should be in the range between the fire-sale market price and the hold-to-maturity fundamental price, but as close to the fire-sale market price as the current valuation of the toxic asset on the banks’ balance sheets permits.  It would not make sense to decapitalise the banks through the TARP, and if the price offered for a toxic asset were below the current ‘fair value’ at which it is carried on the balance sheet, no bank would agree to sell in any case. Recapitalisation (whether through a government injection of capital in exchange for equity or through mandatory debt-to-equity conversions) should not depend on the willingness of banks to come forward.  It should apply to all banks/financial institutions whose capital ratios are too low (according to some metric determined by the government)   or whose leverage ratios are too high.

Making access to the TARP contingent on a government equity stake  and/or on severe contraints on CEO remuneration, would result in many banks that would benefit as institutions not accessing the TARP because of the self-interested behaviour of the CEOs.  That may be outrageous, unpatriotic and irresponsible, but it would happen.  If you want to make the world a better place, you should start by gaining an understanding of why it is in the mess it is in.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

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