Rebuilding the banks

A tamer banking industry is already emerging from the debris of the old, failed one, says Andrew Palmer

BANKING is the industry that failed. Banks are meant to allocate capital to businesses and consumers efficiently; instead, they ladled credit to anyone who wanted it. Banks are supposed to make money by skilfully managing the risk of transforming short-term debt into long-term loans; instead, they were undone by it. They are supposed to expedite the flow of credit through economies; instead, they ended up blocking it.

The costs of this failure are massive. Frantic efforts by governments to save their financial systems and buoy their economies will do long-term damage to public finances. The IMF reckons that average government debt for the richer G20 countries will exceed 100% of GDP in 2014, up from 70% in 2000 and just 40% in 1980

Despite public rage over bank bail-outs, the industry has also comprehensively failed its owners. The scale of wealth destruction for shareholders has been breathtaking. The total market capitalisation of the industry fell by more than half in 2008, erasing all the gains it had made since 2003 (see chart 1).

Employees have scarcely done better. The popular perception of bankers as Porsche-driving sociopaths obscures the fact that many of the industry’s staff are modestly paid and sit in branches, information-technology departments and call-centres. Job losses in the industry have been savage. “Being done” used to refer to hearing about your annual bonus. Now it means getting fired. America’s financial-services firms have shed almost half a million jobs since the peak in December 2006, more than half of them in the past seven months. Many have gone for good.

The pain is nowhere near over. The credit crunch has been a series of multiple crises, starting with subprime mortgages in America and progressively sweeping through asset classes and geographies. There are now some glimmers of optimism in the investment-banking world, where trading books have already been marked down ferociously and credit exposures to the real economy are more limited. But most banks are hunkering down for more misery, as defaults among consumers and companies spiral. In its latest Global Financial Stability Report, the IMF estimates that the total bill for financial institutions will come to $4.1 trillion

With so much red ink still to be spilled, it may seem premature to ask, as this special report does, what the future of banking looks like. For most industries, failure on this scale would mean destruction, after all. Banks, notoriously, are different. The most seismic event of the crisis to date, the bankruptcy of Lehman Brothers last September, demonstrated the costs of letting a big financial institution collapse. Trust evaporated and credit dried up. “October was the most uncomfortable moment in my career,” recalls Gordon Nixon, the boss of Royal Bank of Canada (RBC). “There was a possibility that the entire global banking system could go under.”

Concerted actions by governments since then, first in the form of capital injections and liability guarantees, and more recently via schemes to buy or guarantee loans, have signalled their determination to stabilise and clean up their big banks.

Politics notwithstanding, the commitment of governments to defend their banking systems removes the existential threat to the biggest institutions (or, more precisely, transfers it to sovereign borrowers). Bank bosses have learnt not to pronounce too confidently about the future. If the IMF’s loss predictions turn out to be accurate, there is still too little capital in the system. But most think that the chance of another Lehman-style blow-up has been greatly reduced.

There is still great uncertainty about the nature and extent of the support that governments will end up offering to their banks. But governments are now deeply embedded in banking systems. They are guaranteeing far more retail deposits than before the crisis. They are guaranteeing the issuance of new debt. They own preferred shares in many banks, common equity in others and stand ready to inject capital in others still. Banks that have not taken a scrap of government money still benefit from their stabilising presence. “We all exist at the largesse of the government right now,” says a bank boss.

The types of losses that banks now face have also changed. The huge writedowns on trading-book assets that defined the first phase of the crisis were horribly unpredictable. The complexity of structured finance made it difficult to know how losses would cascade down the ladder of investors in securitised assets. The patchy credit histories of subprime and low-documentation borrowers made it hard to model default rates accurately. And mark-to-market accounting meant that banks were valuing illiquid assets at prices which reflected a lack of buyers as much as underlying credit quality (accounting-standards bodies have since been bullied into allowing bankers to exercise more judgment in how they classify and value such assets).

Although the losses that banks face in their loan books are ugly, they should be more predictable. Shocks are still likely: for instance, the size of the bubble and scale of the bust may overturn historic relationships such as that between unemployment rates and credit-card losses. But losses on loans can be recognised in the accounts more slowly. And the assets that are now under scrutiny may be much bigger than their subprime predecessors but they are also better understood. “The scale of the recession is unprecedented but it is more familiar terrain,” says John Varley, the chief executive of Barclays.

The forgotten art

With government backing assured and impending losses somewhat more predictable, the big banks are slowly starting to lift their heads from the floor. Meetings with investors have been dominated for the past 18 months by discussions about banks’ balance-sheets and, in particular, the amount of capital that banks had. “This is my first experience of the quarterly-earnings game where no one has cared about earnings,” says Bob Kelly, the boss of Bank of New York Mellon.

That is changing. Even the biggest victims of the crisis expect to return to profitability this year. Galling as it may be to contemplate the returns that will once again accrue to banks, the rest of us badly need them to make money. Just as the prospect of continuing losses is what has stopped private capital from entering the system, the prospect of future profits is what will lure investors back in to replace governments. Profitability is also critical to the ability of banks to cover future losses without calling on further government cash. The situation is fluid but analysts at Barclays Capital reckoned in March that cumulative pre-tax and pre-provision income at the top 20 American banks for this year, 2010 and 2011 will be $575 billion, just enough to cover their estimates of losses in that period of $415 billion-$560 billion.

Profits need to be sustainable, of course. They may be the first line of defence against trouble but they disappeared all too quickly during this crisis, wiped out by writedowns and by the implosion of business models. “The discounted future profit streams of financial institutions went from quite something to almost nothing in an instant,” says Andy Haldane, head of financial stability at the Bank of England.

Banks recognise this as much as regulators do. There is a striking degree of convergence between the thrust of planned regulatory reforms and the new strategic thinking of many institutions. Greater resilience is a shared objective. Banks are reducing their dependence on wholesale funding and increasing their reliance on “stickier” deposits. They are reducing the amount of risk they take, which means reducing their proprietary trading and concentrating more on clients and activities that consume less capital. They are rapidly shrinking their balance-sheets. “The banking industry got it so wrong and destroyed so much value that it is difficult to sit in front of investors and say we are going to carry on as before,” says Richard Ramsden, an analyst at Goldman Sachs.

The future looks different to different types of banks. For smaller ones that fall outside the comforting embrace of the state or have less diversified loan portfolios, the outlook is bleaker. American regional banks and Spanish savings banks, or cajas, are among those coming under increasing pressure as commercial-property portfolios suffer. Mike Poulos of Oliver Wyman, a consultancy, expects the number of banks in America, currently some 8,000 or so, to drop by 2,000 or more as a result of the crisis.

Banks in many emerging markets will suffer as the economic climate deteriorates but they need to deleverage less. There is also less need for regulatory change. The Asian banks kept their exposure to cross-border funding flows under control, for example, unlike their peers in eastern Europe. The scale of structural change that these institutions face is relatively limited.

But for those banks at the heart of the crisis, the household names of Western finance, the landscape is different. Their future is secure enough for them to be able to plan beyond survival. Their failures have been big enough for them to know that everything they do, from the way they manage their balance-sheets to the way they pay their managers, has to change. But in seeking to work out what the new normality will be for banks, the first question to ask is how quickly and on what terms governments will disentangle themselves from the industry.

it's unremarkable that a committee of City grandees chaired by the former chairman of Citigroup Sir Win Bischoff wants the UK government to take a leading role in shaping new EU rules, and is opposed to the idea of forcing banks to slim down and specialise.

If there's any kind of controversy about the proposals, I guess it will stem in part from the following excerpt, which is one of the committee's arguments against breaking up banking conglomerates: "The provision of housing finance for individuals or pensions for tomorrow, or of insurance against potential risks for businesses or finance at cost effective rates for their expansion might require the synergies of the combined models."

On housing finance, think subprime and collateralised debt obligations - and ask yourself whether innovation by banking conglomerates has added or detracted from human welfare in recent years.

Here's the thing. The committee was set up by the Chancellor, Alistair Darling. And there's therefore an implication that he endorses what they want.

Which matters. Since it demonstrates that he disagrees with the governor of the Bank of England - who says there is a case for breaking up banks into separate retail and investment operations

And it might suggest Mr Darling concedes that recently the UK hasn't perhaps done enough to shape EU financial proposals, especially those seeking to constrain hedge funds and private equity firms.

But what on earth does it imply about Mr Darling's attitude to tax - since it was only last month that he announced an increase in the top rate of tax and a reduction in relief on pension contributions for high earners, or measures seen in the City as damaging the competitiveness of their industry.

As for what kind of Christmas banks can expect this year, well it's all looking a lot less gloomy than they would have expected a few months ago.

Their shares have trebled and quadrupled over the past few weeks.

Statements today by Barclays and Lloyds indicate that banks should be over the worst.

In the case of both, recession-generated losses on lending to vulnerable companies and individuals are rising - as is inevitable.

But in the case of Lloyds, it has more than enough capital and insurance protection from taxpayers to cope (even though losses generated by corporate lending by HBOS, which it bought in those fraught and controversial circumstances, are still rising in a wince-making way).

Lloyds' core tier one capital ratio is a super-strong 14.5%, which should be enough to withstand anything but economic Armageddon.

For Barclays - as for a number of global banks in investment banking and wholesale banking - it's difficult to see in its figures that the global economy is in a spot of bother.

Its pre-tax profits have risen 15% to £1.4bn in the first three months of the year, even though the contribution from retail and commercial banking has fallen 45%.

However, the early months of this year have been a boom time for investment banks and for banks that help the very biggest companies to raise money.

Barclays has done trebly well, having had the gumption to buy Lehman's US operations for next to nothing last autumn (after the US investment bank collapsed with such damaging consequences for almost everyone on the planet).

Any minute now we'll start to hear complaints not that our banks are almost bust, but that they're making far too much.

Actually, we're not there yet.But in another year or two - after the removal of excess capacity, a widening of margins and a fall in loan losses - banking will again be a very very profitable business.