Major Industry Trends
The years 2008 and 2009 saw unprecedented turmoil and change in the global banking and financial services sector. The global banking crisis first burst into the media spotlight with the announcement by US bank Bear Sterns in June 2007 that two of its more substantial hedge funds (totaling in excess of US$3 billion), both heavily invested in derivative instruments based on the US subprime mortgage market, were failing. From that point onwards, a crisis that had been gestating for around a decade in the banking sectors of the world’s developed economies began to boil over.
The failure of US investment bank Lehman Brothers in September 2008 focused attention on just how intertwined and interconnected debt had become among leading banks. Credit and interbank liquidity froze across the globe. Since then, governments around the world have been bailing out failing banks, and pumping money into the financial system in an effort to “normalize” banking activities, and to prevent a global financial meltdown.
In April 2010, the International Monetary Fund (IMF) estimated (in its “Global financial stability report”) that global bank losses from the financial crisis would total US$2.28 trillion, a drop of US$533 billion from an estimate made in October 2009. The IMF believes that the faster-than-anticipated global recovery is having a beneficial impact on the scale of the losses.
The decline in the IMF’s estimate for bank losses from the financial crisis reflects a drop of 13% in the IMF’s estimate of loan losses, which fell to US$1.65 trillion, and a 31.3% decline in losses on bank securities, which fell to US$629 billion.
For the United States, estimates for losses on bad loans fell 10.1% to US$588 billion, and losses on securities investments fell 20.2% to US$296 billion. However, by mid-2011 there were still plenty of downside risks facing the global banking sector. Bank share prices, which had increased markedly through 2011 are once again dragging back equity markets in developed economies. In its June 2011 “Economics and mortgage market analysis,” Fannie Mae focused on the weaknesses in the US banking sector, saying that “the prospects for economic growth have grown dimmer recently with downward revisions of first-quarter activity and most economic data for the (second quarter of 2011) being downbeat.” The big risk to US banks is that the economy slips into another recession, with a consequent rise in defaults and home repossessions, adding to bank woes. On the plus side, Fannie Mae analysts rate the chances of another recession in the US over the next 12 months as “quite low.”
It is now generally recognized that banks will face considerable challenges as they seek to raise more and higher-quality capital to satisfy investors in anticipation of more stringent regulation. New regulations are also looking almost certain to require banks to reassess their business strategies. In mid-2011 the UK government led the way in a speech by Chancellor George Osborne which announced sweeping changes to the way financial regulation is likely to work in the United Kingdom. In addition to creating a new “prudential regulator” tasked specifically with looking at systemic risks, the Chancellor also announced that an independent commission would look into the breaking up of big banks.
Following the crash, there has been a concerted effort to both understand and deal with its origins. However, since a key part of the analysis that has emerged has to do with global trade imbalances that are still a major feature of the global economic landscape, solutions are proving difficult. The credit and housing bubbles in the United States and, subsequently, in Europe were financed by massive capital inflows from emerging economies such as China. The resulting debt disaster engulfed banks, froze lending, and created a deep pool of “toxic assets” on bank books across the developed world. The solution many governments adopted was both to refinance banks directly, and to create “bad banks” to buy and hold the toxic assets of banks that are judged to have a reasonable chance of survival.
Bank scandals have continued since the crash and litigation is likely to keep the “sins” committed by banks through the crash intermittently in the public eye for years to come. In April 2010, for example, Goldman Sachs, the Wall Street powerhouse, was accused by the US financial regulator of defrauding investors. The Securities and Exchange Commission (SEC) alleged that Goldman failed to disclose conflicts of interest. The claims concern Goldman’s marketing of subprime mortgage investments just as the US housing market faltered. Goldman rejected the SEC’s allegations, saying that it would “vigorously” defend its reputation. The SEC said Goldman failed to disclose “vital information” that one of its clients, Paulson & Co, helped choose which securities were packaged into the mortgage portfolio. These securities were sold to investors in 2007. But Goldman did not disclose that Paulson, one of the world’s largest hedge funds, had bet that the value of the securities would fall. Goldman, arguably the world’s most prestigious investment bank, had escaped relatively unscathed from the global financial meltdown. The action against Goldman Sachs marked the first time regulators acted against a Wall Street deal that allegedly helped investors take advantage of the US housing market collapse.
At the same time, by 2011 the sovereign debt crisis in Europe had grown to the point where bank investments in European area peripheral nation sovereign debt, particularly in Greek, Irish, Portuguese, and Spanish debt, which totals hundreds of billions of euros, is now a major systemic weakness and presents a clear and present danger to the European banking system. The US banks are not free of this contagion risk either since several major US banks have written credit default swap (CDS) insurance contracts with European banks and these CDSs also run to tens of billions of dollars. So the US banks in their turn are subject to substantial risk if Greece, Ireland, or Portugal (which in June 2011 had its debt cut to junk status by Moody’s) were to default.
Deutsche Bank pointed out in a recent banking sector report that performance improvements during the 15 years prior to the 2008 crash had often been due to strong lending growth and low credit losses by banks. Clearly as consumers continue to unwind their unsustainable, pre-crash indebtedness, consumer spending, and hence bank revenue growth in some European countries, but especially the United States, could well remain depressed for several years. Weak loan growth and a return of higher loan losses, as well as a fundamentally diminished importance of trading income and modern capital market activities such as securitization, will mean that these major growth drivers are no longer available to banks, or available to a much lower degree.
One of the ironies of the crash was that despite the furor over “too-big-to-fail” banks, the enforced bailout of troubled banks led to the big getting even bigger. However, the story since 2009 has been more one of restructuring, rather than strategic M&A. Bank results in 2011 have been mixed and in some instances a lot better than their share price has indicated, with investors often ignoring earnings fundamentals and being swept along by the tremors that never seem far from the sector. Enhanced earnings and profit performance improvements by the major banks frequently seem to be originating not from real growth drivers but by rather more tenuous factors such as revised valuations on property holdings, or lower tax bills. In many instances quarter-on-quarter improvements in performance can be put down to reduced loan losses due to the modest recovery, rather than by any exciting increase in business demand. HSBC, for example, reporting its quarterly earnings in May 2011, was able to report an earnings-per-share increase of 53% as a result of being able to offset its massive losses in the US subprime market against tax. That is not an exciting story for investors, particularly since HSBC also reported that the cost of running its operations had increased by 17%, driving the year-on-year increase of its cost-to-income ratio to over 60% from under 50% a year earlier.
Regulation Before and After the Crash
The integration of European financial markets is a firm EU goal, up to the level of integration achieved in the United States under the US Federal Reserve. Prior to the crash, it was thought that Basel II, the second of the Basel accords, as set out by the Basel Committee on Banking Supervision, and embodied in the EU directive, would provide a global standard for banking regulation.
The Basel Committee has no legislative power; it simply makes recommendations after thorough consultation with the banking industry. However, as its members are senior representatives of bank supervisory authorities, and the central banks of the G10 countries plus Luxembourg and Spain, its views hold tremendous sway. The committee meets at the Bank of International Settlements (BIS) in Basel, which accounts for the name of the accord.
Basel II sets up rigorous risk and capital management requirements designed to ensure that banks hold sufficient capital reserves to cover the risks that they incur in trading. It uses a “three-pillar” concept, based on capital adequacy requirements, usually modeled by the banks themselves (pillar 1), supervisory review (pillar 2), and market discipline (pillar 3). It is generally held that all three pillars failed, for various reasons, in the current crisis.
The Basel Committee has already issued a consultation document designed to bring all the off-balance-sheet vehicles and risks, that Basel II failed to capture, back within the modeling regime used by banks to determine capital adequacy. However, while the final shape of banking regulation after the crash is still being worked through, the market in general fully expects banking regulation in future to be much tougher, with the kinds of risks that banks were formerly allowed to run being much more tightly circumscribed. A popular summary of this view is that banks, henceforth, should be seen as a kind of functional, systemically important, low-risk, low-growth utility. Just how well thought through this proposal is remains to be seen. Global merger and acquisition activity requires a rather different model, and where the liquidity is to come from to satisfy the next growth wave, if banks take on the utility model, is presently unclear.
The authorities around the world appear determined to regulate the banks more strictly than was the case in the past.
In 2010, President Barack Obama began the process of pushing legislation through Congress that would increase the regulation of banks and capital markets after the 2008–09 financial crisis. This finally matured as the Dodd–Frank Act of July 2010. The original aim had been to produce an Act that would, in the words of President Obama, “put an end to taxpayer bail-outs, that would bring complex financial dealings out of the shadows, that would protect consumers, and that would give shareholders more power in the financial system.” The Dodd–Frank Act is a compromise between two separate bills, one by the House of Representatives, the other by the Senate Banking Committee. Though the Act has its critics, who claim that it fails to cure the “too-big-to-fail” issue and fails to break up the big banks, it is nevertheless the most sweeping change to the US financial system since Glass–Steagall in the 1930s. By mid-2011, various agencies and offshoots of the US regulatory mechanism were still heavily engaged in formulating the rules that will enable Dodd–Frank to work. The Act changed the existing regulatory structure in the United States, creating new agencies while abolishing others. The new agencies include the Financial Stability Oversight Council, the Office of Financial Research, and the Bureau of Consumer Financial Protection.
The US overhaul has been welcomed by EU leaders. European officials are skeptical of proposals to ban banks from risky trading on their own behalf. They fear it would handicap global European financial players.
In April 2010, the IMF proposed that that all financial institutions should pay a bank levy—initially at a flat rate—and also face a further tax on profits and pay. The measure was designed to make banks pay for the costs of future financial and economic rescue packages. Insurers, hedge funds, and other financial institutions would also have to pay. While the general levy, or “financial stability contribution,” would initially be at a flat rate, this would eventually be refined so that riskier businesses paid more.
It was agreed at the G20 summit in London in April 2010 that financial institutions and not taxpayers should pay for future bank rescue packages. Since then, several proposals have been put forward by various governments, including the so-called “Tobin Tax” on financial transactions. Some nations, including Canada, oppose any new bank tax. By mid-2011 a number of countries had introduced some form of levy for large banks. In its June 2011 Stability Review, the European Central Bank said that eight member countries had introduced a levy system while a number of others were in the process of introducing it. Concerns persist, however, on the potential impact of such a levy on banks’ ability to provide credit. One of the worries about a levy system, the ECB points out, is that financial institutions could still look to swell their own profits through excessive risk taking, while transferring losses to a common rescue fund. Another concern is that unless the rules were brought in on a coordinated basis, across the G20, for example, institutions would simply choose where they operated, moving to jurisdictions with less-tough financial regulation.