PROMISES THAT PROVED ULTIMATELY EMPTY / THE FINANCIAL TIMES COMMENT & ANALYSIS ( A MUST READ )

January 9, 2012 11:25 pm

Promises that proved ultimately empty

By John Gapper
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Unless banks can better demonstrate their usefulness to society, they face a debilitating battle against new regulation
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City banks must draw up 'resolution plans' by mid-year

More than three years after taking the world to the brink of economic meltdown, banks remain heavily troubled. Instead of the rebound from losses that would normally have taken hold, they are now confronted with a rumbling debt crisis in Europe.


The crisis of legitimacy in capitalism has meanwhile spread since 2008, just as Occupy Wall Street has expanded from its original focus on bail-outs and bankers’ pay to a global reference point for the grievances of the “99 per cent”. Yet it was within banks where the crisis emerged and where its heart still lies.
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Their troubles go beyond the financial. In the 1990s and 2000s, banks became a leading force in western economies. Their share of gross domestic product rose sharply; Wall Street banks such as Goldman Sachs extended their reach across Europe and Asia; the boundaries between commercial and investment banking were eroded, and bankers were highly rewarded and even regarded as glamorous.


Today, they are resented for holding taxpayers hostage by having become “too big to fail”. Many argue that banks have drifted from their basic social function – to encourage growth by making loans, underwriting securities and advising companies – into a self-interested drive to make money by any means possible.


The hostile mood is exacerbated by the pay practices that grew up on Wall Street and in the City of London following deregulation in the 1970s and 1980s – the habit of half-mimicking the old partnership structures by paying investment bankers and traders large bonuses. Big financial institutions managed to absorb the gains from trading and risk-taking while socialising their losses. “There is a deep question of legitimacy that banks need to face up to,” says Ranu Dayal, senior partner at Boston Consulting Group. “The under­lying level of dislike of banks is compounded if they are not seen to have reformed and to be playing an important role in economic resurgence – or to have failed as a result of compensation structures or just naked greed.”


Unless they can find a way to demonstrate their usefulness clearly, and to curb the practices that most alienate outsiders, banks face a long, debilitating trench war against new regulation. For economies, this could limit the beneficial aspects of a thriving and focused financial sector.


Postponed and hidden risk


For a long time, banks coasted on a wave of growth in credit markets – driven by the rise of derivatives, the loosening of regulation and capital standards, and a hubristic belief that they had somehow broken their old habit of losing billions of dollars in downturns. This turned out to be, as Andrew Haldane, an executive director of the Bank of England, concluded, “as much mirage as miracle”.


Instead, it transpired that most of the risks had simply been postponed and hidden, even from banks’ own directors. As Adair Turner, chairman of the Financial Services Authority, the main UK regulator, put it last year: “Some financial activities ... far from adding value in some complex though difficult to understand fashion, in fact created financial instability and produced economic harm.”


Such dangers went unseen. “There was a massive overconfidence that risk had been transformed and we were in a different banking paradigm,” says Philip Augar, a financial author and former analyst in the City. “It was all egged on by governments who listened to investment bankers and appointed them to high positions. They were told that all they had to do was to get out of the way.”


Banks that had relied on a variety of businesses to make money – from mergers and acquisitions advice to securities underwriting – shifted overwhelmingly towards trading. Foreign exchange trading volumes rose 234-fold between 1977 and 2010, while trading – particularly in bonds and currencies – made up 80 per cent of the biggest banks’ revenues in 2010, according to BCG.

Banking by numbers

23,000%
Approximate rise in foreign exchange trading volumes, 1977-2010

20%
Approximate level of return on equity for many banks in mid-2000s

40,000
Number of jobs lost in European banking sector in 2011

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“People migrated from traditional corporate banking and dealing in equities and bonds into exotic products that required the nuanced understanding of risk,” says Mr Dayal. “The industry pushed through the boundaries of what regulators could foresee.”


This brought high profits for a while, but it undermined the argument that they did something useful. “The investment banking industry has drifted from its original focus, which was raising capital for industry and providing advisory services,” says Bob Gach, the head of Accenture’s capital markets consultancy arm.


Thomas Philippon, a professor at New York University’s Stern School, estimates that the industry’s share of US gross domestic product rose from about 3 per cent in 1950 to more than 8 per cent in 2010. Instead of the intensified use of information technology increasing efficiency, as it did in retailing, banks simply got bigger.


Prof Philippon says that this growth in trading has not been accompanied either by sharper pricing in securities markets or by better financial insurance for industrial companies. “Bankers such as J.P. Morgan were doing just as much as today’s industry in the past but they were more efficient. The more I look at the rise in trading, the more I conclude that society gets nothing from it. It is empty.”


A balance to restore


That has important implications for governments. Government and central banks were traditionally willing to back deposit-taking institutions in times of crisis – from the UK secondary banking crisis of the early 1970s to the 1980s US savings and loans shake-outs – because of the value of a sound banking system.


Even this was left deliberately ambiguous – central bankers did not want to admit that any single institution was too big to fail. And it definitely was not intended to cover securities brokers and investment banks which, since the Glass-Steagall Act of 1934, were deliberately separated in the US from commercial banks.


The 2007-08 crisis destroyed that delicate balance, not only making European governments rescue large banks but leading to the US Federal Reserve extending the protection of its discount window to Goldman Sachs and Morgan Stanley. The old ambiguity disappeared and the protected club of “systemically important financial institutions” widened.


But just because a bank is systemically important – meaning it would cause severe disruption across financial markets if it failed – that does not make it economically vital. The most important function of banks is also their least glamorous – taking deposits and making loans. This has been mingled with riskier, trading-related activities in ways that are difficult to disentangle.



The sharpest effort has emerged in the UK, where the government has backed the Vickers Commission’s proposal to ringfence retail banking deposits. Elsewhere, banks have fought regulations such as the Volcker rule curbing proprietary trading. “The regulatory agenda was too modest to start with, and the banks’ political power is incredible,” says Simon Johnson, a professor at MIT Sloan School.



A prolonged fight to keep doing the same thing while fighting regulation will do nothing for banks’ legitimacy, however, and little for the economies in which they operate. Nor will it address the need to restructure, which is being driven by a basic economic force – the financial pressure that banks now face. Institutions such as UBS and Citigroup are struggling to recover from their losses during the crisis and the European banking sector as a whole lost 40,000 jobs last year. After a post-2008 bounce, when central banks cut interest rates, trading revenues have fallen sharply.



Banks might be able to argue and delay their way out of their current troubles and wait for memories to fade. But that outcome is by no means assured, and would not be the best one for society as a whole. A healthy banking system – both in size and scope – is vital to a sound economy.


Nor is regulation the only challenge that banks face – the market is exerting even strong pressures for them to change their ways.


Meanwhile, corporate banking suffers from overcapacity that was left unaddressed in the growth years. “At heart, banking is a commodity business and a very mature one,” says Peter Hahn, a professor at City University’s Cass School. “Most industries deal with that through consolidation, but this was an industry that consolidated without taking out capacity. That’s a big problem.”


Banks had avoided having to face a low and shrinking return on assets by taking on more of them – leveraging balance sheets in order to boost their return on equity to historically high levels. While many banks had only single-digit returns on equity in the 1990s, these rose to 20 per cent or more in the mid-2000s.


Reduced returns


Despite the regulatory pushback, central bankers are imposing higher capital and liquidity requirements, preventing them from using leverage as aggressively as before. The market has also imposed tougher discipline on institutions with highly leveraged balance sheets and fragile funding – as the collapse of MF Global, the bond broker, showed late last year.


This is causing big problems for banks, which were able to compensate for falling profitability in their core businesses by taking on more risks and increasing the size of their balance sheets. Now, any bank that tries to do so, even if its regulator allows it, risks its credit rating being cut and its access to funds evaporating.


If banks cannot find new revenues, the alternative is to cut costs, and to shrink and merge as those in other commoditised industries do. Governments, however, are wary of allowing them to become too big to fail, and the generation of executives at the senior levels of banks have never operated in a contracting industry.


“This industry is run by entirely the wrong people now,” says Prof Hahn. “It is not that they are idiots but, for three decades with only small intervals, you succeeded by growing your business and piling on risk. The new regime is about efficiency and cost and none of them knows about that.”


One investment banker says the mood in the industry is sober. “Revenues and capital are both under pressure and that is affecting compensation and the employment outlook, which causes a fair degree of nervousness. There isn’t a depression but neither is there much ebullience.”


Large banks had a strong incentive in the past to invest heavily in new investment banking operations and to hire teams of bankers from others in order to push themselves into the “bulge bracket” of global banks. As Mr Turner notes, activities such as trading and securities underwriting are “natural oligopolies” in which those with a big market share take a large slice of the available profits.


But banks such as UBS have now pulled back from a growth-at-all-costs strategy. They are instead trying to focus on activities where they have an edge, such as domestic retail banking, wealth management and specialist areas such as securities custody.


The combination of lower leverage and curtailed ambition is likely to make banks much less profitable. Mr Dayal predicts that “from being a business of return on equity in the high [percentage] teens, it will go down to high single digits to low double digits”. It will revert to looking more like a utility industry.


If shareholders are willing to accept lower returns, banks may be able to regain some social legitimacy. Those that focus on deposit-taking and lending stand a better chance of being seen by governments as important to the economic system. Even investment banks that focus on securities underwriting and advisory work rather than trading will have a better story to tell.


The question is whether banks can and will transform themselves. Some are sceptical. “I don’t take the view that investment banking is finished,” says Mr Augar. “It will be less profitable and smaller for a period and it will be quite a while before we see so many would-be global banks trying to gain a seat at the top table. But not that long. Five years?”


Financial flashpoints: profits and pay


If there is one flashpoint in relations between investment banks and governments – and one reason bankers remain unpopular – it is pay.


The fact that banks that were given official support to avoid collapse in the 2007-08 crisis, but then proceeded to pay large bonuses to employees, caused widespread resentment.


The phenomenon was particularly pronounced in 2009, when low interest rates and a reduction in competition allowed banks to benefit from a benign trading environment.



Since then, profits have grown harder to come by. So, too, have bonuses; between 2009 and 2010, cash bonuses on Wall Street fell by 9 per cent.



Under pressure from governments, and domestic and international regulators, many lenders have restructured their pay arrangements. Before the crisis, aggressive bonus structures contributed to the proliferation of traders taking positions that were profitable in the short term but proved vulnerable to losses when markets became volatile. The most notorious example of these “short volatility” trades is the credit default swaps written on mortgage-backed securities by AIG, the American insurer bailed out in 2008 during the credit crisis.


Some banks now have introduced clawbacks, under which bonuses for trading are not paid in full for up to five years, and are ultimately denied if trades that initially appeared profitable turn out to lose money.



Lenders have also reduced the rising ratio of pay to net revenues, which surpassed 50 per cent at many institutions during the 2000s. Provisions for employee pay at Goldman Sachs, for example, fell by 59 per cent in the third quarter of 2011 year on year; for the first nine months of the year, the pay ratio stood at 44 per cent.

Copyright The Financial Times Limited 2012.