It’s the Same Banking Crisis, Stupid!

The crisis that started in 2008 is a banking crisis and it is still going strong. Banks all over the world over-leveraged their capital and extended loans unwisely to the undeserving. American financial institutions lent money to homeowners who could not pay back, buried as they were under a mountain of debt. European banks lavished funds on countries such as Greece and Italy which were technically insolvent or illiquid owing to low economic growth rates and bloated public sectors. Chinese “banks” were coerced into bankrolling near-bankrupt state-owned (SOEs) enterprises and municipalities. Consequently, China’s financial crsis is imminent as is the collapse of the municipal bond markets in the West.
Thus, what appear to be disjointed economic crises are actually manifestations of a single cancerous phenomenon: the avarice, recklessness, and inanity of banks. The solution? To Nationalize all the major banks, starting this coming November 2011.

The “sovereign debt” phase of the banking crisis (2010-2) emanated from the realization that lower growth rates throughout the industrialized West were insufficient to guarantee the repayment of debts accumulated by governments. The proceeds of the credits and loans assumed by public sectors throughout Europe and in the USA were ploughed into successive futile attempts to stimulate ailing economies and avert banking crises and panics.

Banks are the most unsafe institutions in the world. Worldwide, hundreds of them crash every few years. Two decades ago, the US Government was forced to invest hundreds of billions of Dollars in the Savings and Loans industry. Multi-billion dollar embezzlement schemes were unearthed in the much feted BCCI – wiping both equity capital and deposits. Barings bank – having weathered 330 years of tumultuous European history – succumbed to a bout of untrammeled speculation by a rogue trader. In 1890 it faced the very same predicament only to be salvaged by other British banks, including the Bank of England. The list is interminable. There were more than 30 major banking crises this century alone.

That banks are very risky – is proven by the inordinate number of regulatory institutions which supervise banks and their activities. The USA sports a few organizations which insure depositors against the seemingly inevitable vicissitudes of the banking system. The FDIC (Federal Deposit Insurance Corporations) insures against the loss of every deposit up to a certain amount. The HLSIC insures depositors in saving houses in a similar manner. Other regulatory agencies supervise banks, audit them, or regulate them. It seems that you cannot be too cautious where banks are concerned.

The word “BANK” is derived from the old Italian word “BANCA” – bench or counter. Italian bankers used to conduct their business on benches. Nothing much changed ever since – maybe with the exception of the scenery. Banks hide their fragility and vulnerability – or worse – behinds marble walls. The American President, Andrew Jackson, was so set against banks – that he dismantled the nascent central bank – the Second Bank of the United States.

Banks are institutions where miracles happen regularly. We rarely entrust our money to anyone but ourselves – and our banks. Despite a very chequered history of mismanagement, corruption, false promises and representations, delusions and behavioural inconsistency – banks still succeed to motivate us to give them our money. Partly it is the feeling that there is safety in numbers. The fashionable term today is “moral hazard”. The implicit guarantees of the state and of other financial institutions move us to take risks which we would, otherwise, have avoided. Partly it is the sophistication of the banks in marketing and promoting themselves and their products. Glossy brochures, professional computer and video presentations and vast, shrine-like, real estate complexes all serve to enhance the image of the banks as the temples of the new religion of money.


Banks operate through credit multipliers. When Depositor A places 100,000 USD with Bank A, the Bank puts aside about 20% of the money. This is labelled a reserve and is intended to serve as an insurance policy cum a liquidity cushion. The implicit assumption is that no more than 20% of the total number of depositors will claim their money at any given moment.

In times of panic, when ALL the depositors want their money back – the bank is rendered illiquid having locked away in its reserves only 20% of the funds. Commercial banks hold their reserves with the Central Bank or with a third party institution, explicitly and exclusively set up for this purpose.

What does the bank do with the other 80% of Depositor A’s money ($80,000)? It lends it to Borrower B. The Borrower pays Bank A interest on the loan. The difference between the interest that Bank A pays to Depositor A on his deposit – and the interest that he charges Borrower B – is the bank’s income from these operations.

In the meantime, Borrower B deposits the money that he received from Bank A (as a loan) in his own bank, Bank B. Bank B puts aside, as a reserve, 20% of this money – and lends 80% (=$64,000) to Borrower C, who promptly deposits it in Bank C.

At this stage, Depositor A’s money ($100,000) has multiplied and become $244,000. Depositor A has $100,000 in his account with Bank A, Borrower B has $80,000 in his account in Bank B, and Borrower C has $64,000 in his account in Bank C. This process is called credit multiplication. The Western Credit multiplier is 9. This means that every $100,000 deposited with Bank A could, theoretically, become $900,000: $400,000 in credits and $500,000 in deposits.

For every $900,000 in the banks’ books – there are only 100,000 in physical dollars. Banks are the most heavily leveraged businesses in the world.

But this is only part of the problem. Another part is that the profit margins of banks are limited. The hemorrhaging consumers of bank services would probably beg to differ – but banking profits are mostly optical illusions. We can safely say that banks are losing money throughout most of their existence.

The SPREAD is the difference between interest paid to depositors and interest collected on credits. The spread in Macedonia is 8 to 10%. This spread is supposed to cover all the bank’s expenses and leave its shareholders with a profit. But this is a shakey proposition. To understand why, we have to analyse the very concept of interest rates.

Virtually every major religion forbids the charging of interest on credits and loans. To charge interest is considered to be part usury and part blackmail. People who lent money and charged interest for it were ill-regarded – remember Shakespeare’s “The Merchant of Venice”?

Originally, interest was charged on money lent was meant to compensate for the risks associated with the provision of credit in a specific market. There were four such hazards:

First, there are the operational costs of money lending itself. Money lenders are engaged in arbitrage and the brokering of funds. In other words, they borrow the money that they then lend on. There are costs of transportation and communications as well as business overhead.

The second risk is that of inflation. It erodes the value of money used to repay credits. In quotidian terms: as time passes, the Lender can buy progressively less with the money repaid by the Borrower. The purchasing power of the money diminishes. The measure of this erosion is called inflation.

And there is a risk of scarcity. Money is a rare and valued object. Once lent it is out of the Lender’s hands, exchanged for mere promises and oft-illiquid collateral. If, for instance, a Bank lends money at a fixed interest rate – it gives up the opportunity to lend it anew, at higher rates.

The last – and most obvious risk is default: when the Borrower cannot or would not pay back the credit that he has taken.

All these risks have to be offset by the bank’s relatively minor profit margin. Hence the bank’s much decried propensity to pay their depositors as symbolically as they can – and charge their borrowers the highest interest rates they can get away with.

But banks face a few problems in adopting this seemingly straightforward business strategy.

Interest rates are an instrument of monetary policy. As such, they are centrally dictated. They are used to control the money supply and the monetary aggregates and through them to fine tune economic activity.

Governors of Central Banks (where central banks are autonomous) and Ministers of Finance (where central banks are more subservient) raise interest rates in order to contain economic activity and its inflationary effects. They cut interest rates to prevent an economic slowdown and to facilitate the soft landing of a booming economy. Despite the fact that banks (and credit card companies, which are really banks) print their own money (remember the multiplier) – they do not control the money supply or the interest rates that they charge their clients.

This creates paradoxes.

The higher the interest rates – the higher the costs of financing payable by businesses and households. They, in turn, increase the prices of their products and services to reflect the new cost of money. We can say that, to some extent, rather than prevent it, higher interest rates contribute to inflation – i.e., to the readjustment of the general price level.

Also, the higher the interest rates, the more money earned by the banks. They lend this extra money to Borrowers and multiply it through the credit multiplier.

High interest rates encourage inflation from another angle altogether:

They sustain an unrealistic exchange rate between the domestic and foreign currencies. People would rather hold the currency which yields higher interest (=the domestic one). They buy it and sell all other currencies.

Conversions of foreign exchange into local currency are net contributors to inflation. On the other hand, a high exchange rate also increases the prices of imported products. Still, all in all, higher interest rates contribute to the very inflation that are intended to suppress.

Another interesting phenomenon:

High interest rates are supposed to ameliorate the effects of soaring default rates. In a country like Macedonia – where the payments morale is low and default rates are stratospheric – the banks charge incredibly high interest rates to compensate for this specific risk.

But high interest rates make it difficult to repay one’s loans and may tip certain obligations from performing to non-performing. Even debtors who pay small amounts of interest in a timely fashion – often find it impossible to defray larger interest charges.

Thus, high interest rates increase the risk of default rather than reduce it. Not only are interest rates a blunt and inefficient instrument – but they are also not set by the banks, nor do they reflect the micro-economic realities with which they are forced to cope.

Should interest rates be determined by each bank separately (perhaps according to the composition and risk profile of its portfolio)? Should banks have the authority to print money notes (as they did throughout the 18th and 19th centuries)? The advent of virtual cash and electronic banking may bring about these outcomes even without the complicity of the state.

But what is behind all this? How can we judge the soundness of our banks? In other words, how can we tell if our money is safely tucked away in a safe haven?

The reflex is to go to the bank’s balance sheets. Banks and balance sheets have been both invented in their modern form in the 15th century. A balance sheet, coupled with other financial statements is supposed to provide us with a true and full picture of the health of the bank, its past and its long-term prospects. The surprising thing is that – despite common opinion – it does.

But it is rather useless unless you know how to read it.


Financial statements (Income – or Profit and Loss – Statement, Cash Flow Statement and Balance Sheet) come in many forms. Sometimes they conform to Western accounting standards (the Generally Accepted Accounting Principles, GAAP, or the less rigorous and more fuzzily worded International Accounting Standards, IAS). Otherwise, they conform to local accounting standards, which often leave a lot to be desired. Still, you should look for banks, which make their updated financial reports available to you. The best choice would be a bank that is audited by one of the Big Four Western accounting firms and makes its audit reports publicly available. Such audited financial statements should consolidate the financial results of the bank with the financial results of its subsidiaries or associated companies. A lot often hides in those corners of corporate holdings.


Banks are rated by independent agencies. The most famous and most reliable of the lot is Fitch Ratings. Another one is Moody’s. These agencies assign letter and number combinations to the banks that reflect their stability. Most agencies differentiate the short term from the long term prospects of the banking institution rated. Some of them even study (and rate) issues, such as the legality of the operations of the bank (legal rating). Ostensibly, all a concerned person has to do, therefore, is to step up to the bank manager, muster courage and ask for the bank’s rating. Unfortunately, life is more complicated than rating agencies would have us believe.


They base themselves mostly on the financial results of the bank rated as a reliable gauge of its financial strength or financial profile. Nothing is further from the truth.


Admittedly, the financial results do contain a few important facts. But one has to look beyond the naked figures to get the real – often much less encouraging – picture.


Consider the thorny issue of exchange rates. Financial statements are calculated (sometimes stated in USD in addition to the local currency) using the exchange rate prevailing on the 31st of December of the fiscal year (to which the statements refer). In a country with a volatile domestic currency this would tend to completely distort the true picture. This is especially true if a big chunk of the activity preceded this arbitrary date. The same applies to financial statements, which were not inflation-adjusted in high inflation countries. The statements will look inflated and even reflect profits where heavy losses were incurred. “Average amounts” accounting (which makes use of average exchange rates throughout the year) is even more misleading. The only way to truly reflect reality is if the bank were to keep two sets of accounts: one in the local currency and one in USD (or in some other currency of reference). Otherwise, fictitious growth in the asset base (due to inflation or currency fluctuations) could result.


Another example: in many countries, changes in regulations can greatly effect the financial statements of a bank. In 1996, in Russia, for example, the Bank of Russia changed the algorithm for calculating an important banking ratio (the capital to risk weighted assets ratio). Unless a Russian bank restated its previous financial statements accordingly, a sharp change in profitability appeared from nowhere.


The net assets themselves are always misstated: the figure refers to the situation on 31/12. A 48-hour loan given to a collaborating client can inflate the asset base on the crucial date. This misrepresentation is only mildly ameliorated by the introduction of an “average assets” calculus. Moreover, some of the assets can be interest earning and performing – others, non-performing. The maturity distribution of the assets is also of prime importance. If most of the bank’s assets can be withdrawn by its clients on a very short notice (on demand) – it can swiftly find itself in trouble with a run on its assets leading to insolvency.


Another oft-used figure is the net income of the bank. It is important to distinguish interest income from non-interest income. In an open, sophisticated credit market, the income from interest differentials should be minimal and reflect the risk plus a reasonable component of income to the bank. But in many countries (Japan, Russia) the government subsidizes banks by lending to them money cheaply (through the Central Bank or through bonds). The banks then proceed to lend the cheap funds at exorbitant rates to their customers, thus reaping enormous interest income. In many countries the income from government securities is tax free, which represents another form of subsidy. A high income from interest is a sign of weakness, not of health, here today, gone tomorrow. The preferred indicator should be income from operations (fees, commissions and other charges).


There are a few key ratios to observe. A relevant question is whether the bank is accredited with international banking agencies. These issue regulatory capital requirements and other mandatory ratios. Compliance with these demands is a minimum in the absence of which, the bank should be regarded as positively dangerous.


The return on the bank’s equity (ROE) is the net income divided by its average equity. The return on the bank’s assets (ROA) is its net income divided by its average assets. The (tier 1 or total) capital divided by the bank’s risk weighted assets – a measure of the bank’s capital adequacy. Most banks follow the provisions of the Basel Accord as set by the Basel Committee of Bank Supervision (also known as the G10). This could be misleading because the Accord is ill equipped to deal with risks associated with emerging markets, where default rates of 33% and more are the norm. Finally, there is the common stock to total assets ratio. But ratios are not cure-alls. Inasmuch as the quantities that comprise them can be toyed with – they can be subject to manipulation and distortion. It is true that it is better to have high ratios than low ones. High ratios are indicative of a bank’s underlying strength, reserves, and provisions and, therefore, of its ability to expand its business. A strong bank can also participate in various programs, offerings and auctions of the Central Bank or of the Ministry of Finance. The larger the share of the bank’s earnings that is retained in the bank and not distributed as profits to its shareholders – the better these ratios and the bank’s resilience to credit risks.


Still, these ratios should be taken with more than a grain of salt. Not even the bank’s profit margin (the ratio of net income to total income) or its asset utilization coefficient (the ratio of income to average assets) should be relied upon. They could be the result of hidden subsidies by the government and management misjudgement or understatement of credit risks.


To elaborate on the last two points:


A bank can borrow cheap money from the Central Bank (or pay low interest to its depositors and savers) and invest it in secure government bonds, earning a much higher interest income from the bonds’ coupon payments. The end result: a rise in the bank’s income and profitability due to a non-productive, non-lasting arbitrage operation. Otherwise, the bank’s management can understate the amounts of bad loans carried on the bank’s books, thus decreasing the necessary set-asides and increasing profitability. The financial statements of banks largely reflect the management’s appraisal of the business. This has proven to be a poor guide.


In the main financial results page of a bank’s books, special attention should be paid to provisions for the devaluation of securities and to the unrealized difference in the currency position. This is especially true if the bank is holding a major part of the assets (in the form of financial investments or of loans) and the equity is invested in securities or in foreign exchange denominated instruments.


Separately, a bank can be trading for its own position (the Nostro), either as a market maker or as a trader. The profit (or loss) on securities trading has to be discounted because it is conjectural and incidental to the bank’s main activities: deposit taking and loan making.


Most banks deposit some of their assets with other banks. This is normally considered to be a way of spreading the risk. But in highly volatile economies with sickly, underdeveloped financial sectors, all the institutions in the sector are likely to move in tandem (a highly correlated market). Cross deposits among banks only serve to increase the risk of the depositing bank (as the recent affair with Toko Bank in Russia and the banking crisis in South Korea have demonstrated).


Further closer to the bottom line are the bank’s operating expenses: salaries, depreciation, fixed or capital assets (real estate and equipment) and administrative expenses. The rule of thumb is: the higher these expenses, the weaker the bank. The great historian Toynbee once said that great civilizations collapse immediately after they bequeath to us the most impressive buildings. This is doubly true with banks. If you see a bank fervently engaged in the construction of palatial branches – stay away from it.


Banks are risk arbitrageurs. They live off the mismatch between assets and liabilities. To the best of their ability, they try to second guess the markets and reduce such a mismatch by assuming part of the risks and by engaging in portfolio management. For this they charge fees and commissions, interest and profits – which constitute their sources of income.


If any expertise is imputed to the banking system, it is risk management. Banks are supposed to adequately assess, control and minimize credit risks. They are required to implement credit rating mechanisms (credit analysis and value at risk – VAR – models), efficient and exclusive information-gathering systems, and to put in place the right lending policies and procedures.


Just in case they misread the market risks and these turned into credit risks (which happens only too often), banks are supposed to put aside amounts of money which could realistically offset loans gone sour or future non-performing assets. These are the loan loss reserves and provisions. Loans are supposed to be constantly monitored, reclassified and charges made against them as applicable. If you see a bank with zero reclassifications, charge offs and recoveries – either the bank is lying through its teeth, or it is not taking the business of banking too seriously, or its management is no less than divine in its prescience. What is important to look at is the rate of provision for loan losses as a percentage of the loans outstanding. Then it should be compared to the percentage of non-performing loans out of the loans outstanding. If the two figures are out of kilter, either someone is pulling your leg – or the management is incompetent or lying to you. The first thing new owners of a bank do is, usually, improve the placed asset quality (a polite way of saying that they get rid of bad, non-performing loans, whether declared as such or not). They do this by classifying the loans. Most central banks in the world have in place regulations for loan classification and if acted upon, these yield rather more reliable results than any management’s “appraisal”, no matter how well intentioned.


In some countries the Central Bank (or the Supervision of the Banks) forces banks to set aside provisions against loans at the highest risk categories, even if they are performing. This, by far, should be the preferable method.


Of the two sides of the balance sheet, the assets side is the more critical. Within it, the interest earning assets deserve the greatest attention. What percentage of the loans is commercial and what percentage given to individuals? How many borrowers are there (risk diversification is inversely proportional to exposure to single or large borrowers)? How many of the transactions are with “related parties”? How much is in local currency and how much in foreign currencies (and in which)? A large exposure to foreign currency lending is not necessarily healthy. A sharp, unexpected devaluation could move a lot of the borrowers into non-performance and default and, thus, adversely affect the quality of the asset base. In which financial vehicles and instruments is the bank invested? How risky are they? And so on.


No less important is the maturity structure of the assets. It is an integral part of the liquidity (risk) management of the bank. The crucial question is: what are the cash flows projected from the maturity dates of the different assets and liabilities – and how likely are they to materialize. A rough matching has to exist between the various maturities of the assets and the liabilities. The cash flows generated by the assets of the bank must be used to finance the cash flows resulting from the banks’ liabilities. A distinction has to be made between stable and hot funds (the latter in constant pursuit of higher yields). Liquidity indicators and alerts have to be set in place and calculated a few times daily.


Gaps (especially in the short term category) between the bank’s assets and its liabilities are a very worrisome sign. But the bank’s macroeconomic environment is as important to the determination of its financial health and of its creditworthiness as any ratio or micro-analysis. The state of the financial markets sometimes has a larger bearing on the bank’s soundness than other factors. A fine example is the effect that interest rates or a devaluation have on a bank’s profitability and capitalization. The implied (not to mention the explicit) support of the authorities, of other banks and of investors (domestic as well as international) sets the psychological background to any future developments. This is only too logical. In an unstable financial environment, knock-on effects are more likely. Banks deposit money with other banks on a security basis. Still, the value of securities and collaterals is as good as their liquidity and as the market itself. The very ability to do business (for instance, in the syndicated loan market) is influenced by the larger picture. Falling equity markets herald trading losses and loss of income from trading operations and so on.


Perhaps the single most important factor is the general level of interest rates in the economy. It determines the present value of foreign exchange and local currency denominated government debt. It influences the balance between realized and unrealized losses on longer-term (commercial or other) paper. One of the most important liquidity generation instruments is the repurchase agreement (repo). Banks sell their portfolios of government debt with an obligation to buy it back at a later date. If interest rates shoot up – the losses on these repos can trigger margin calls (demands to immediately pay the losses or else materialize them by buying the securities back).


Margin calls are a drain on liquidity. Thus, in an environment of rising interest rates, repos could absorb liquidity from the banks, deflate rather than inflate. The same principle applies to leverage investment vehicles used by the bank to improve the returns of its securities trading operations. High interest rates here can have an even more painful outcome. As liquidity is crunched, the banks are forced to materialize their trading losses. This is bound to put added pressure on the prices of financial assets, trigger more margin calls and squeeze liquidity further. It is a vicious circle of a monstrous momentum once commenced.


But high interest rates, as we mentioned, also strain the asset side of the balance sheet by applying pressure to borrowers. The same goes for a devaluation. Liabilities connected to foreign exchange grow with a devaluation with no (immediate) corresponding increase in local prices to compensate the borrower. Market risk is thus rapidly transformed to credit risk. Borrowers default on their obligations. Loan loss provisions need to be increased, eating into the bank’s liquidity (and profitability) even further. Banks are then tempted to play with their reserve coverage levels in order to increase their reported profits and this, in turn, raises a real concern regarding the adequacy of the levels of loan loss reserves. Only an increase in the equity base can then assuage the (justified) fears of the market but such an increase can come only through foreign investment, in most cases. And foreign investment is usually a last resort, pariah, solution (see Southeast Asia and the Czech Republic for fresh examples in an endless supply of them. Japan and China are, probably, next).


In the past, the thinking was that some of the risk could be ameliorated by hedging in forward markets (=by selling it to willing risk buyers). But a hedge is only as good as the counterparty that provides it and in a market besieged by knock-on insolvencies, the comfort is dubious. In most emerging markets, for instance, there are no natural sellers of foreign exchange (companies prefer to hoard the stuff). So forwards are considered to be a variety of gambling with a default in case of substantial losses a very plausible way out.


Banks depend on lending for their survival. The lending base, in turn, depends on the quality of lending opportunities. In high-risk markets, this depends on the possibility of connected lending and on the quality of the collaterals offered by the borrowers. Whether the borrowers have qualitative collaterals to offer is a direct outcome of the liquidity of the market and on how they use the proceeds of the lending. These two elements are intimately linked with the banking system. Hence the penultimate vicious circle: where no functioning and professional banking system exists – no good borrowers will emerge.


Basel III


In the wake of the Great Recession (2007-8) – a crisis largely of the financial system – the multinational Basel Committee and the Group of Central Bank Governors and Heads of Supervision, comprised of central bankers, banking supervisors, and regulators more than doubled the amount of equity (Tier 1) capital banks must have to 4.5%.


Another 2.5% of their assets must be held as an equity “conservation buffer” to be amortized and deployed in case of emergency. Banks which resort to the buffer must, however augment their capital by any (legal) means possible (for instance, by not distributing dividends, by divesting non-core assets, or by issuing new stock). Yet another 1.5% of the balance sheet must be held in “less-than-equity” quality investment vehicles and the total leverage ratio must never go below 3% in equity (admittedly, a liberal number).


Moreover: regulators can impose the equivalent of yet another 2.5% in risk-weighted assets (including off-balance-sheet assets, such as derivatives) in the form of a “countercyclical buffer”. This is intended to counter the pro-cyclical nature of most capital requirements and reserves regimes: the more assets’ prices rise (and commensurate risks increase), the less the capital set aside as loans are deemed “safer” by greedy bankers whose compensation is often tied to their institution’s short-term performance.


The Basel III regime has to be fully implemented by 2019, a concession to under-capitalized banking sectors in various EU members (notably Germany). Ironically, the Basel Committee was created in 1974, following the failure of a German bank and an ensuing near-collapse of the currency markets. Indeed, the Basel regime is as strong as its weakest link: multilateralism has its price. This in-built frailty forces the Committee to remain vague on what constitutes capital; on disclosure regarding derivatives; and on the loaded issue of subordinated debt vs. corporate bonds (subordinated debt would force banks to become a lot more transparent and is likely to foster shareholder activism).



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