Most of us in the financial markets were well aware of the micro issues that led to the financial crisis that reached its zenith five years ago this month. The bubble in the housing market; the moral hazards created by the bailout of Bear, Stearns & Co.; the poor and conflicted ratings of the “Big Three” credit ratings agencies; and unfettered risk taking and leverage in the swaps and derivatives sectors all were micro causes that contributed to the creation and severity of the crisis. But they don’t give the bigger picture as to why the rotting from the inside was occurring without anyone stepping in to stop it.
For that, I believe, we need to recognize the dangerous combination of leverage, asset concentrations, and size over the course of the 15 years prior to the crisis.
Relearning the Dangers of Financial Leverage
Everyone in finance 30 years ago was well aware of the dangers of leverage because it was regularly taught in business school at the time. Yes, we were taught it could goose earnings per share and return on equity handsomely in the short term — but at a cost. That cost, of course, was default, bankruptcy, and failure should revenues slip, should rates jump, should anything go wrong.
But many investors, regulators, and lawmakers over the past 20 years seemed to believe that the laws of finance had been suspended. Indeed, the low-interest rate policies of the Fed, the European Central Bank, and the Bank of Japan facilitated this view, in part by flooding the marketplace with so much liquidity that debt had become the funding mechanism of choice.
Making matters worse, large financial institutions were given more leeway to increase their leverage thanks to the risk-weighting processes embedded in Basel II under which most of the world operated. These risk weights cut the capital cost of loans and investments for mortgages, highly rated mortgage-backed instruments, and debts of Organisation for Economic Cooperation and Development (OECD) sovereigns. Theoretically, under this structure (which will continue under Basel III) an institution could own a €1 trillion portfolio consisting solely of OECD sovereign debt, and be permitted to maintain de minimis capital as support.
Compounding matters, these same large financial firms stepped up their borrowings in the money markets, often through affiliated money market mutual funds. The nexus of highly leveraged financial institutions obtaining volatile institutional funds from money market funds was another of those elements that made the crisis even worse.
Risky Portfolio Concentrations
Another pernicious effect of the Basel risk-weighting system is its ability to encourage institutions to invest in certain classifications of assets. As noted above, OECD sovereign debts bear a 0% risk weighting; hence the near infinite leverage for a portfolio comprised exclusively of such debt.
But the European debt crises didn’t become apparent until 2010. Mortgage assets were most prominent in the 2008 crisis. According to study by Jeffrey Friedman in Critical Review from 2009, 30% of the world’s triple-A-rated asset-backed securities were held on banks’ balance sheets, with another 20% held in off-balance-sheet structured investment vehicles. The goal of diversification is to reduce risk by investing in a variety of historically uncorrelated assets with the belief that poor performance or failure in one sector will not affect the performance of the other sectors. Concentration of this magnitude, on the other hand, put not only individual institutions but also the entire system at risk of failure should the sector of choice falter. By providing a push in one unified direction, the Basel rules internationally and their U.S. counterparts contributed mightily to the development of large stockpiles of mortgage assets.
“Too Big to Fail” Banks Even Larger
The more tolerant attitude toward leverage, combined with industry consolidation, helped transmogrifythe financial industry into a small number of global leviathans, all presumably too big for their governments to permit to fail.Beginning in 1990 as J.P. Morgan & Co., the New York banking company was the largest U.S. bank by a factor of two with nearly $217 billion in assets. As of 30 June, the now-named JPMorgan Chase & Co. is 1,024% larger with $2.4 trillion in assets. Bank of America Corp.’s growth was even more dramatic, climbing more than 2,000%, to $2.1 trillion from $110.7 billion in 1990.
Combined, the four largest U.S. banks have total assets reported at nearly 50% of national GDP. It is the magnitude of the institutions involved, and the shock waves a failure of one would create throughout the global financial system, that makes the living wills of these institutions superfluous. Where they are now, it is unthinkable for policy makers to consider letting one collapse just to send a message to the other three.
Holding Banks Accountable
Making sure the leviathans have adequate capital to cushion a failure is the near-term goal of policy makers. Basel III has taken important steps in this regard, boosting standard capital requirements as well as improving the quality of that capital by mandating a leverage ratio for the first time in its two decades of existence.
With size, however, comes power and influence, and the banks have fought doggedly against the higher capital requirements, making such safeguards uncertain for the long term. To their credit, though, policy makers in parliaments, legislators, and regulators in league with investors have withstood the pressure and are moving ahead on higher capital requirements.
Ultimately, these banks aren’t providing good returns on assets, with only Wells Fargo & Co. of the “Big 4” (JPMorgan, BofA, Citigroup, and Wells) earning a respectable return on assets. Given the significance of their control over financial resources, they are a drag on the economy, not to mention a drag on their own shareowners. The only group benefiting are staff and those in Washington and in Brussels benefiting from the increased lobbying.
In normal industries and in normal times, investors facing these kinds of problems would launch a buyout of such firms in the belief that they could remake the entity into a leaner, more profitable enterprise or series of enterprises. Indeed, there is little argument that the biggest banks should be broken up into smaller pieces. But such options are off the table in the banking world (particularly among the largest 12 banks), where breaking up the large banks is made more difficult because bankers are the preferred option when it comes to taking over banks or their subsidiaries. The incestuous nature, in turn, magnifies the herd mentality that leads to portfolio concentrations.
It’s time, therefore, to begin to rethink the way financial institutions are coddled and guarded from competition. The question is how to do it. We welcome your suggestions.
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Photo credit: AP Images
As a seasoned financial analyst with a deep understanding of the intricacies of the financial markets, I'd like to shed light on the concepts mentioned in the provided article. My expertise extends across various aspects of finance, and I have closely followed and analyzed the dynamics that led to the financial crisis mentioned in the article.
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Financial Leverage: The article emphasizes the dangerous combination of leverage, asset concentrations, and size over the 15 years leading up to the financial crisis. Financial leverage involves the use of borrowed capital to increase the potential return on investment. The article discusses how the perception of low-interest rates, especially due to the policies of central banks like the Fed, ECB, and Bank of Japan, led to a widespread belief that the traditional risks associated with leverage were somehow mitigated. The consequences of this misconception are highlighted, particularly in terms of default, bankruptcy, and the overall failure of financial institutions when adverse events occur.
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Risk-Weighting System (Basel II and Basel III): The Basel risk-weighting system, mentioned in the article, is a regulatory framework that assigns risk weights to different assets, influencing the amount of capital financial institutions are required to hold. Basel II and Basel III are specifically mentioned. The article notes that risk weights, especially for OECD sovereign debts, contributed to excessive leverage by reducing the perceived capital cost. It also suggests that these risk-weighting processes, which continue under Basel III, allowed financial institutions to hold disproportionately large portfolios with minimal capital support.
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Risky Portfolio Concentrations: The article highlights the pernicious effect of the Basel risk-weighting system in encouraging institutions to concentrate on certain asset classifications. In the context of the financial crisis, mortgage assets are discussed as an example. The concentration of assets in a particular sector, coupled with the belief in the diversification benefits, led to systemic risks. The failure of one sector, such as the housing market, had cascading effects on the entire financial system due to these concentrated portfolios.
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"Too Big to Fail" Banks: The article discusses the growth of financial institutions, particularly the largest U.S. banks, over the years. The tolerance toward increased leverage, combined with industry consolidation, resulted in a small number of global behemoth institutions deemed "too big to fail." The magnitude of these institutions and the potential shockwaves their failure could create throughout the global financial system are highlighted. The article emphasizes the challenges policymakers face in dealing with these institutions and their living wills.
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Capital Requirements and Basel III: The article touches on the importance of policymakers ensuring that these large financial institutions have adequate capital to cushion a failure. Basel III is mentioned as a regulatory framework that has taken steps to boost standard capital requirements and introduce a leverage ratio. However, it notes that the banks have resisted higher capital requirements, raising uncertainties about the effectiveness of such safeguards in the long term.
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Call for Rethinking Financial Institutions: The article concludes by advocating for a reevaluation of how financial institutions are treated, suggesting that the current approach of coddling and guarding them from competition may need to be reconsidered. It raises questions about the viability of breaking up large banks and explores potential solutions to address the challenges posed by the size, influence, and concentration of these financial institutions.
In summary, the article delves into the complexities of financial leverage, risk management, regulatory frameworks, and the structural issues surrounding large financial institutions, offering insights into the factors that contributed to the financial crisis.
