Banks occupy a special place in the economic and financial system. Industrial companies may be allowed to go to the wall. Banks are normally viewed with a more protective eye by the authorities, although there is no such thing as a blanket guarantee of support for a bank in trouble.
Why the special treatment? First, there are not many aspects of economic life that can function without a stable banking system. Second, banking is a business that depends on confidence – allow the confidence to be destroyed and you are a fair way to destroying the banks. Third, banks play a vital role in the creation of money: something that governments like to keep within their control. Fourth, they play a central role in the operation of payment systems around the world.
To see two of these considerations at work, look back to the events surrounding the collapse of Barings, one of the City’s oldest merchant banks, early in 1995. Barings had lost over £800m – considerably more than the total shareholders’ money in the business – through wild and probably unauthorized gambles by a trader in the derivatives markets of the Far East (see also Chapter 18). The bank was bust. Should the Bank of England step in to save it with taxpayers’ money?
After a week-end of intensive discussions with the London banking community (which was not on its own prepared to undertake a rescue while the size of the bill was still unknown) the Bank of England decided against bailing out Barings. On the one side was the desire to sustain the reputation of the City and confidence in its banking system. On the other, Barings was judged to be a fairly small player and it was not thought that there was great systemic risk in allowing it to fail. In other words, the knock-on effect on the banking system as a whole was judged to be fairly small. Later, the main operations of Barings were taken over by Dutch banking group ING which was prepared to pump in cash to replace the missing millions. Consequently, while holders of the bank’s shares and other securities lost out, there was no loss to Barings’ depositors.
The best way to understand what is written about banking is to start by looking at what a bank is. This is particularly important now that the growth of telephone banking and Internet banking have concentrated attention on the techniques for delivering banking services, perhaps at the expense of focusing on the services themselves. At its simplest, a bank takes retail deposits from private individuals and others, and lends money (makes advances) to borrowers. A certain proportion of the money it takes in as deposits is held in liquid or near-liquid form: as cash or in a form in which it can readily be turned into cash. This is a safeguard in case some depositors want their money back. Another proportion will normally be held in the form of investments which are a little less liquid but can still be cashed in if necessary. The remainder can be lent to customers.
The detail may vary, but the principle is much the same for most deposit-taking institutions, including building societies which are really just a specialist form of bank whose business in the past has been to lend mainly to homebuyers. In practice, banks are not completely dependent on retail deposits because they also borrow wholesale funds in the money markets, which add to the money they have available to lend.
Like any company, a bank needs some money of its own -shareholders’ funds – as well as the borrowed money it obtains from depositors or in the money markets. But banks are very much more highly geared than most industrial and commercial companies. They use a lot of borrowed money and relatively little of their own. How this structure translates into a simlified bank balance sheet is shown in Table 14.1:
The bank in the example in Table 14.1 has only £100 of its own money against £1,000 of borrowed money from depositors. Its total resources are thus £1,100. It holds £100 (equivalent to 10 per cent of its deposits) in liquid form, a further £250 as investments and lends the remaining £750.
|
|
|
|
£ |
|
Liquid assets |
100 |
|
Investments |
250 |
|
Loans to customers (Advances) |
750 |
|
|
|
1,100 |
FINANCED BY: |
|
|
Current and deposit accounts |
1,000 |
|
Share capital and reserves |
100 |
|
(shareholders’ funds) |
|
|
|
1,100 |
Table 14.1
How do banks create money? Assume that the bank in our example in Table 14.1 attracts a further £100 of deposits. It will hold £10 of this as cash and lend the remaining £90. The customer who borrows the £90 spends it on, say, a piece of office equipment. He pays the £90 to the office equipment supplier, who deposits it in his own bank. This increases the deposits of the supplier’s bank by £90 of which the supplier’s bank will lend £81, holding back £9 in cash form for safety. And so on. Since the money finds its way back into the banking system at each stage, that original £100 of extra deposits in the first bank actually generates – in this case – a further £1,000 of spending power in the economy.
If the proportion of their deposits that banks held in liquid form were lower (8 per cent, say) each additional £100 of deposits would create proportionately more spending power. One of the ways central banks sometimes try to control expansion of the money supply (see below) is by varying the permissible ratio between deposits and the amount held as reserve assets, which covers cash and certain other near-cash items (reserve assets ratio), though this system is no longer used by the British regulator.
The most commonly quoted measures of money supply in the press in Britain are M0 (‘M nought’) and M4(‘M four’). The M0 measure comprises notes and coins in circulation plus banks’ balances at the Bank of England. The broader M4 measure covers notes and coins plus private-sector current and deposit accounts with banks and building societies and private-sector wholesale deposits.
A bank works on the principle that no more than a small proportion of depositors will want their money back at any one time and this calculation affects the proportion of deposits held in liquid form (the liquidity ratio). And a glance back at the simplified bank balance sheet in Table 14.1 shows the main ways a bank can get into trouble. If depositors suddenly lose confidence in a particular bank, they may all try to get their money back at the same time and a run on the bank develops. This does not mean that the bank is necessarily unsound, but may cause it to collapse all the same. The bank will not be able to get back rapidly the money it has advanced to customers and if it runs out of cash it may be forced to close its doors.
Whatever his problems, a banker is virtually obliged to maintain that his bank is totally sound until he has to close the doors. Any admission of difficulties will worry depositors and make them more likely to withdraw their money. So statements from bankers that everything in the garden is rosy must be treated with a large dose of salt. It may be true, but the banker would be equally obliged to say this if it wasn’t.
This illustrates one of the paradoxes on which a banking system rests. Even the soundest of banks is sound only as long as its depositors think that it is sound. It explains why central banks play a vital role.
To prevent a run if the bank is basically sound, the central bank will often organize a recycling operation. Banks which are not under any pressure from depositors will be persuaded to make deposits with the troubled bank to replace its vanishing deposits from the public. Such a rescue for third-tier money-lending institutions – euphemistically referred to as secondary banks - was organized in the 1973–75 period of financial crisis or secondary bank collapse in Britain. The clearing banks were dragooned into forming a lifeboat via which they made money available to secondary banks which had seen their normal deposits melt away.
In reality, most of the secondary banks were not sound – their liabilities (what they owed) exceeded the real value of their assets (the money they had lent, much of which they lost). And this brings us to the second way a bank gets into trouble. The bank in our sample balance sheet in Table 14.1 could not lose more than £100 of the money it has lent without becoming insolvent. If it loses £100 of its £750 of advances, this completely wipes out the £100 of shareholders’ money in the business. Any further losses and it will not be able to cover what it owes to depositors. The problems of the Barings bank in 1995 illustrated this process at work.
Again, a banker has to judge what ‘cushion’ of shareholders’ money he needs to allow for any likely losses on his business activities. And the central bank normally makes doubly sure by imposing certain capital adequacy ratios which stipulate the amount of its own money a bank needs relative to its total assets. Since a bank that operated with less of its own money and more borrowed money could have an advantage over its competitors (though at greater risk), there have been moves in recent years to impose international standards for capital adequacy (see below).
This capital ratio or solvency ratio is not a simple calculation: the regulator will look at the make-up of a bank’s business and decide that the risks that need to be covered are higher for some types of business than others. Mortgage loans on residential property, for example, are judged safer than lending to small businesses. And it will take into account some off balance sheet risks that do not appear in the accounts: forms of guarantee and underwriting commitment the bank may have undertaken or risks involved in derivatives. Nor are shareholders’ funds the exact measure of the bank’s own money that the authorities adopt. In calculating its capital base to arrive at a figure for primary capital a bank may be able to include certain subordinated loans (see glossary) but will have to make deductions for other items. A risk asset ratio shows primary capital as a proportion of risk-weighted assets. Capital ratios are part of what are normally described as prudential ratios: ratios dictated by banking prudence rather than by the central bank’s need to control the money supply via the banking system.
Under the international agreement known as the Basle Accord, all banks are required to maintain primary capital equal to at least 8 per cent of their risk-weighted assets (mainly, the loans they make). Above this minimum, central banks may impose whatever ratios they consider appropriate to individual banks within their jurisdiction, to reflect differing degrees of perceived risk.
While the relatively simple business of taking deposits and making loans remains at the core of banking activities, banks are considerably more complex operations nowadays. There are six changes in particular to note.
• The dependence on retail deposits from the public has been reduced. Today’s banks raise large amounts of the money that they need in the form of wholesale funds in the money markets (see Chapter 15).
• The process of disintermediation that we touched on earlier has brought big changes to the ways that banks operate. No longer do they simply borrow and lend. This is because many of their larger customers, instead of simply borrowing from a bank, raise money by selling debt securities in a market instead. To replace interest income that they have lost, banks need to be active in the markets in which securities are issued: underwriting the issue of securities, arranging their sale and distribution, etc. In this way they can earn fee income to replace some of the interest income. In practice, many have also tried to boost their income by more active dealing in securities markets (own account trading).
• The scale of loan required by major companies is often too large for a single bank to take on board. So syndicated loans have become more common. Suppose a company wants to raise £200m. An individual bank might be reluctant to take the risk of lending this amount to a single customer. Instead, a syndicate of, say, ten banks is put together, each of which contributes £20m of the loan, which is organized by one bank as lead manager.
• As we saw earlier, the changes brought about by the Big Bang in Britain allowed banks to own stockbroking and marketmaking businesses, thus introducing them to aspects of securities trading that had been closed to them before. Some plunged more enthusiastically into the new areas than others.
• Traditional banks with high-street branches have had to adapt to the information technology revolution and learn new ways of interacting with their customers. The first step was telephone banking, allowing customers to carry out transactions without going near a bank branch. This was followed by Internet banking, allowing customers to manage their accounts from a home computer. While traditional banks offered Internet services, the way was also paved for true Internet banks, operating only over the Internet and perhaps with no physical presence in the UK. And, at the same time, traditional banks faced competition from unusual sources as supermarkets offered savings and money-transmission services.
• Banks have had a central part to play in the development of the mushrooming markets in derivatives (see Chapter 18). Derivative products such as futures and options evolved as a way of hedging or reducing risk. Such contracts allow risks to be transferred to those best able to manage them. But the derivatives markets rapidly acquired a momentum as gambling markets where large amounts of money could be made or lost on small movements in the prices of commodities, currencies, bonds, equities and many other financial products. It was gambles in the financial futures markets that brought down the merchant bank Barings in 1995.
By no means all derivatives business takes place in the public markets. The big commercial banks are major vendors of over-the-counter or OTC derivatives products. These are products that can be tailored for (and sold to) individual clients. A company wants to arrange an interest-rate swap (see Chapter 17) or a cap on its borrowing costs (see Chapter 15). It goes to its bank. For a fee, the bank sells it the desired product. The bank might agree that it will accept the obligation to pay the interest on a £100m floating-rate loan the company has raised and charge the company a fixed rate of interest instead (a swap). Or it might agree to compensate the company for any rise above, say, 9 per cent in the interest rate on a £100m floating-rate loan (a cap). And vastly more complex hedging products than these can be devised.
Selling OTC derivatives products of these kinds had become very big business for the banks by the 1990s and there has been considerable comment in the press and elsewhere about the risks involved. What, for example, if interest rates rose sharply and the banks had to pay out under the arrangements whereby they had contracted to insure against increases in interest rates on floating-rate loans?
In practice, the banks lay off their risks. A bank may agree to pay the floating-rate interest on a loan and charge a fixed rate in a swap arrangement. But it will match this commitment by charging a floating rate of interest and accepting responsibility for a fixed rate of interest on a loan for another client. Provided neither client defaults (the counterparty risk) the two transactions simply cancel each other out, with the bank taking a small cut in the middle.
But as derivatives became more and more weird and wonderful, observers began to question whether the banks’ arrangements for hedging their risks were likely to be proof against all eventualities. So complex were some of the derivative products dreamed up by the rocket scientists (mathematical geniuses) whom the banks increasingly employed that few if any in the upper echelons of banking could understand them or the risks they implied. The directors thus became increasingly dependent on the judgement of those rocket scientists and the computerized risk-matching systems that they devised.
The risks inherent in these derivative products are mainly off balance sheet for the banks: they do not appear in the main financial statements. For example, if you look at the accounts of Barclays Bank for 1998 you will see that loans made by the bank to customers were shown at about £96 billion in its group balance sheet. Excluded here was a further £1,600 billion of off-balance-sheet financial instruments entered into by the bank. This figure was, of course, the ‘principal amount’ of the contracts (the amount subject to interest rate or exchange rate undertakings) and not the amount at risk. And since many of the risks cancelled each other out, the ‘fair values’ of the bank’s derivative positions were only around £14 billion on the positive side and £16 billion on the negative side.
Such figures are pretty typical of the major commercial banks. But, reflecting international evaluation of derivatives risk, press comment is increasingly homing in on the adequacy of risk-evaluation methods and control systems in the derivatives markets. Predictions of derivative-induced crises in the financial system are not uncommon.
A visitor from Mars who surveyed recent banking history could be forgiven for concluding that it consisted of periodic crises interspersed with relatively short periods of calm. In Britain we have had three major upsets in the past 30 years: the property and secondary bank crisis of the mid-1970s; the Latin-American debt crisis of the 1980s (very much an international problem); and the property and small business loan crisis of the early 1990s.
The secondary banking crisis we have already touched on. The Latin-American debt crisis or, in wider terms, the Third World debt crisis had its roots in the 1970s when the major commercial banks, particularly in the United States, drew in deposits from oil-producing countries that had generated massive revenue surpluses from the oil price increases of that decade. Much of the money was lent to Third World countries – less developed countries or LDCs in the common banking euphemism – which seemed good business at the time. The total debt of the Third World was put in the mid-1980s at over $1,000 billion. For a variety of reasons – including high interest rates and low prices for basic commodities – many of these borrowers found themselves unable to service their loans (meet interest charges and capital repayments).
The outcome was an excellent illustration of the old banking adage that you are at your banker’s mercy if you owe him £5 and he is at your mercy if you owe him £5m. A game of poker – for somewhat larger sums – ensued. If the banks admitted they would not get their money back and wrote off their loans, they would be shown to be insolvent or at least they would fail the capital adequacy tests. So they attempted to maintain the fiction that the loans were sound. To do so they frequently arranged a rescheduling of the original loans. At best this meant extending the terms of the loan to give the debtor countries more time to pay. At worst it meant lending them more money (which they were unlikely to be able to repay) to meet the instalments of capital and interest (which they could not otherwise pay) on the original loans. Without rescheduling, the debtor countries would be forced to default on the loans (fail to keep to the terms) and the lending banks would then be forced to classify the loans as non-performing.
The debtor countries in their turn had a difficult choice. If they simply defaulted, they would find it difficult to borrow again in the international capital markets. But the threat of default was a powerful weapon in bargaining with the lending banks.
The game of make-believe that rescheduling made possible was somewhat disrupted in May 1987 when Citicorp, one of the major American lenders, announced a $3 billion provision or reserve against its Third World loans. This meant it was not writing down the value of specific loans but was accepting that it stood to lose at least $3 billion of its Third World lending. Citicorp could afford to make the provision but it posed problems for some other lenders with less capital who were forced by Citicorp’s action to acknowledge realities. The major British banks made similar provisions in due course. The banking emperors were not seen entirely without clothes, but were left looking distinctly chilly in their underpants.
The saga provided several insights into the nature of banking. First, banks do not always write off loans as soon as they suspect that the money is lost. While the banking authorities require banks to provide against losses on a prudent and timely basis, an observer might conclude that they sometimes fudge the realities until they have accumulated enough reserves to be able to afford the write-offs. Banking is not only a matter of confidence. The make-believe element is often important.
Second, ‘profit’ in banking is a more than usually nebulous concept. A bank declares good profits in the years that it makes the loans that will ultimately bring it severe losses. Third, dud loans can sometimes be sold – at a price. In the later years of the Latin-American debt crisis a secondary market in bank debt emerged. It worked like this: a bank with non-performing loans to the Republic of Erewhon might decide it would rather take its losses and get shot of the whole business. So it would sell the loans at, say, 50p in the pound to some other financial institution that was prepared to take a gamble on the amount it could recover. The prices at which the debt of different countries traded in this secondary market gave a pretty fair view of bankers’ estimates of the likelihood of recovery.
No sooner was the worst of the Latin-American debt crisis out of the way than banks internationally were again lending very heavily for property development and purchase in the late 1980s (see Chapter 20). In Britain, very substantial lending on commercial property was exacerbated by a great expansion of lending to small businesses. In the severe recession of the early 1990s in Britain, property values fell like a stone and numerous small businesses went bust. Many billion pounds worth of lending had to be written off by the British clearing banks alone.
There is nothing like a period of high interest rates accompanied by economic recession to expose the financing follies of the previous era. In the early 1990s companies that had expanded over-fast by takeover in the 1980s, and financed on borrowed money, were going to the wall like flies. In some cases there was no choice but to let the companies be wound up. In others, the lending banks decided that they would lose less in the long run by trying to keep the company going, probably with the help of a capital reconstruction or capital reorganization.
No two cases were quite alike, so we will take a hypothetical example to illustrate the main principles. Suppose Splurgeandspend Holdings had gone on a takeover spree in the great Thatcherite days of the 1980s and borrowed most of the money to do it. By 1991 the interest rate on its loans had more than doubled and, with the recession, its profits had halved. It faced an interest bill of £150m a year and had profits of only £70m before interest. Result: a pre-tax loss of £80m.
Splurgeandspend’s total borrowings at this point were about £1 billion. The value of the businesses it had bought in the 1980s had slumped heavily and many of the assets required writing down to realistic values. Once these write-downs had been made, the value of the group’s assets would have been £200m less than the money it owed to the banks. It had a deficiency on shareholders’ funds of £200m. Add to this the fact that Splurgeandspend was running out of cash and had no way to raise more.
The lending banks knew that, if they closed the business down on the spot, they would get very little for the assets and would lose a large part of their loans. Since some of Splurgeandspend’s businesses would have been quite promising in more normal economic conditions, they decided to try to keep the company going. First, they agreed to convert £300m of their loans into shares in the company at a price of 4p per share (the shares had, of course, slumped to virtually nothing in the market). This equity-for-debt swap would eliminate £300m of Splurgeandspend’s borrowings and therefore also eliminate the interest charge on this amount.
Second, they converted a further £200m of their existing loans into a new kind of subordinated loan on which no interest would be payable for five years. Third, they agreed to waive the interest due on the remaining £500m of loans for one year to give the company a breathing space to sort itself out and sell some of its businesses (if it could) to raise cash. Finally, they agreed to make available a new overdraft facility of £30m to provide the company with a little cash to tide itself over.
Splurgeandspend thus has no interest bill to worry about for a year. For the following four years it will pay interest on only £500m of borrowings and thereafter on £700m. It has a chance of survival. But there is a price – banks are not charities. The company’s share capital is massively expanded by the conversion of £300m of loans into shares. The original shareholders are left with only 5 per cent of the enlarged capital and are thus virtually wiped out. The rest belongs to the banks. If the company recovers, they will reap the rewards. The major British banks do not usually own shares in companies. But the early-1990s recession left them temporarily with quite significant shareholdings in troubled companies that arose through this kind of reconstruction.
The major problem in organizing a reconstruction of this kind, if the company has loans from many different banks, lies in getting all the banks to agree. Where the company has a syndicated loan from, say, 20 different banks there will often be some banks that want to close the company down immediately and recover what they can. Recognizing this problem, the Bank of England developed guidelines known as the London Rules, designed to persuade banks to give troubled companies a chance of surviving where possible. Some overseas banks with a different lending culture were not always easy to convince.
In the past, banking institutions were regulated by the Bank of England and building societies had their own regulatory structure. The 1987 Banking Act had abolished an earlier distinction between banks and licensed deposit takers or LDTs, which had comprised mainly the less established or second-tier concerns. Under this Act, all but the smallest deposit-taking institutions were allowed to call themselves banks provided they satisfied prudential requirements as to the way the business was run (and provided the people running it were judged fit and proper).
But critics had long suggested that the Bank of England had a conflict of interest in that it was supervisor of the banks as well as being the body which advised on (and implemented) monetary policy. Cynics asked whether the Bank would really be prepared to advise the government to, say, raise interest rates at a time when this might damage the banks for which it had supervisory responsibility.
The position has now been resolved with the Bank of England acquiring greater responsibility for monetary policy but ceding its regulatory powers over the banks to the new ‘super-regulator’, the Financial Services Authority (see Chapter 22). The Bank still, however, has responsibility for the stability of the banking system as a whole. The FSA has also taken over responsibility for building societies.
The major UK banks have their own corporate websites which are used both to promote their services to customers and to provide information to shareholders. Background information on banking in the UK is available at the British Bankers’ Association site at www.bankfacts.org.uk/. The Chartered Institute of Bankers site at www.cib.org.uk/ is aimed more at those who work in banking. Needless to say, the Bank of England website at www.bankofengland.co.uk/ also contains information of relevance to the banking business. The European Central Bank site is at www.ecb.int/ and the European Bank for Reconstruction and Development at www.ebrd.com/. International banking and related organizations include the World Bank at www.worldbank.org/, the International Monetary Fund at www.imf.org/ and the Bank for International Settlements at www.bis.org/.