One of the most important lessons from the subprime crisis is that the growth of banks’ capital fell behind the dramatic growth of total credit and overall risks over the last twenty years. Until August 2007, we were not alarmed by this, having been lulled by the comforting hypothesis that the risks were sold outside the banking system and widely spread over many investors. The almost $ 500 billion (and counting) of bank losses incurred prove that this was pure wishful thinking: first, most risks were still on banks’ books; second, other risks had to be taken back to avoid further reputational damages, and worst of all, some risks were simply hidden under the carpet in the form of a “shadow banking system”, according to the Bank for International Settlements.1
Warnings and optimism
In the past few years the main international agencies have repeatedly warned about the risk of a major crisis, but at the same time they kept stressing that the international banking system was robust as never before, thanks to the overall prudential supervision, the capital adequacy rules put in place since the mid-80s, and, most importantly, the imminent significant overhaul of the Basel agreements.
The simple and sad truth is that in the last two decades (and in particular in the last one) we have seen an unprecedented credit boom with the usual component of euphoria and over-optimistic valuations. Bank capital was adequate under in that favourable scenario but not in the face of a consistent shock. As soon as the overall mood changed, the markets priced into interbank rates and credit default swap premia a significant probability of illiquidity and even insolvency for all major banks, notwithstanding the extraordinary interventions of the main central banks as lenders of last resort and the not-less-extraordinary rescue operations put in place for Northern Rock, Bear Stearns, and the like.
The problem for the European banking system is well described by the two following figures taken from research analysis published by Citigroup.2 They show two significant weaknesses:
- Total assets grew much faster than the risk-weighted assets against which banks must hold capital.
- The tangible component of equity decreased, which means that a part of the capital cushion was largely made of intangible assets deriving from the merger process within the banking system.
Figure 1. Total assets to risk-weighted assets ratio
Figure 2. Tangible equity to reported assets ratio
An excess of credit is at the same time a shortage of bank capital. The economic research prompted by the crisis has shown that banks’ leverage grew at a consistent pace in the past twenty years.3 It is also inherently pro-cyclical as it is amplified by the decisions of the household sector (determined by house prices) and the decisions of the banking system, based on the desired level of capital. Both these engines of the boom have been abruptly put into reverse.4 The result is a painful process of deleveraging in the international banking system – a process that risks amplifying the inevitable reduction of credit supply, thus worsening the macroeconomic impact of the crisis.
Crisis abatement: Correcting the credit/capital imbalance
As Greenlaw et al5 put it, the crisis will abate once one or more of three conditions are met:
- Banks (both commercial and investment banks) contract their balance sheets until their capital cushion is once again large enough to support their balance sheets;
- Banks raise sufficient new equity capital to restore the capital cushion to a size large enough to support their balance sheets;
- The perceptions of risk change to a more benign outlook so that the current level of leverage can once again be supported with existing capital.
The third appears highly unlikely. This means that the choice is between great injections of bank capital or greater credit contraction with its attendant macroeconomic pain. Clearly, the priority now should be to rebuild the capital base of the main banks.
Regulators are using all their powers of moral suasion to push banks towards capital rebuilding, but new equity issues have not even kept up with new capital losses (write downs, etc.). In a few cases, the gap is quite significant.
Figure 3, taken from the last data published by the IMF6, shows that new capital trails write-downs (i.e. the emergence of unexpected losses) by some $ 100 billion.
Figure 3. Bank write-downs and capital raising (billions of dollar)
In other words, all the regulators’ efforts could not bring the banking system back to its position before the start of the crisis. If the market has discovered that banks’ capital was not adequate, it cannot tolerate a situation where banks’ capital is lower than one year ago, also taking into account that a large part of the intangible component of equity has evaporated.
This Achilles-and-the-tortoise-like adjustment process has two negative effects. It maintains a sentiment of distrust even within the banking system, creating a gridlock in the market for liquidity instruments. And, it can worsen the effect of deleveraging and the ensuing credit crunch. Both can make the crisis last longer and have stronger adverse macroeconomic effects.
Recapitalisation is painful but necessary
One of the main obstacles to the recapitalisation effort has been the reluctance of banks to venture into operations that could be very costly and could significantly dilute existing shareholders. This kind of resistance is well proven by recent data from the Bank of England, shown in Figure 4.7
Figure 4. Major banks’ tier one capital raising by type since September 2007
The figure clearly shows that banks preferred to issue hybrid instruments (essentially debt instruments that contain some features of equity, such as coupon suspension and principal write-down) and in a second stage they turned to off-market private placements of mandatory convertible securities to sovereign wealth funds. Only in the second quarter of 2008 did the focus of capital raising shift to market-based public rights issue. In other words, not only do capital injections lag behind the emergence of losses, but the financial instruments that have been used are not the less “powerful” available, from the point of view of their true equity content.
In this contest, the whole process of bank recapitalisation seems to be a new version of the Zeno’s paradox. Achilles will never reach the tortoise and therefore the effects of the crisis can be very serious and long lasting.
Merrill Lynch’s salutary example
The recent case of Merrill Lynch proves that realistic medicines, although bitter to swallow, can generate positive effects in the market. Only a few days after John Thain, Merrill’s chief executive, had said that the bank did not need more capital, the board approved a complex plan whose main components were the sale of collateralised debt obligations ($30.6 billion of notional value at $0.22 to the dollar, implying further write-offs of $ 4.4 billion in the third quarter); a final settlement in the controversial monoline business; an $ 8.5 billion issuance of common stock, implying an increase in the number of shares of some 38%. Most analysts reacted very well8 and the Lex Column of the Financial Times judged the move “cathartic” and “ahead of the crowd”.9
More policy action needed
Notwithstanding these favourable judgments, most banks seem still reluctant to follow Merrill Lynch’s example. It is therefore important to encourage new issues of capital, however painful for the existing shareholders (but more in the short term than in the long term). The moral suasion that regulators are reported to exert must be strengthened, under a strict cooperative effort, as they successfully in the field of lending at last resort in the past twelve months.
From this point of view, one can argue that the global financial system has to cope with a double shortage: liquidity and bank capital. While the first has been solved with extraordinary measures and an extraordinary cooperative effort that has profoundly changed the lender-of-last-resort mechanisms, the shortage of capital also requires an extraordinary and coordinated effort. This is even more important, as European legislation could prove to be more rigid than America’s, as it requires giving shareholders first rights to new equity capital.
Europe’s special problem
From this point of view, it is interesting to remember the recent initiative from a group of British institutional investors, who asked for a series of initiatives to make the process of raising new capital easier while maintaining the principle of pre-emption to existing shareholders.10
In other words, both from the supply- and the demand-side of bank capital, there are signs of willingness to restore the equity base of the financial industry. Regulators must do all in their power to encourage this trend. It is true that they could have mixed feelings, because this would mean admitting that banks’ capital was not adequate as they had pretended or that they had been aiming at the wrong indicators (risk-weighted assets instead of total assets).
But regulators must face the hard truth, as Merrill Lynch did: “the credit crisis has destroyed the idea that unregulated financial markets always efficiently channel savings to the most promising investment projects”.11 This means that regulation must be thoroughly revised and capital adequacy rules must be strengthened.
Supporting market forces that are already pushing banks to rebuild their capital base, at least to pre-crisis levels, appears to be of the utmost importance. The sooner we acknowledge it, the milder the hangover of the present crisis. Let Achilles reach the tortoise.
1 BIS, Annual Report 2007-2008, Basel, June 2008. The expression has been used also by Mario Draghi (who chairs the Global Financial Stability Committee) in the Bank of Italy’s Annual Report.
2 Citigroup, Jeremy Sigee et al, Time To Delever. Rethinking Capital Needs For European Investment Banks, 22 April 2008.
3 Tobias Adrian - Hyun Song Shin, Liquidity, Monetary Policy, and Financial Cycles, in “Federal Reserve Bank of New York, Current Issues in Economics and Finance”, January-February 2008.
4 Marco Pagano, The Subprime Lending Crisis: Lessons for Policy and Regulation, in “Unicredit Group, Finance Monitor”, June 2008.
5 David Greenlaw - Jan Hatzius - Anil K Kashyap - Hyun Song Shin, Leveraged Losses: Lessons from the Mortgage Market Meltdown, U.S. Monetary Policy Forum Report No. 2,
Rosenberg Institute, Brandeis International Business School and Initiative on Global Markets, University of Chicago Graduate School of Business, 2008, p. 34.
6 International Monetary Fund, Global Financial Stability Report, Market Update July 28, 2008.
7 Bank of England, Markets and Operations, in “Quarterly Bulletin”, Second Quarter 2008.
8Goldman Sachs, William Tanona et al, “Capitulation trade. Painful but necessary to move forward”, 29 July 2008. The analyst judged that the “decision to finally sell the majority of its ABS CDO portfolio and write-off its monoline exposure was the right thing to do in order to move the firm forward. [..] Although painful, we believe putting these issues largely behind it will better enable the firm to focus on existing business opportunities in the marketplace”.
9 “CDOh no” (Lex Column), Financial Times, 29 July 2008.