The Europe of Broken Dreams, Part 2: Leveraged Banking, it takes Three to Tango28th January 2013

Well Europe is quickly back in the headlines with speeches and opinions galore. In last week’s blog we took a foray to Spain, one of the largest and most troubled European economies, to introduce our FYI blog series on Europe. We also briefly looked at how banks create money, as this is a crucial starting point to understanding the economic situation.[1]

So why choose Spain, when Greece has been leading the European troubles? Well, a Financial Times article by Victor Mallet piqued my interest in Spain’s finances way back in August 2011; “Cash crunch feeds Spanish pharmacists a bitter pill”, where “Dolores Espinosa, a Toledo pharmacist, and her partner and husband Federico Aguado have just discovered what happens when one of Spain’s 17 regional governments runs out of money”.

Toledo is in Castilla-La Mancha, by no means the poorest region in Spain, being just half way down the internal league-table. Don Quixote made it famous for chasing windmills. With prescriptions representing the majority of small pharmacists’ revenues, without payment they could no longer pay their suppliers, nor continue to issue prescriptions to customers. The regional Government claimed it had literally run out of money. What a wake-up call for both businesses and consumers in a society that has become accustomed to relying on state promises.

So these shoddy economic events are real and painful, and pretty close to home, and the causes really do need to be understood.

The banking lending system …

Last week we discovered that banks create money; if I arrange a loan the bank simply creates an electronic loan account and places some electronic money into my current account for me to spend. It really is easier than baking a cake because the bank doesn’t even need to bother with the ingredients.

It used to be the case that banks kept all their deposits in safe-keeping. Then they started to lend, funded by pooling their total deposits, just leaving a small amount of cash in the safe, and some other funds capable of being turned quickly into cash, readily accessible to meet depositors’ expected withdrawals.

Getting more confident they realized that as long as they made good loans, they could lend more than their deposit base, provided they kept that safety margin to satisfy withdrawals and to cover any bad debts. Risks between the different banks as their respective customers paid each other would be cleared through the central bank. The central bank would also require the banks to hold both a liquidity and solvency safety margin, and if one bank overstepped the mark the central bank would behave in a stern manner, demanding change or even closing it down. If necessary the central bank would provide liquidity to meet withdrawals, ideally to prevent or, worst case, to satisfy a bank run until confidence returned.

In this environment banks could and did go bust, some depositors lost their deposits, and those running the remaining banks were reminded to operate in a sensible manner or lose the confidence of their depositors. In banking, confidence is everything. Banks, like the early train stations, specified grand columns and high ceilings in their architecture to reassure the public that the activity in which they traded was safe and sound. The new money created by banks was thought to enable the expansion of the economy as the population grew and more economic activity needed to be financed.

European lending in practice …

So how can things go so wrong? This was wonderfully explained in a letter to various newspapers this week by a certain John Corcoran of Co Dublin: “A property has two prices, the price you can get for it, or the net present value of its cash flows. If a €5 note was auctioned … and an unwise person bid it up to €20, then a surveyor would value all €5 notes as €20 notes. Likewise if an unwise person paid €2m for a house with a net present value of €½m then a surveyor would value all similar houses at €2m. Almost all of the Irish banks’ reckless lending was done using surveyors valuations. These valuations were as good as money. This is the valuation error that created the property bubble and bankrupted the country.”

So lending based on these valuations became unsound, and when the bubble broke the value of the banks’ collateral reduced. This is what we now hear all the time, the banks lending money and getting everyone and themselves into trouble. Of course the borrowers had to borrow too, but that’s not even half the story.

Banking deposits …

As the economy boomed, and politicians decided that depositors’ money should be guaranteed by the state, we became careless, and forgot that there was a reason why some banks paid higher interest on deposits than others, which is exactly what happened with the Icelandic banks. If depositors see or perceive no risk in getting their money back, they will generally chase the highest return, especially if encouraged to do so by the “best buy” tables of the national newspapers. A bank that has a lower safety margin, or less stable lending, should rightly have to work harder and pay more to attract deposits, and that should be a warning sign to depositors. But it wasn’t.

In Europe, as in the UK, deposits became easy to come by as we forgot risk (remember that lending also creates deposits), assets were rising in value supported by ever higher valuations, and the banks were able to create money almost at will, further driving up the value of the assets and the collateral they held.

The regulators of course watched over, and could have put a brake on this growth, but failed to do so. After all, as homes and other assets are rising in value the voters feel good, the politicians get re-elected, the value of bank collateral is rising, and as everything seems to be going so well no regulator wants to be the party pooper.

Now imagine being a bank that starts to worry, and slows down its lending. In the old days depositors would probably have seen that as a good sign, moved their deposits to the cautious bank, and have happily accepted lower rates on their savings in return for sleeping soundly at night. But in recent times if all the other banks are continuing to lend at the same frantic pace, and paying high deposit rates, whilst this one cautious bank reduces its lending and profit opportunity, this occurs without a corresponding ability to profit from paying significantly lower deposit rates. It is likely to rapidly fall behind and be taken over by one of its more aggressive competitors.

So the regulatory and state interference designed to make things safer has in fact ensured that there is little encouragement to behave. Banking was the most regulated industry in the run-up to the crisis, but banks pushed leverage to the permitted limit. This is not the first example of regulations having the absolute opposite effect from that desired. I am sure it will not be the last.

European leverage …

So banks continued to leverage up their assets. For EU banks the Basel II capital and risk requirements established regulatory “capital adequacy” ratios for banks. The basic capital safety margin was 6%. So for every €6 of capital they could lend €100, or 16x their own money. So their lending needed to be good, as bad debts would rapidly evaporate their equity.

But within this 16x ratio banks were free to identify certain lending as less risky that others. The 16x multiple applied not to all lending, but to a risk-weighted model of that lending. The safer the lending was modelled, the more could be lent, the more profitable the bank, the higher the share price and bonuses, with the effect that European banks became far more highly leveraged, and were last year, according to the IMF, leveraged by 26x. Lehmans was leveraged 30x when it blew up, so it really isn’t a safe level.

Some believe the real leverage is very much higher still, which is quite possible given the scale of the housing bubble in Europe. The Economist has a good interactive chart of house price indicators[2], showing for instance that Spain’s house price index rose some 38x over the past 30 years. So that’s plenty of valuation and collateral growth to support extra lending, until the music stops.

The music stops …

Now imagine that just 4% of the bank’s lending goes bad, or just has difficulty being repaid. If it is already lending at say 25x it’s own money, it has lent €100 for every €4 of its capital reserves. The losses of €4 promptly destroys all of the bank’s capital reserves. The liquidity risk is a bank run as news spreads that the bank has become unsafe, and an immediate solvency need to raise another €4 of capital from shareholders despite a plummeting share price.

Providing short-term liquidity to prevent bank runs is fairly easy; it is hopefully a temporary thing organised by central banks. Last August Spain’s banks saw a bank run of €70bn, that’s around €1,500 for every man, woman and child in Spain, in one month. The system coped. In fact the European Central Bank stepped in with massive liquidity measures to stop the rot.

But replacing insolvent balance sheets is another thing entirely, with long-lasting consequences. Whilst depositors were pulling €70bn out of the system, the Spanish bank’s total market capitalization was little over €100bn. Not much chance of raising extra money from shareholders.

Solvency crisis …

Across Europe banks have sought to shrink back their lending as the value of the collateral held against those loans shrunk, and the faster they pulled back the faster the collateral shrunk. This has impacted right across the world, as European banks have generally been far more highly leveraged than their US cousins. When French banks, which used to be at the forefront of commodity lending pulled back, as far away as Asia business’ ability to finance their stocking and purchasing of commodities became much harder, and the wheels of international trade slowed and asset values fell.

Recent regulatory intervention to “make banks safer” has, under Basel III, raised the level of capital they must hold over time, thus reducing leverage. That sounds good, and safer, but the cost of raising the new capital through shareholders or taxpayers is so enormous, and their current profitability so difficult to determine (due to continuing write-downs, fines, refunds and low interest rates) that it is more advantageous for the banks to shrink their lending back even further towards their capital, rather than to raise their capital towards their lending. So the banks are trying to shrink.

Hindsight is a wonderful thing, but regulations, if they are of any benefit at all, really should make things tougher when the going is easy, and easier when the going is tougher.

Over the past couple of years virtually every analysis of the European banking black hole has been quickly overturned by events. Banks that were believed to have modest deficits were rapidly found out, as the risk weightings of different lending segments changed, as the value of collateral held dropped further, and as depositors money was withdrawn.

To illustrate this, in 2010 Bankia, Spain’s fourth largest bank, was formed from a merger of 7 regional Spanish banks. Shares were sold to the Spanish public in 2011 and traded at €3.70. On 9th May 2012 Bankia asked the Spanish Government for a €4.5bn loan, and the Government stated that Bankia was solvent. On 21st May the funding request was approved. Two days later the bail-out rose to €11bn. A day later it rose to €15bn. A day later it rose to €19bn. By the start of January 2013 the shares had fallen by 90% to €0.37.

So to Tango it seems that it takes 3: The lenders, the depositors, and the regulators. All have made mistakes, or at the very least uninformed assumptions.

There is worse to come. Incredibly, lending to Government is deemed to be ”risk free”, despite the fact that Governments can and do default. Think Brazil and Russia within the last 20 years, before we even start on Europe.

Hmm, I wonder why lending to Governments is regulated as “risk free”? Last week we mentioned the “symbiotic embrace” between banking and Government, and we’ll cut to the chase on that next week.

[1] If you missed the blog or want a refresher, click here.

[2] To see the Economist interactive chart, click here