From Reykjavik
Late last night I returned from a four-day visit to Iceland with Professor Anne Sibert, co-author of a report anticipating the collapse of the Icelandic banking system and joint carer for our cats and children.
Iceland’s largest three banks with border-crossing activities collapsed last fall, as did its currency. The three banks are in administration and new state-owned banks with a purely domestic focus have been set up. Strict capital controls make external borrowing all but impossible and discourage foreign investment. The country now has an IMF program. Strangely enough, the programme does not impose any fiscal pain until 2010. This year the fiscal automatic stabilisers are allowed to work freely, although no further discretionary expansionary fiscal measures are being proposed. Starting in 2010, under the programme, discretionary fiscal tightening of more than 8 per cent of GDP is envisaged between now and 2013. That number could be higher if the external indebtedness of the state turns out to be higher than the 110 per cent of annual GDP estimate of the IMF.
The true state of the gross and net external indebtedness, including contingent off-balance sheet exposure, of the Icelandic state is a mystery even now. In addition to sovereign debt and sovereign-guaranteed debt, there are credit lines and possibly other contingent external liabilities whose take-up has to be estimated/guessed to get an accurate view of the state’s external obligations. It is possible that the IMF figures include an offset against the sovereign’s external liabilities in the form of an estimate of the recovery value of some of the external assets of the sovereign (e.g. its share in the assets of the UK subsidiaries of Kaupthing and Landsbanki). Assigning any positive value to these assets is an act of faith. In any case, it would be helpful to have the hard external liabilities and the soft external assets reported separately.
Iceland’s government had to let the country’s three main banks go into administration because it did not have the fiscal capacity to bail out financial institutions with balance sheets amounting to 600-700 per cent of annual GDP. Any attempt to commit further government resources to the rescue of the banking system would have precipitated a sovereign default.
With each day that passes, estimates of the recovery value of the assets of the three ‘bad banks’ melts away like snow in April. The decision not to guarantee the liabilities or the assets of the banks (other than retail deposits, including retail deposits with foreign branches for amounts up to €20,000) was the only wise thing the Icelandic authorities have done in this whole sorry mess. It isn’t even clear that the Icelandic authorities came up with this sensible idea themselves. More likely the IMF opened their eyes. The creditors of the banks, which include Commerzbank and Bayerische Landesbank will have to explain to their own shareholders and taxpayers why they now in effect own large chunks of three defunct Icelandic banks.
…to London
Returning to London from Reykjavik last night was like coming home from home. Allowing for the differences in the scale of the Icelandic economy and the British economy (the UK population is more than 200 times larger than Iceland’s Coventry-sized population), there are disturbing economic parallels. The excesses in Iceland during the past decade were greater than in the UK, but not qualitatively different. In both countries, the regulation of banks was laughably lax. The UK’s much-touted light-touch regulation turned out to be soft-touch regulation. Relaxation of regulatory norms was consciously used by the British government as an instrument for attracting financial business to London, mainly from New York City. Fiscal policy in both countries became strongly pro-cyclical during the boom years preceding the financial crisis. Households were permitted, indeed encouraged, to accumulate excessive debt - around 170 per cent of household disposable income in the UK, over 210 percent in Iceland.
Both countries permitted the real exchange rate of their currencies to become materially over-valued, more so in Iceland than in the UK, but still to a worrying extent even in the UK. The same version of the ‘Dutch disease’ - the crowding out of the non-financial internationally exposed sectors (exporting and import-competing) by the excessive growth of the financial sector and the construction industry - occurred in both countries, again to a greater extent in Iceland than in the UK, but to an highly undesirable extent even in the UK. Iceland’s gross and net external indebtedness are much greater than that of the UK, and its current account deficits during the years just prior to the crisis were much larger than those of the UK. But the UK too built up very large stocks of gross foreign assets and liabilities and ran persistent current account deficits.
Both countries pay the price for the hubris of policymakers who believed that they had engineered the end of boom and bust and replaced it with perpetual boom. The risks associated with asset market and credit booms and bubbles were dismissed (”how can you be sure it is a bubble? Do you know better than the market etc.”). In neither country have the responsible parties (the prime minister, the minister of finance, the governor of the central bank and the head of banking regulation and supervision) admitted any personal responsibility for the disaster. Instead we are told tales of a once-in-a-lifetime calamity, coming at us from abroad, that ruined a perfectly sensible and sustainable set of domestic policies, regulations, rules and arrangements. As if!
Both countries allowed the unbridled growth of banks that became too large to fail. In the case of Iceland, the banks also became too large to rescue. In the UK, the jury is still out on the ‘too large to rescue’ issue, but I have serious and growing concerns. Incrementally, the British authorities have guaranteed or insured ever-growing shares of the balance sheets of the UK banks. And these balance sheets are massive. RBS, at the end of June 2008 had a balance sheet of just under two trillion pounds. The pro forma figure was £1,730bn, the statutory figure £1,948 (don’t ask). For reference, UK GDP is around £1,500 bn. Equity was £67 bn pro forma and £ 104bn statutory, respectively, giving leverage of 25.8 times (pro forma) and 18.7 times (statutory), respectively.
With 25 times leverage, a 4 per cent decline in the value of your assets wipes out your equity. What were they thinking? The fact that Deutsche Bank used to have 40 times leverage and is now proud to have brought it down to just below 34 is really not a good excuse.
Lloyds-TSB Group (now part of the Lloyds Banking Group) reported a balance sheet as of June 30, 2008 of £ 368bn and shareholders equity of £11bn, giving leverage of just over 33 times. Of course, for all these banks, the risk-adjusted assets to capital ratios are much lower, but because the risk-weightings depend both on private information of the banks (including internal models) and on the rating agencies, they are, in my view, worth nothing - they are the answer from the banks to the question “how much capital do you want to hold?”. That the answer is “not very much, really”, should not come as a surprise. For the same date, HBOS, the other half of the new Lloyds Banking Group, reported assets of £681bn and equity of £21bn, giving leverage of just over 32 times; Barclays reported total assets of £1,366bn and shareholders equity of £33bn giving leverage of 41 times, and HSBC (including subsidiaries) reported assets of £2,547 bn and equity of £134 bn, implying leverage of 19 times.
The total balance sheets of these banks about to around 440 per cent of annual UK GDP. The government seems to be well on its way towards guaranteeing most if not all of it. No one outside the banks (and perhaps even no-one inside them) has a good sense of the true value of what they hold on and off their books.
There is a strong possibility that the UK banks are still hiding toxic or dodgy assets on and off their balance sheets, or are still valuing them at substantially more than their fair value. They are aided and abetted in this by the relaxation of fair value (mark-to-market) principles condoned by the International Accounting Standards Boards, when it permitted the reclassification of certain investments between the three categories of (1) ‘assets held for trading’ (which are valued at market prices and have these valuations reflected through the profit and loss account), (2) assets ‘available for sale’ (which are valued at market prices have these valuations reflected only in the balance sheet, not through the profit and loss account) and (3) ‘assets held for investment’ (which need not be valued at market prices). The new IASB rules are an invitation to management to hide capital losses or to delay their translation into the profit and loss account by strategic reclassification of the assets in question. It is truly scandalous that the IASB approved this ex-post reclassification of investments.
In the name of preventing a collapse of the UK banking system, we are witnessing the socialisation - at first gradual, but now quite rapid - of all balance sheet risk of the UK banks by the UK government. This is risky and, in my view, unwise. The manner in which it is done also seems designed to maximise moral hazard. The good news is that it is unnecessary for restoring and maintaining the flow of new credit in the the British economy.
The state is stretching and testing its current and future fiscal resources both by guaranteeing or insuring ever-growing amounts of new and existing bank funding and bank assets, and through its assumption of private credit risk through such facilities as the £200bn Special Liquidity Scheme (SLS), which swaps Treasury bills against securities backed by mortgages and other loans originated before 2008. The new £50bn Asset Purchase Facility, through which the Bank of England will engage in qualitative easing (increasing the proportion of private and possibly illiquid securities in its portfolio) through outright purchases of private securities rather than by accepting them as collateral in repos and at the discount window, also raises sovereign credit risk, even though the Bank of England is required to purchase only “high-quality” assets. ABS backed by US subprime mortgages were considered high quality once.
In view of this progressive socialisation of the balance sheet risk of the UK banks, it is not surprising that there has been some convergence between the CDS rates of the UK sovereign and of the UK banks whose balance sheets are guaranteed or insured to an ever-growing extent by the UK sovereign. I expect this convergence to continue, with the CDS rates of the banks falling and that of the UK sovereign rising. A similar pattern of converging sovereign and banking sector credit risk premia can be observed in other countries. As the banks become more secure, the government becomes less secure.
The UK may not be the first EU member state to face a sovereign debt crisis. According to the rating agencies, the CDS rates and the 10-year sovereign spread over Bunds, the leading candidates for a sovereign solvency crisis are Greece, Spain, Portugal, Italy and Ireland. Some of these countries are in fiscal trouble not because of their sovereign’s exposure to the banking sector but for other reasons, such as a long-standing inability to reduce a very high public debt to GDP ratio, coupled with the prospect of large cyclical deficits as the economy goes into a deep recession. Greece and Italy fall into that category.
Among the countries where the sovereign is highly exposed to the banking sector, Ireland may well be the next country where the ‘too large to rescue’ theory may be tested, although countries like the Netherlands, Belgium, Luxembourg, the UK and, outside the EU, Switzerland, are also potential candidates for the ‘too big to rescue’ (without external support) club. Ireland’s outstanding sovereign debt is low as a share of GDP (around 25 per cent) , but the exposure of the sovereign to its overgrown banking system is massive: the Irish state guaranteed the entire liability side of the banks’ balance sheets, except for the equity.
Irish 10-year sovereign debt spreads over Bunds stood at 198 basis points on January 16. We may get a test of Eurozone or even of EU fiscal solidarity before this crisis is over, as argued by Wolfgang Munchau. I believe that this crisis will certainly deepen EU-wide fiscal cooperation between national governments. It may even provide the spur for the creation of an embryonic proper supranational EU fiscal authority with independent revenue raising and borrowing powers.
But even if the UK is not the next European country to face a sovereign debt challenge, there is a non-negligible risk that before too long, the growing exposure of the British sovereign to the banking system (and especially to the foreign currency funding risk faced by the UK banking system), together with the 9 and 10 per cent of GDP general government fiscal deficits expected for the next couple of years, may prompt a loss of confidence by the global financial community in the British banks, currency and sovereign.
We may well witness the UK authorities going cap-in-hand to the IMF, the EU, the ECB and the fiscally super-solvent EU member states (if there are any left), prompted by a triple crisis (banking, sterling and sovereign debt), to request a bail out. I hope and trust that the UK authorities are in regular contact with the IMF, the US administration, Brussels, Frankfurt and the leading EU member countries to prepare for a possible internationally coordinated bail-out operation for the British banking system and sovereign.
My belief that the UK government should take over all UK high street banks (on a temporary basis) is based on the simplification this would provide as regards the governance of these institutions under extreme circumstances, when private ownership and governance have clearly failed, and on its positive effect on incentives for future bank behaviour (’moral hazard). When the public interest and the interests of the existing private shareholders and the incumbent managers and boards of directors diverge as manifestly as they do in this crisis, the sensible thing to do is to buy out the existing shareholders (as cheaply as possible). That way the failed and failing management and boards can be restructured (fired without golden parachutes) and the new owner can insist on and enforce an open, verifiable valuation of toxic and dodgy assets, on and off the balance sheet of the bank.
The non-state shareholders of the UK high street banks ought no longer to be a factor in the discussion of what to do. As of yesterday, their market capitalisations were (according to today’s Financial Times) as follows: Lloyds Banking Group £10.6bn, Barclays £7.4bn, RBS £4.6bn and HSBC £60.8bn. And these valuations reflect the implicit subsidies granted the banks through their access to such state-owned and state-run facilities as the Special Liquidity Scheme, the government’s guarantee of new bank borrowing, deposit guarantees, and the mitfull of new insurance/guarantee schemes announced yesterday.
The second major rescue package for UK banks in three months includes very large (and in at least one case potentially uncapped) packages of guarantees and insurance offered to the banks by the state on terms that are not clear. This is very much in the US tradition, promoted by the US Treasury, the Fed and the FDIC, of maximising moral hazard for a given amount of immediate crisis fire-fighting. In the incoming Obama administration, both Treasury secretary Tim Geithner and NEC chair Larry Summers have had many years of experience, in the US and all over the globe, throwing good money after bad in pointless bail-out packages. The trio of Ben Bernanke, Geithner and Summers are likely to produce a veritable moral hazard monsoon.
The second instalment of the UK bank rescue package provides unnecessary, undesirable and costly comfort for existing management and boards, for existing private shareholders and for existing creditors and bond holders of the banks. It is unnecessary because the same quantum of crisis-fighting solace can be provided with much smaller effects on the banks’ future incentives for excessive risk taking, by taking the banks into full public ownership and restricting government guarantees to new credit flows.
A modest proposal
So here is my proposal:
(1) Take into complete state ownership all UK high street banks. This has to be mandatory, even for the banks that still like to think of themselves as solvent.
(2) Fire the existing top management and boards, without golden or even leaden parachutes, except those hired/appointed since September 2007.
(3) Don’t issue any more guarantees on or insurance for existing assets - regardless of whether they are toxic, dodgy or merely doubtful. Issue guarantees/insurance only on new lending, new securities issues etc. A simple rule: guarantee the new flows, not the old stocks. This will reduce the exposure of the government to credit risk without affecting the incentives for new lending.
(4) Transfer all toxic assets and dodgy assets from the balance sheets of the now state-owned banks (or from wherever they may have been parked by these banks) to a new ‘bad bank’. If possible, pay nothing for these toxic and dodgy assets. Since the state owns both the high-street banks (I won’t call them ‘good’ banks) and the bad bank, the valuation does not matter. If the gratis transfer of the toxic or dodgy assets to the bad bank would violate laws, regulations or market norms, let an independent party organise open, competitive auctions for these assets - auctions in which the bad bank, funded by the government, would be one of the bidders. Whatever price is realised in these auctions is paid by the new bad bank to the old banks.
Capitalize the bad bank with the minimum amount of capital required to meet regulatory norms. Fund the rest of the assets through a loan from the state to the bad bank or through a bond issued by the bad bank and bought by the state.
As regards the bad bank, that’s effectively it. With toxic and dodgy securities on the asset side of its balance sheet and with the state owning all the equity and as the only creditor, the assets can either be sold off, if a market develops again, or held to maturity, earning whatever cash flows they may yield.
(5) As a special case of (4), take the high street banks into full public ownership and treat these existing banks in their entirety as bad banks. Close the existing banks for all new business. Transfer the deposits of the high street banks (now the bad banks) to new (state-owned) ‘good’ banks (or perhaps rather, not yet bad banks). Replace the deposits on the books of the bad banks with loans from the state to the bad banks or with bond issues by the bad banks purchased by the state. Let the new banks (New Lloyds, New RBS, New Barclays and New HSBC) acquire, in a competitive bidding process also open to other market participants, any of the assets of the old banks. Run the new banks as competing publicly owned, profit maximising banks until they can be privatised again, when a sensible regulatory regime for banks is in place and the market for bank shares recovers. Don’t guarantee or insure any items on the balance sheet of the old banks. Use guarantees/insurance exclusively for new lending and new investments by the new banks. Gradually run down the old banks as their assets mature, as under (4).
The miracle of limited liability applies also when the state is the owner. As long as the state-owned bad banks (which could be merged into a single super bad bank) don’t obtain sovereign guarantees for their obligations, the financial exposure of the sovereign is limited to its equity stake and the existing guarantees and insurance it has provided in the past.
It is key that there be no further injections of funds by the state into the bad banks until there are no longer any private creditors. If a bad bank becomes balance-sheet insolvent or liquidity insolvent and it still has private creditors (as it would, in general, under the model of item (5)), the bad bank should be put into administration and its debt to parties other than the British state should be converted into equity. That equity would be then be purchased by the UK state. With the bad bank now not just 100 per cent state-owned but also without private creditors of any kind, the assets can be managed as the state sees fit - one hopes in such as way as to maximise the present discounted value of their held-to-maturity cash flows.
The balance sheets of the British banks are too large and the quality of the assets they hold too uncertain/dodgy, for the British government to be able to continue its current policy of extending its guarantees to ever-growing shares of the banks’ liabilities and assets, without this impairing the solvency of the sovereign. Britain risks becoming a victim of the new inconsistent quartet: (1) a small open economy with (2) a large internationally exposed banking sector, (3) a currency that is not a serious global reserve currency and (4) limited fiscal capacity. It risks a triple crisis and a threefold run: on its banks, on its currency and on its sovereign debt.
Limiting the exposure of the sovereign to what is fiscally sustainable may imply giving up on saving (all of) the banks. If my proposal for institutionally and legally separating existing stocks of assets and liabilities from new flows of credit and lending is acted upon, the flow of new lending and the supply of new credit need not require the survival of all (or indeed any) banks hitherto deemed systemically important.
I look forward to the time when I will be blogging on the best way of privatising the banks again, under new regulatory and governance regimes.
