Views on the integrity of global capital markets
17 September 2013

Five Years after the Financial Crisis: Reexamining the “Deadly Sins” of Banking

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 transmogrify the 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

About the Author(s)
Jim Allen, CFA

Jim Allen, CFA, is head of Americas capital markets policy at CFA Institute. The capital markets group develops and promotes capital markets positions, policies, and standards.

1 thought on “Five Years after the Financial Crisis: Reexamining the “Deadly Sins” of Banking”

  1. Tim MacDonald says:

    Is it time to consider that the market for capital and the capital markets are not co-extensive, and that the default form of investment as securities trading for pensions and other stewards of retirement savings has proven to be not fit-for-purpose, giving rise to the new reality of systemic risk.

    We have a new form of Investor – the pension trust that is large, purposeful, powerful and evergreen. They do not end. They just keep going.

    We have a new experience of systemic risk.

    We need a new form of investment that upgrades pension investing from the ticker tape to something more fit for their purposes.

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