Commentary: Global Banks and Systemic Risk

There was a time when global banks, these large multi-national financial institutions with asset sizes in the trillions of dollars, were lauded for their acumen in growing assets, diversifying their portfolio across the globe and having the scale to exercise market-moving trades. What became clear in the last two years was the ripple effect that these banks can have across their peers and the entire financial market when they crash. Global banks posed a real systemic risk; problems within these financial institutions could have dire consequences on the industry as well as the broader economy. We saw this all too painfully with the failure or near failure and subsequent emergency rescues of Bear Stearns, Lehman Brothers, Merrill Lynch, Royal Bank of Scotland and Citigroup, to name a few. Markets fell significantly with each of these events.

As individual governments and central banks began dealing with these institutions using whatever means at their disposal—including nationalizations, conservatorships (government control) and forced mergers—it became clear that the measures were not enough to thwart a global meltdown. When central banks and government leaders saw vast market disruptions despite their attempts to allay fears, they proceeded with unprecedented policy intervention, including government investment in private companies, direct government guarantee of private debts, and monetary easing by central banks through lower interest rates. “Bad bank” schemes, where a separate entity takes ownership of non-performing assets and then manages them in order to maximize their value were successfully used in the Swedish and Asian banking crises in the 1990s. They began emerging in various degrees as it appeared that investors would not be satisfied with anything less than a full cleansing of bank balance sheets.

Defaults of the magnitude experienced in U.S. sub-prime mortgages (the riskiest type of home loans) and some parts of the European housing markets effectively made many of these institutions insolvent. Their paper-thin capital bases were essentially wiped out as they wrote off these bad debts.

With guarantees and nationalizations, the risk of losses from global banks was effectively transferred to the public sector. Sovereign credit default swap (CDS) spreads (a measure of the cost of insuring against government bonds defaulting) rose, and there was speculation that countries like the U.S. and UK would lose their triple-A (top-quality) credit ratings. State support systems became overwhelmed (e.g. Iceland, Ireland, the Netherlands, Italy and Germany) as they dealt with losses from banks within their borders that had become global in nature. Many supranational¹ banks issued warnings on potential national failures, particularly for those in emerging and developing markets.

Market Stabilization

Fortunately, the markets have stabilized. Reason returned and an understanding of the fundamental values began to show in the spreads (differences) between the yields on government bonds (perceived to be the safest investments outside of cash) and the rest of the bond markets. Indicators that had reflected a high risk of system-wide failure have come down significantly from their highs following Lehman’s bankruptcy. By the second quarter of 2009, the banks reported better-than-expected results, passed stress tests given by the government to determine the magnitude of their bad debts (or “toxic assets”), successfully raised capital and kept their lending practices tightly controlled. In fact, it was unclear whether government support was what brought the banking system back from the abyss, or if time alone could have had the same effect. On their own, banks began reducing cross-border lending, unloading toxic assets in large chunks and refocusing on basic functions.

Regardless of the huge rally in the sector from its March lows, banks have suffered great losses and capital remains tight. This is even more of a concern now as the ongoing economic downturn will yield additional losses from other sectors such as commercial real estate and commercial lending in general. Sovereign CDS spreads still remain somewhat elevated due to expectations of further government debt issuance. However, the main risk remains with the government and central banks. At some point, stimulus strategies such as massive government stimulus and extremely low interest rates will need to be discontinued or reversed, and the market’s reaction is uncertain. It is paramount that the right sequence of exits is communicated between countries, and timed correctly. Recent meetings of U.S. Federal Reserve officials and the G-20 nations are a good start, as they confirmed the potential risk associated with badly timed exits of government support. This is particularly true as banks’ debt maturity schedules have shortened significantly due to market disruption and the prohibitive cost of issuing longer-term debt. As banks write off defaulted loans and non-performing assets continue to grow on their balance sheets, governments must understand the systemic risks that remain. A non-functioning or underperforming banking system will be a drag on economic growth, and liquidity can be cut off easily as investor confidence remains fragile.

The good news is that officials acknowledge the complexity surrounding global banks and realize that reform must be introduced to gain lasting confidence in the financial system. More stringent capital requirements and transparency of information will be positive outcomes. Multi-national reform efforts aimed at improving the risk profile of global banks are underway and are likely to continue. This may well result in the creation of “living wills” — plans detailing how multi-national institutions would be rescued if they run into trouble —as recently suggested by the UK’s Financial Services Authority. In our view, well-timed exits of public support, followed by reforms to provide more information and oversight, should result in more sustainable government policies and debt levels. After that, confidence should return to the marketplace.

¹ Supranatural organizations are those that transcend national boundaries, making decisions that impact the entire group. In the case of banks, this includes organizations such as the Asian Development Bank, the Council of Europe Social Development Fund, the European Bank for Reconstruction and Development and the World Bank.

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