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. 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 direct government guarantee of private debts, liquidity provisions, direct capital infusions and monetary easing. “Bad bank” schemes, which were successfully used in the Swedish and Asian banking crises in the 1990s, 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. subprime mortgages 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 supranational 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 between the yields on government bonds (perceived to be the safest investments outside of cash) and the rest of the bond markets. Indicators such as swap spreads and the TED spread (the difference between the yield on 3- month Treasury bills and the interbank lending rate), which had been reflecting high risk of a 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, 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. Their strategies for unwinding massive stimulus (exit strategies) have yet to be tested, 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 finance officials at Jackson Hole and the G-20 meetings 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 charge-offs and non-performing assets continue to grow on banks’ 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.

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only.

There are risks involved with investing, including loss of principal.

SEI Investments Management Corporation serves as investment advisor for SEI Global Fixed Income Management.