- Five years have passed since the collapse of Northern Rock, an event pervaded by many of the faultlines of the global financial crisis. Since then, the global political and regulatory communities have embarked on an ambitious, multi-layered undertaking to engineer a more robust financial system—and they have attempted to do so against an ongoing background of extreme financial and economic weakness.
- The reform efforts broadly follow four tracks: micro-prudential regulation (the detailed rule book, especially on capital and liquidity, that governs individual bank behaviour); macro-prudential regulation (attempting to address the collective behaviour of the banking and broader financial system); resolution regimes (which deal more effectively with failing banks); and structural reform of the industry.
- Although many of these initiatives are far from complete, and significant uncertainty about both scope and timing persist, Western Asset believes that the overall direction of travel will result in a safer banking system and will benefit bondholders. Profitable investing will, however, only be built upon a fundamental foundation of sound credit analysis.
Lessons Learned: A Hard Road Still to Travel
Though it was neither the largest nor the most spectacular bank collapse of the global financial crisis (GFC), the September 14, 2007 fall of Northern Rock, a mid-sized regional UK bank (the only collapse to provoke a full-blown classic retail bank run) exposed all the faultlines of the GFC disaster: bad business models, over-leverage, poorly designed regulation, lax supervision, mispriced risk, overly rapid growth, too much opacity and complexity, reliance on short-term market funding, management hubris, misaligned incentives and, last, an almost complete absence of appropriate tools for dealing with a failing bank.
So, five years on, where do we stand in reassembling the pieces of this comprehensively broken system? And will the new system be significantly more robust than before? A major challenge is, of course, that the crisis has not yet run its course. Indeed, a climax in the end-game of the eurozone crisis, for good or ill, is still ahead of us. In this context, re-engineering the financial system is akin to re-engineering a lifeboat while still a long way from a safe harbour. In other words, the enterprise is fraught with risk.
That, of course, has not prevented a huge expenditure of effort (and money) on precisely this re-engineering task. Whereas in the decade preceding the GFC, the overwhelming bulk of regulatory effort was poured into the micro-prudential space (i.e., the detailed rule book by which banks operate)—primarily in the form of the increasingly complex Basel capital regime—the political and regulatory imperative has imposed the need for a broader perspective and response. In addition to micro-prudential regulation reforms, the post-GFC financial regulatory landscape takes in three additional elements:
- Macro-prudential regulation, which seeks to address the pro-cyclical nature of much banking activity;
- Recovery and resolution regimes, which seek to equip regulators with adequate tools for dealing with failing banks, including the ability to explicitly impose losses on banks’ creditors, and
- Structural reform both within the banking system and in the broader financial system, which will reduce risks within the banking system and the negative externalities that make banking crises so expensive to deal with.
Together with the ongoing work on the micro-prudential framework, we refer to these elements as the “four pillars of banking wisdom,” and will look at them briefly in turn before concluding with some thoughts on whether they indeed make banking safer, and what they mean for fixed-income investors.
Despite the flaws of the Basel II regulatory capital regime being cruelly exposed scarcely before the ink on the paper was dry, the regulatory community ultimately decided that these flaws were in the details rather than the concepts. Consequently they have ploughed on with Basel III, piling ever more complexity on complexity. Where the Basel I rules ran to 30 pages and were translated into 18 pages in the US and 13 pages in the UK, Basel III has resulted in over 1000 pages of documentation in both countries. Although some influential voices like Andrew Haldane’s of the Bank of England (BoE) have lucidly questioned the wisdom of creating this “Tower of Basel,”1 it strikes us that this process is unlikely to halt, let alone significantly reverse. Apart from the high costs to financial institutions of complying with regulation of this magnitude, there is a more fundamental question as to whether it is even effective. There is no doubt that higher levels of capital and better liquidity at the heart of reforms to the current micro-prudential pillar should make banks safer for depositors and other creditors. However, having that regulation dressed in complexity and opacity, with the arbitrage opportunities that brings, risks undermining the good intentions. Without fruitful work on the other pillars, we would be sceptical of the effectiveness of this rules-based approach.
A new element of the Basel III regime is the capacity for regulators to impose a “counter-cyclical buffer”—an amount of additional core capital that banks would be required to hold if the authorities believed credit expansion was leading to an overheating economy, or classic bubble situation. This is the most obvious manifestation of the authorities trying to exercise macro-prudential levers on the banking system—our second pillar. With much credit creation outside the banking system, regulations will likely be extended beyond capital requirements for banks, and this will be the preserve of numerous committees around the world, including, among others, the Financial System Oversight Council in the US, the European Systemic Risk Board in Europe and the Financial Policy Committee in the UK, as well as international bodies such as the International Organization of Securities Commissions. Against the immediate backdrop of deleveraging and weak economic growth, it will likely be some time before we see this approach tested in anger, but reservations have been raised: Alan Greenspan dismissively described it in The Financial Times as “leaning against the wind.”
The third pillar—ecovery and resolution regimes—has perhaps the greatest potential to impact fixed-income investors. As the crisis broke, most regulators discovered that they simply did not possess the statutory tools to handle failing institutions of any size or complexity. The US was perhaps best positioned, with the FDIC successfully resolving Washington Mutual, which had total assets in excess of US$300 billion. As a non-bank broker dealer, however, Lehman Brothers was outside the reach of the FDIC, and Citigroup and Bank of America were evidently judged “too big to fail.” In Europe, the “too big to fail” threshold proved to be even lower with many second- and third-tier banks joining the genuinely large players in the orderly (and fast-moving) queue for taxpayer funded bailouts, rather than joining the disorderly (and probably slow-moving) queue through the bankruptcy courts. This might have saved the world from financial Armageddon post Lehman, but it has come at enormous cost to taxpayers and, in some cases, most notably in Ireland and to a significant degree in Spain, has resulted in the beggaring of whole economies.
This taxpayer largesse not only extended to bank depositors (by consensus a genuine public policy goal), but also to senior unsecured bond creditors and, to a very large extent, to junior providers of subordinated debt and quasi-regulatory subordinated capital. Although the position of the latter has begun to erode under the concept of “burden-sharing” (and this process will be further advanced in the imminent Spanish banking system rescue package), European regulators have yet to impose losses on the senior unsecured creditors of a failing bank of any consequence. This is, however, likely to change in the years ahead. The US has enacted the Dodd-Frank Act2 (although much of the detailed rule-making lies ahead), and the EU is well on the way to enacting its Recovery and Resolution Directive (RRD)3; the goal of both is to obviate (and in the case of Dodd-Frank to explicitly forbid) taxpayer-funded recapitalisation of failing (or in the new jargon “non-viable”) financial institutions. Under this new dispensation, banks that reach the point of non-viability (as determined by their regulators) will be placed in resolution. In essence much of this will not be substantially different from the long-standing and well-proven FDIC process, whereby guaranteed/insured depositors are either paid out or transferred to a sound institution along with much of the infrastructure and staff if deemed appropriate to safeguard the utility-like functions of the bank. Under this scenario, most other creditors are left behind to face liquidation and almost inevitable losses. The new legislative framework does, however, recognise that for large complex institutions a “whole bank” solution is likely to be the most efficient and least systemically disruptive response. Whereas historically this could only be achieved by the injection of taxpayers’ funds as fresh equity capital, thus cushioning the entire liability structure, resolution regimes envisage the deployment of what amounts to a pre-packaged recapitalisation from within. Then, progressively, from the bottom up, a bank’s capital and liabilities are either wiped out or converted into equity. This process has come to be known as “bail-in”, and the full intention is that it extends to senior unsecured creditors. The bulk of RRD is projected to come into force on 1 January 2015, with the implementation of the “bail-in” tool delayed until 1 January 2018 to allow more of the currently outstanding debt to mature. In this context, some commentators have talked about the possible exemption or “grandfathering” of existing senior debt maturing beyond 2018, but we believe this rests on a misconception. In our view, there is simply nothing to grandfather. Moreover, we are cautious about seeking comfort in the 1 January 2018 deadline. Losses can be imposed on senior debt via the other resolution tools, such as the partial sale or good bank/bad bank split mechanisms. Furthermore, several countries, including the UK and Germany, have already enacted legislation that can achieve these aims, and others have demonstrated that emergency legislation can be enacted very quickly.
In the European context, the RRD timeline could potentially be accelerated by what could turn out to be the most significant element of our fourth pillar, structural reform: the plan to establish a banking union across the eurozone, the centrepiece of which will be a single supervisory mechanism (SSM) for all eurozone banks under the auspices of the European Central Bank (ECB).4 This idea has gained startling momentum over a very short amount of time. It was first called for by the European Commission (EC) in May 2012, and according to plans announced on 12 September, the EC is targeting implementation of the SSM on 1 January 2013, effective in the first year for large systemically important institutions and entities seeking state support, and, one year later, effective for all 6,000-odd banks in the eurozone. Whether this ambitious schedule is practicable remains to be seen, but in our opinion, the most interesting aspect of this proposal for fixed-income investors is whether it facilitates pan-eurozone funded bail-outs (the EC Q&A paper refers to the SSM “opening the way for the European Stability Mechanism (ESM) to directly recapitalize banks that fail to raise capital on the markets”). Conversely, in removing national political bias, this plan to set up a pan-eurozone regulator could make it easier to make the politically sensitive decision to intervene in a failing bank. Ultimately, this is clearly the intention, and the same Q&A document states, “In particular shareholders and creditors should bear the costs of resolution before any external funding is granted, and private sector solutions should be found instead of using taxpayers’ money.” We believe that this latter approach will prevail and that investors (and sooner or later, the rating agencies) should increasingly discount the potential for a reduced level of sovereign support for failing banks.
The only other major structural reform that has gained real traction is the plan in the UK to partially separate retail and commercial banking from supposedly riskier investment banking activities via the ring-fencing of the former5—a sort of Glass-Steagall-lite! In the wider European context, a similar proposal has been put forward by the “Liikanen group of experts.”6 The primary rationale for this is the removal of the effective cross-subsidy of investment banking that arises from the implicit support from which systemically important universal banks have undoubtedly benefited; Royal Bank of Scotland and Lloyds Banking Group are 82% and 40% state-owned, respectively, as a result of being bailed-out. Effective resolution mechanisms (as referred to above) should achieve that goal, in which case the main benefits of ring-fencing will boil down to simpler and more readily resolvable structures. In this context, we are cautious of falling into the trap of assuming that the non-deposit creditors of the ring-fenced retail banks will be bailed-out as they have been in the past. Along with ring-fencing, the UK is introducing one other significant reform: depositor preference. Perhaps surprisingly, very few banking systems operate depositor preference (not to be confused with depositor insurance/guarantees), and even in the USA it was only introduced as recently as 1993. Given the incidence of large banks getting into trouble in this crisis on both sides of the Atlantic, depositor preference has a bearing on what happens once banks fail, but not on the probability of banks failing. Once failed (and assuming effective resolution under a Dodd-Frank or RRD regime), senior unsecured bond creditors are almost certainly looking at far lower recoveries. Depositor preference does not appear to be on the EU agenda and the matter has not been addressed by the Liikanen group, although it would reduce the potential exposure of any future eurozone mutualised deposit guarantee scheme.
One might conclude that banks are simply uninivestable, with all this regulatory upheaval, much of which is still subject to uncertainty in both scope and timing, combined with an as yet unresolved financial crisis in which banks are central players. Indeed, the uncertainties surrounding banks in part explains the unusual bond yield premium (as opposed to discount) at which banks have had to borrow relative to industrials since 2008. We believe that banks will continue to be essential components of any advanced financial system and that in order to remain viable, they will ultimately revert to being able to borrow at a yield discount to industrials. Many, if not all, of the measures described in this paper are, quite rightly, designed to make banks and banking systems safer for both depositors and other senior creditors. While we might not agree with every detail in isolation, we do believe that in the round the measures are achieving and will further achieve this goal. Banks, especially in the US, are already deleveraging their balance sheets and should be better capitalised and should hold more genuine liquidity. Regulators do have a better understanding of the riskiness of much of the financial innovation of the 1990s and early 2000s. Proper ownership of the risks in banking should reduce the age-old problem of moral hazard and enhance market discipline. Even the removal of the tax-payer funded implicit guarantee of “too big to fail” should not deter us. What this means, however, is that while policy support may not be entirely withheld in the future, we have to be comfortable with a bank on its own merits. It has to have a sustainable business model and a durable franchise that we can understand. It has to be well capitalised and have a good asset quality, and these features need to be genuinely transparent and discernible to the outside world. These have re-established themselves as the fundamental foundations of sound credit analysis following the collapse of Northern Rock.
- Andrew Haldane, The Dog and the Frisbee (Bank of England August 2012)
- The Dodd-Frank Wall Street Reform and Consumer Protection Act, July 2010
- European Commission proposal for a directive of the European Parliament establishing a framework for the recovery and resolution of credit institutions and investment firms, June 2012
- European Commission “A Roadmap Towards a Banking Union”, September 2012
- UK Independent Commission on Banking, September 2011
- European Commission High Level Expert Group on reforming the structure of the EU banking sector, October 2012