On banks, bailouts, texting and driving
The idea that a brush with death will change a lucky escapee’s priorities apparently does not apply to bailed out banks.
While you might be pulled from the smoking wreckage of your car and decide to stop texting while driving, the banks which got government injections of capital during the financial crisis concluded, it would seem, that the problem was that they were not pressing the buttons fast enough.
A new study by the Bank for International Settlements, the so-called central banks’ central bank, shows that not only did the bailed out banks not cut back on risk in their lending into the syndicated loan market after being defibrillated by their governments, they actually increased it relative to the market and banks which did not get rescued.
This is both astounding and totally predictable. Astounding because it was so clear that those risks were not just foolish but destructive. Predictable because of course the banks realised that they had not been just lucky but had been given a special exemption from death which will be very hard to revoke.
The study looked at the behaviour in the syndicated loan market of a group of 87 banks from industrial economies, accounting for about half of global banking assets, 40 of which took public capital. The syndicated loan market, in which banks originate and distribute loans, is a key source of company funding and is used to fund mergers, recapitalisations, investment or simply ongoing corporate need.
Predictably, the banks which got bailed out were those taking the biggest risks in the syndicated loan market before the crisis, according to the study, making more leveraged loans with high interest rates, and making loans with longer maturities. Their loan books also got hit with more credit downgrades after the crisis broke.
You could argue that the truly toxic combination is too-big-to-fail status and zero interest rates.
They were also, according to the study, not being paid enough compensation for the risk before the crisis, not just in absolute terms, which given the debacle is obvious, but even relative to the go-go market in which they were operating.
“During the crisis, rescued banks did not reduce the riskiness of their new syndicated lending compared to their non-rescued peers. In fact, our results suggest that the relative riskiness of their lending increased,” the authors of the study Michael Brei and Blaise Gadanecz wrote.
Banks which did not take government coin cut their participation in the riskier leveraged market by about a quarter and made loans in with an average margin which was 36 basis points less. Bailed out banks, in contrast, upped slightly their share of leveraged lending and were paid higher rates. While they upped pricing to make it better in line with risk, it was by a small enough amount that it was not statistically significant.
Policy or self-interest
It is possible, of course, that getting banks to continue making silly loans was exactly the intention of the bailouts. After all, global funding markets reached a rate of near shut down, and the knock on impact to the real economy was massive and, much like the lending, indiscriminate. Interestingly, bailed out banks raised loan prices more in their home markets than abroad, so clearly they were not simply doing their patriotic duty having been pulled from the fire.
And of course, the same set of incentives were still broadly in place for bankers, though compensation was limited at some firms which were bailed out. Since capacity was being artificially supported, and since bankers get paid for doing deals rather than not driving their firm out of existence, it is only natural that those at banks with hard proof they would not be allowed to explode would continue lending.
You could argue that the truly toxic combination is too-big-to-fail status and zero interest rates. With rates at virtually nothing at the short end, and not much higher two, three or five years out, large banks can no longer count on the sort of net interest margin which has been their traditional lifeblood.
Today’s market is a big contrast to the late 1980s and early 1990s, when the U.S. banking industry was allowed to heal and recapitalise, helped along by a big differential between where they could borrow for short periods and lend for four or five years.
Loan demand also simply is not all that great, especially in the U.S., though there is a huge supply/demand mismatch in the dicier parts of Europe. This has pushed banks towards using their cheap borrowing privilege and ample liquidity to simply speculate in the kind of propriety activity which proved so expensive and embarrassing for J.P Morgan.
With the Fed pouring on more quantitative easing, and with no real sign that too big to fail will be dealt with effectively, moral hazard and risky banking seem to be more a feature than a bug in the global financial system.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com)