Search This Blog


Monday, 22 September 2008

Investment Banking's Weak End

Yesterday, while walking our dog with a hundred other dog owners on the seashore at Cramond, the village of Robert Louis Stevenson's story Kidnapped set in 1751 a few years after the defeat of the Jacobite rising, independent investment banking finally surrendered, and on a Sunday too! Subject to a 5 day grace period, the US Fed approved applications by Goldman Sachs and Morgan Stanley to become Federal Reserve-regulated bank holding companies (BHCs). Both firms will be subject to bank regulations and capital requirements (to be phased in over a transition period). We can hardly doubt this was an involuntary move. It also spells out that what has been called 'shadow banking' is now firmly to be accounted for.
It also means that the two firms gain access to term lending facilities with broader collateral base (rather than overnight only) at a time when overnight rates are down but 3 month money continues to be prohibitively expensive. The Fed can now also lend to Goldman, Morgan and Merrill’s London-based broker dealer subsidiaries directly.
In early June it was noted that the financial regulators were eyeing up the $10-$12tn shadow banking market ($2.2tn CP SPE/SIV conduits of ABS & ABCP plus $2.5tn repo/reverse repo market, plus $4tn combined brokerage assets plus $3tn hedge funds) outside regulated banking without adequate "own capital" reserve provisions (plus within the regulated banking system another $10tn or so?). Brokerage firms may face stricter capital requirements. Otherwise, how are "deposits" protected during market runs for cover that no one in official authority can oversee? The investments that performed best during the shadow’s banking's formation were related to Home prices, financial stocks with subprime exposure, consumer-based equities, and selling U.S. dollar denominated net financial assets generally to foreign buyers with trade surplus $ funds.
The run on off-balance sheet shadow financial system funds (a disputed fact) arguably forced the Fed to step in as lender of last resort to non-deposit-taking institutions for which it is not the regulatory superviser. By doing so the Fed would take on unknown credit and market risk of collateral-providing dealers defaulting. In fact, sorting out and recovering collateral from Lehman and others is a current cash-flow headache for many banks.
it is not the job of the Fed to bail out cash-flow insolvent non banks. If a bail out should occur this policy action would have to be decided by Congress after the relevant equity holders have been wiped out and senior management fired without golden parachutes and huge severance deals. Many will say this is market insiders savings other insiders, but there remains a Damocles sword of public anger hanging over the bonus culture, something retail bankers, now emboldened by the credit crunch, also publicly deplore. The press talk of "worthless paper" or "junk" when referencing complex structured products that supposedly "no-one understood". That is not so, but their value is entirely a systemic risk when investors get emotional.
It was back in March (St. Patrick's Day) when the Fed first extended unlimited discount window borrowing facilities to non-bank primary dealers, and therefore it was from then that the end of shadow-banking was but a matter of time. The original Fed policy under The Federal Reserve Act: Direct Fed lending to individuals, partnerships, and corporations (IPC) was much more stringent. Some commentators blame the repeal of the Glass-Steagal Act during the Clinton Presidency for the current crisis. That will be the future subject of many an academic thesis.
Note: in the OECD generally there is about $3tn in cash in CDOs of which hedge funds had $1.4tn exposure by end 2007, banks $0.75tn, asset managers $0.565tn and insurers $0.3tn. I'd like to see someone do a reckoning of how much was dumped into retail investment funds, and we are all still waiting to see how much is in East Asia and the Middle East oil economies including in the much hyped sovereign funds?



Shadow Banking comprises lenders, brokers and opaque or off balance sheet financing vehicles outside traditional banking that included the 'investment banks' and AI funds and banks' SPE/SIV conduits
accumulating more than $10 trillion in assets (by early 2007) making shadow banking similar in size to traditional banking. While this fuelled credit boom economies (US, UK and 7 other OECD countries) that could thereby run large trade deficits, the subprime credit crunch eentually burst the credit growth bubble. Shadow banking did not have direct regulated access to short-term funds at times of stress and had to rely on strong-arming the banks. Therefore, taking this bull by the horns seemed increasingly necessary.
"The shadow banking system model as practiced in recent years has been discredited," said Ramin Toloui, exec VP of Pimco, reported by Marketwatch. The model relied on support from asset managers and banks and therefore their business model supporting shadow banking and creating shadow banking subsidiaries is also discredited. About 3,000 firms constitute the shadow banking market!
"The bright new financial system, for all its talented participants, for all its rich rewards, has failed the test of the market place," Paul Volcker, former chairman of the Fed, said in April. "It all adds up to a clarion call for an effective response." In June, Tim Geithner, president of the NY Fed and others responded. "The structure of the financial system changed fundamentally during the boom, with dramatic growth in the share of assets outside the traditional banking system," he warned, "that made the crisis more difficult to manage." Also in June, Henry "Hank" Paulson said the Fed should be get authority to collect data from large complex financial institutions and intervene if necessary., including taking over and closing a failed brokerage firm, he added. This is of course problematic when the firm are nestling within banking groups or owned by them? These intermediaries borrow by selling CP (short-term loans) to be rolled over again and again (sometimes with longer term security in the form of contracts with investors) and then these entities bought mortgage-backed securities and other more complex securities that they sometimes stripped out the collateral risk and the upside for sale as total return funds since all they wanted was the AAA rated assets to leverage off.
A $10 trillion shadow
By early 2007, conduits, special vehicles and similar held about $2.2tn in assets with another $2.5 tn were financed overnight in the repo market. Big prime brokerage firms, nad combined balance sheets of $4tn before the credit crunch dried out the money markets.
Hedge funds held another $1.8tn, but their otal funds are reputedly about $3tn. (source: Federal Reserve). The 5 largest banks in the U.S., held just over $6tn in early '07 (60% of the total of the whole of the US traditional banking system).
When short-term financing dried up the classic flaw of borrowing short to invest long was exposed once those investments (structured products) proved to be illiquid i.e. not easily tradable except at a large discount in the OTC markets.
But, given the scale of the crisis it is doubtful that regulatory reserves would have sufficed. More important would be adherence to prudential rules liquidity risk but the AI funds and non-banks were designed around models that wholly discounted liquidity risk!
Separation dwindled


After the stock market crash of 1929, U.S. Congress passed The Glass-Steagall Act (1933 as one of the first actions of the Roosevelt Presidency when US banks collapse fully 3 years after the 1929 stock market crash) that separated commercial banks from owning non-bank subsidiaries (investment banking) if they wished to access Federal funds and to stop prudential conflicts of interest. This was repealed as one of the last actions of the Clinton Presidency (Gramm-Leach-Bliley Act, Nov 4, 1999). The arguments for Glass-Steagal ring true today.
The arguments for its repeal were to secure more profitable business for banks. But the SEC could not enforce rules with comparable financial force as the Fed. Therefore, arguably, there was arbitrage between banking and trading books that could be "abusive".
Banks wanted into investment banking to follow their large corporate clients which were selling more bonds, rather than borrowing directly from banks.
One long term consequence never fully resolved was the cultural dissonence or dysfunctional relationship between the traditional banking and investment banking sides of large banking groups. This may yet have to be tackled and has proved to be the the most problematic aspect of Basel I and Basel II and related regulations and accounting (IAS and IFRS-7)!