BANKING IN CREDIT CRUNCH RECESSION

Recessions are periodically inevitable, unavoidable like the equinox-tides. All recessions are different in their precise triggers and are variously severe depending on national and international responses, but they also all have common or comparable events and sequences of events. Looking for the aggregates and averages across all post WW2 recessions does give reliable guidance as to shape, depth and longevity e.g. peak to trough and trough to peak. Some of these are quite well-known and furnish the indicator values that the banking regulators advise the banks to test for in economic scenario stress-tests. In the years before the credit crunch and subsequent recession, such tests could be called forecast simulations for unexpected shock events at some indeterminate time in the future. The tests would therefore be limited in the number and quality of factors to be considered, usually logical and financial only, but still requiring very high quality expertise and relatively massive computational, financial and economic modeling skill. There is politics involved, but usually only internal to the bank i.e. is executive management prepared to accept higher economic capital reserve buffers when this means curtailing asset growth merely to be prepared for a theoretical downturn that cannot be given precise timing forecast?
When such tests are required in the middle of a downturn crisis, they are no longer theoretical, there is massively more information to be processed and judgements must extend to quantitatively less tangible values such as market confidence factors in all risks and much more about how risks are networked and systemic, and above all the cyclical dimension including modeling for government responses and what impacts are going to and coming from all banks in the general economy, mostly the national economies for the banking book and internationally via global markets in the trading book. One difference between banks and non-banks is the inherent greater susceptibility of banks towards loss of confidence - bank runs - other types of business can experience share collapses, but banks can also have runs on them by depositors, and strikes by funding sources, or angry bondholders, who like many of bank's major shareholders are also competitor firms in the same sectors of financial services industry! No bank can withstand "a run" (fatal loss of confidence from any source), which is why we have Central Banks and Treasuries as Lenders of Last resort.
A bank may trade on its own account, but its main business is to intermediate between savers, borrowers, other banks, and all kinds of investors. Investments take anything from less than a day to years to generate economic return, or a whole business and political cycle in the case of governments as borrowers and investors. The complexity of managing the risks in the wide variety of transmission mechanisms between funding and lending is immense, but generally is assumed to be safe if the diversification is across the whole of the economy. The profile of a bank is not capable of being shaped to match the whole of the economy, it is shaped by the demands of the economy on banks, and that is never exactly proportionate to, or symmetrical with the economy, no more than the terms to maturity of funding and lending can ever be exactly matched. If banks sell loans before investments mature, or cannot economically balance between all the countervailing factors that impact banks' balance sheets, then banks risk possibly serious losses. In years when all seem to be on a rising tide, mis-management of liquidity and other risks are cushioned. By foreclosing on account A, there may be higher returns from accounts B, C and D. In a downturn, foreclose on A and B, C and D can all suffer domino-effect losses. The downturn spiral is more severe than the upward spiral is benign. Most savers want the ability to retrieve all of their money instantly at any time and they fear the downside more than hope for the upside. Hence banks must bias conservatively in risk terms. there can never be a perfect equilibrium balance to all of this. Logic depends on confidence to work. Focus on logic only and confidence will be lost!
Most banks and large complex financial institutions rely on 'sticky retail customer deposits' and on 'short term wholesale debt' that rolls over. The credit crunch began with the roll-overs no longer being reliable. Good houses may retain long term value, but not if the tiles come off the roof. That's what happened to banks when they couldn't keep repairing their balance sheets in timely fashion. When sufficient number of liability funders do not roll over their debt, the bank either has to issue long term debt, or liquidate assets, and in 2007-2009, these responses threatened the continued viability of banks' business models. Instead of rolling with the hits to net interest income, the banks balked at changing their business models. The consequence was they lost many times more in shareholder value and their capital reserves got more heavily depleted than should have happened.
Thus the problem today is we have no idea what the net assets (book values) of banks are really worth, because the information provided by banks does not allow that calculation. It takes an experienced risk expert and an economist and an accountant to do the sums, and maybe a maths professor of financial risk too. Without this information all people can see is a growing disconnect between stock prices and income flow values. The assets cannot be priced by their net income. This happens on the slower way up and on the very much faster way down! The shock hits at the most fundamental idea that of intrinsic or fundamental value. If no-one turns up wanting to buy my house I don;t imagine it has suddenly gone from being worth mega-bucks to zero. But, according to day to day market values, if I want the equity in the house today it is either worth nothing (totally illiquid) or worth very much less than I want or need (one-way buyer's market).
The old argument of an asset being worth only what someone will pay for it is not to be forgotten or discounted. Hence I, or the banks, need bridging loans to buy time until market confidence returns (more balanced two-way markets) and is no-one else then that requires the lender of last resort Governments to invest in lending.
People make human extrapolations based on what they know from experience, such as where various types of assets can trade. But, anyone reliant on a big abstract market, anyone not a market insider, they have no reliable experience, and so they panic! Anxiety is a state of mind of not knowing what and from where to precisely fear the worst or where to run too for safety.
Confidence can be restored by mapping out the precise risks and solutions. When governments and bankers and others cannot be trusted to do this, or simply don't do it, then everyone is right to panic! HSBC was such a place of safety and a source of confidence. It was important thereby to the whole market alongside few others. When it reveals as today that it has a complex and not quite clear appetite for increased risk-taking combined with sowing doubts about its balance sheet, the systemic effect is incalcuable. HSBC has failed to understand its wider market position.
Lloyds has said that traded debt pricing as in CDS spreads is a reliable if conservative proxy for all their assets. This builds a wide margin in their books for improving the balance sheet, but in precise accounting audit terms this is arguable absurd. But, for now, this is a realistic place for the bank to site its base camp 1 before climbing up the mountain. Unfortunately, HSBC, has not recognised at this time the need to be similarly globally risk-sensitive. Lloyds has produced bad results, but it has established a basis for renewed confidence. HSBC had more confidence than it deserved, and decided to risk squandering some of it! Wrong chess move, bad gambit, wrong direction to go in!
The world's internet bloggers, financial analysts and economists have been suggesting that our banks are generally insolvent, meaning, the liquidated value of their assets is below the value of renewing their liabilities. Commentators need not, and do not, offer precise data to support their insolvency claims. Are they inferring merely from the stock market prices? They are definitely correct if funding sources refuse to roll over short term debt, and when observers claim that interbank and wholesale funding is dead, a desert, frozen, or merely too expensive and in too short supply. Many large banks are insolvent, but if banks are the main funders of banks, is this just a self- fulfilling prophesy, or even technically true at any time in banking just because of funding gaps between customer deposits and customer loans? See 2009 list of maturing bank debt. There are different ways of analysing the question to produce half a dozen different quality answers. It's a difficult problem, especially because simultaneous with governments' financial stabilization plans for the economy as well as for banking, and we have mostly vague political-economy scenario stress tests that wipe out banks's capital reserves 1-3 times over. Therefore, it is a matter of regulatory and official government discretion, to deem if any bank is insolvent! The markets are in such an anxiety attack that mark-to-market fair value accounting, applying market prices and or estimates based on proxy indicators, does mot imply cash-flow insolvency but could trigger loss of confidence effects, political or not, that could trigger cash-flow insolvencies.
We can rely on the norms of past recessions and proxy approaches using derivative market values and various triangulations to get at the best approximations - but however this is done the risks remain that we might unnecessarily destroy a great amount of value that is then irrecoverable in the near-future. Recognise that much first and then think about your bank's strategy in terms of each of the major risk factors (see list) for the next 1-4 years. That's my advice to HSBC.