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On the indispensability of (investment) banks

As might be expected, there’s a fair amount of questioning about the finance system as a whole going on.

The claim is that the market is best able to distribute this cash to the most worthy of projects, but at what point is their judgement questioned? How are these bastards allowed to be indispensable?

It’s true that the purpose of the finance industry is to, as efficiently as possible, allocate capital (i.e. savings), risk and returns; or, as the Economist puts it, to write, to “write, manage and trade claims on future cashflows for the rest of the economy.” In that regard, the industry as a whole plays a vital role in the economy. But that on its own doesn’t necessitate the indispensability of individual banks. That comes from a variety of inter-related factors:

  • There are banks and there are banks. Ceteris paribus, nobody cares if a Small-Town Bank (STB) goes bust because it is provincial: nobody other than its direct debtors and creditors are affected. Investment banks are (effectively, sort of) where the STB goes to borrow money, though. If they go down, so do all the little commercial banks that depend on them. To use a cheap analogy from The Wheel of Time series of fantasy novels, one might think of the central bank as the True Source, the investment banks as Rand al’Thor using one of those artefacts and all the little banks as power-wielders that are vastly powerful compared to civilians but insects next to Rand. Rand channels the hundreds of little power-wielders and adds his own enormous ability to suck down the juice in order to draw massively on the true source. If somebody were to kick Rand in his privates while he’s doing his thing, half the planet gets ripped asunder. Therefore, the protection of Rand while he’s doing his thing is paramount. He is genuinely indispensable. This analogy neatly explains why you don’t actually want a single investment bank, btw. Having a single, semi-god-like character that’s able to channel the über-load of the True Source is great in a novel, but bloody stupid in real life. Redundancy is key. You want several investment banks that are competing with each other so that if one goes belly-up, the others can take over.
  • Real innovation is rare, so when somebody has an idea, all the banks leap on it at once. That’s nominally fine in itself, but it unfortunately means that the actions of the (investment) banks are highly correlated, which makes for fantastic profits when it all works and a world of pain when it doesn’t. In essence, even though they’re are several investment banks competing with each other, since they all offer the same services at the same prices using the same strategies, they’re acting as though they’re a single investment bank.
  • The latest round of innovations has served to tie a lot of financial institutions together from the perspective of policy makers. This point really comes in two parts:
    • Securitisation and the splitting of those securities into tranches of risk exposure, in principle, allow financial institutions to spread and share individual risk between themselves so that if a Bad Event happens, they all lose a little rather than just one of them losing a lot.
    • There has been a general move away from transparency, with most of these securities being held off balance sheets and being traded in private sales instead of on open markets.

    The securitisation and tranching may have gone too far over the last few years, but that on its own isn’t the problem. The problem is that it was combined with a lack of transparency, meaning that it has become enormously difficult to pick apart the pieces when somebody falls.  To quote the Economist again, “Bear Stearns may not have been too big to fail, but it was too entangled.”  While they could have let Bear Stearns fall rather than be swallowed by JP Morgan, doing so would have required the careful unpicking of all of Bear Stearn’s positions, which would have taken months.  That would then have fed into the final point …

  • People are nervous lemmings. Even if the investment banks were properly competitive and transparent and each employed different strategies so that if one fell, there wasn’t so much risk of the others falling, a major bank collapse is still a problem because we’re all idiots. We panic. Then we see each other panicking, which helps us justify our own panicking and makes us wonder if maybe we’re not panicking enough.  The panic can then develop a momentum of its own, causing other banks to collapse when they otherwise didn’t need to.

So … that’s why they’re indispensable. But that doesn’t mean that we should be paying them the way we do.  Judgement of bankers’ performance is really only measurable after we pay them, which is stupid.  I’ve written briefly on bankers’ pay before here.  It is worth noting, though, that calls for bankers’ pay to be made in the form of stock have to face up to the fact that many employees of Bear Stearns had a huge share of their savings invested in Bear Stearns stock.

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A prediction: Only Bear Stearns will fall; Lehman Brothers is safe

The “orderly liquidation” of Bear Stearns is certainly dramatic, but I think that it will be the only US investment bank to fall from the current mess. The reason can be found in this press release from the Federal Reserve:

Release Date: March 16, 2008

For immediate release

The Federal Reserve on Sunday announced two initiatives designed to bolster market liquidity and promote orderly market functioning. Liquid, well-functioning markets are essential for the promotion of economic growth.

First, the Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets. This facility will be available for business on Monday, March 17. It will be in place for at least six months and may be extended as conditions warrant. Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities. The interest rate charged on such credit will be the same as the primary credit rate, or discount rate, at the Federal Reserve Bank of New York.

Second, the Federal Reserve Board unanimously approved a request by the Federal Reserve Bank of New York to decrease the primary credit rate from 3-1/2 percent to 3-1/4 percent, effective immediately. This step lowers the spread of the primary credit rate over the Federal Open Market Committee’s target federal funds rate to 1/4 percentage point. The Board also approved an increase in the maximum maturity of primary credit loans to 90 days from 30 days.

The Board also approved the financing arrangement announced by JPMorgan Chase & Co. and The Bear Stearns Companies Inc.

You might argue that this should have been in place a while ago, but now that it’s in place, I doubt that any more US investment banks will fall. You can safely assume a 50bp drop in the base rate in the next week, I think. As with the previous drops, I think that we will see little, if any drop in longer-term paper. That increased gradient in the yield curve, combined with the effectively-intentional inflation (their liabilities are largely nominal and a fair fraction of their assets are real), should be enough to recapitalise the banks over time. The new lending facility from the New York Fed seems designed explicitly to give them that time.

See also this comment from Deutsche Bank’s Mike Mayo (HT to Calculated Risk):

Lehman is Not Bear. 1) It has more liquidity, 2) It has support among its major counterparties, evidenced by an extension on Friday of a $2B working capital line with 40 banks (one issue w/Bear Stearns [BSC] seems to be that counterparties pulled in lines). 3) Its franchise is more diversified given almost half outside the US and an asset management business that is more than twice as large relative to its size (BSC was more plain vanilla). 4) It has a seasoned and experienced CEO (Bear’s CEO was new). We maintain our Buy rating given a belief that LEH will weather this storm and our estimate of a price to adj. book value ratio of 83%.

The industry issue seems more liquidity than solvency, and LEH protected itself more fully after it’s problems similar to BSC in 1998. At year-end, it had $35B of excess liquidity combined with $63B of free collateral, implying $98B available for liquidity, or $70B more than needed for $28B of unsecured short-term debt (which includes the current portion of long-term debt). While it also has $180B of repo lines, we take comfort that 40 banks extended credit on Friday and believe that some of the repos are likely to be termed at least to some degree.

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Bear Stearns

Just after the loans to Bear Stearns from J.P. Morgan with the unlimited backing of the US Fed were announced, but before it became public that it was actually a buyout, my brother sent me a quick email:

This is [bad word removed]. Surely if the Fed bails out a large bank/ financial company they should receive some equity in return for their cash. Otherwise you just ensure the rich stay rich no matter what.  Please respond with a thoughtful rightwing diatribe.

Fed moves to bail out major US bank: http://www.abc.net.au/news/stories/2008/03/15/2190458.htm

I responded with:

*) Yes, it’s [bad word removed]. It should be allowed to collapse on its own. If the government does get involved, it should be to nationalise the thing outright, close its operations and then immediately sell the various arms off to the highest bidders on the market. The government should not attempt to keep it running as a going concern (as the UK is with Northern Rock).

——

*) No, it’s not [bad word removed]. It is commonly said (including by me) that central banks have two tasks: control inflation and minimise unemployment. The US Fed, unlike most central banks, (a) does not have real independence from the executive or legislature; and (b) is forced to consider unemployment at the same time as inflation. For the BoE, RBA and ECB, fighting inflation comes first and ONLY THEN, when it’s under control, do they look at unemployment.

This isn’t quite true, though. The US Fed actually has three roles:

a) As an independent institution, to control inflation, but not — as yet — with an explicit target like the BoE, RBA and ECB have;
b) As a semi-independent institution, to minimise unemployment; and
c) As simply one of a collection of government agencies working together, to ensure the ongoing stability of the financial system.

That third point, for the US, takes absolute priority over everything else. To be honest, it does in Britain, Australia and Europe as well. It’s important because if the entire financial system melts down, you end up with 3rd-world-style catastrophes and we know that those aren’t fun.

It was clearly on that third point that the US Fed offered its recent US$200 billion facility to the market at large and also on that third point that they declared Bear Stearns too big to fail. They are clearly worried that that the market is a long way from rational right now and that the collapse of even one investment bank would have domino effects that really would threaten the entire system.

——

Personally, I think the US$200 billion facility was reasonable but I think the Bear Stearns bail-out was not. I appreciate the domino risk, but so long as the Fed is acting to ensure that there is market liquidity, I don’t think there is too much cause for concern. To the extent that they prop Bear Stearns up at all, it should be under the explicit understanding that a) it is short term; b) Bear Stearns open their books to the world; c) Bear Stearns negotiate for someone else to buy them out; and d) if they fail to sell themselves within a month, they get nationalised and the Fed then sells it off in chunks.

Some people are likening the Fed’s reactions to those of the Bank of Japan in the 1990s: propping up banks and ought-to-be-bankrupt borrowers so their financial system never had to recognise the dodgy loans on their books. As far as I can tell, the two main differences are that a) the BoJ initially had much lower interest rates, so they had less room to manoeuvre in keeping the real economy out of recession; and b) the US banks are notionally required to “mark to market” when doing their accounts rather than their preferred “mark to model”, which means that so long as the market for sub-prime-mortgage-backed assets is illiquid, they’re obliged to mark those assets as having a value of zero. That is, they’re forced to recognise the bad loans upfront rather than hanging on to them for a decade or so.

And this morning I wake up to this:

In a shocking deal reached on Sunday to save Bear Stearns, JPMorgan Chase agreed to pay a mere $2 a share to buy all of Bear – less than one-tenth the firm’s market price on Friday.

Well, waddayaknow …