Shrinking Banks

I was high when I gave my presentation on risk to the Zermatt symposium this morning — 8,471 feet above sea level, to be precise, in an idyllic place called Riffelberg. Who needs wifi when you have views like that. In any event, it went quite well: after all the high empirical seriousness of the past couple of days, I think that the attendees enjoyed me blowing off steam by telling them that we had to do something which of course we won’t do at all: abolish the tax-deductibility of interest, move in general from a world of debt finance to a world of equity finance, and, insofar as there is credit in the world, encourage that credit to be in the form of loans rather than bonds.

“I wondered where you were going there,” said Princeton’s Harold James after I was done, adding that he thought for a while that I was going to propose moving, essentially, to a world of Islamic finance. Doesn’t Islam essentially prescribe from a religious perspective exactly what I was prescribing from a practical perspective?

Yes, it does. One of the themes of my talk was that it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution, with an attendant surge in demand for triple-A-rated bonds. Investors didn’t want risk, and investment banks made billions of dollars, during the boom, by waving their magic securitization wands and seemingly making that risk disappear. In Islam, high religious authorities are tasked with looking at complex structures designed to circumvent the prohibition on paying interest; in western finance, the ratings agencies played a similar role, blessing highly complex structures (CPDOs, anyone?) which otherwise investors would never have touched.

There followed lunch, and a spectacular walk even higher, to the Gornergrat (10,210 feet) before we descended back to Zermatt on the famous railway to hear Professor James give his presentation, which was very good. James quoted Mervyn King, the governor of the Bank of England, as saying that “the behemoths of global finance have been global in life, but national in death”, and said this posed a problem for small, open countries, including Switzerland, which in general did well during the boom. Such countries just aren’t big enough, he said, to cope with a domestic banking crisis and embark upon a major Keynsian counter-cyclical spending spree at the same time, especially when such spending has to be financed abroad.

More generally, James sees big banks splitting up, becoming increasingly regional and/or national, and the sheer number of banks falling substantially, not least in the US, which has a huge assortment of small banks. The happy medium, he said, is somewhere like Canada, which has a manageable number of large, boring banks which in general don’t venture too far abroad. That sounds right to me, and I suspect that the upshot might be felt very keenly in Mexico, nearly all of whose banks are foreign-owned. Given (a) that the Spanish government has neither the inclination nor the ability to conduct a bank rescue in Mexico; (b) that there are questions over the health of BBVA, the owner of the largest bank in Mexico; and (c) that bank failures are managed by the regulators in the parent country, I can see moves afoot to pressure BBVA into selling Bancomer. The story could be repeated in Brazil and Chile for Santander (STD).

James also raised an intriguing hypothetical, a propos the new nationalism which he sees emerging in the banking industry — how might the world look instead had Dick Fuld sold Lehman Brothers to the Koreans? It’s fascinating to wonder whether that one failed deal might have made an absolutely enormous difference in the future of global banking, between continued globalization and the beginning of deglobalization, if that is indeed what we’re now embarking on.

Comments

[Erwan Mahe:]

good insight, salmon. how do you reconciliate that with bbva buying Garanty bank ?

Aug 26 03:34 PM

[traden4alpha:]

Interesting ideas, as always. I definitely agree about the debt- vs. equity issue. A 100% LTV mortgage is really more like an equity instrument (in it's delta sensitivity) than a debt instrument and the institutions that didn't know that are now paying the price.

But the deeper issue is that global banks are a reflection of our global times. Although national regulators can certainly impose new mandates that banks behave responsibly, regulators will have a harder time imposing responsible behavior on investors. Investors' stubborn search for excess-returns without excess risk (i.e, the over-caution seekers that spawned high-yield AAA toxic MBS) won't stop and if national banks can't deliver what global investors seek, then capital will leave that nation's banking system.

Regulators can de-globalize, but what if investors don't follow?

Aug 26 04:02 PM

[Donald Ingram:]

"Shrinking Banks". And here I thought immediately more failures!
Surprise! Although more bank failures there will be - no doubt about that! Your presentation points of responsibility, high quality credit rather than bonds and regulators of high caliber, I would classify as wishful thinking. Very admirable none the less, however not easily attainable considering human greed and hubris. Its in the nature of the beast.

Aug 26 05:10 PM

[Tony Petroski:]

"I was high when I gave my presentation on risk to the Zermatt symposium this morning — 8,471 feet above sea level, to be precise, in an idyllic place called Riffelberg."

I try to stay in touch, (Mr. Salmon, the images are wonderful) but the "Zermatt symposium?"

Aug 26 06:20 PM

[Bryan Gomez:]

Reminds of HSBC thinking local despite being global. Surprisingly they are still alive. Too much of a very good thing this time turned out pretty bad. So bad we are still talking and philosophizing about it.

Aug 26 10:14 PM

[Burton A. J...:]

Could the elephant in the parlor be the near-confiscatory tax rates imposed by First World Nations? In the U.S., about the only break left for the high income earner is the deduction for a homestead mortgage?

Could another elephant in the parlor be the FDIC, another one of FDR's ideas that has turned into a racket, that essentially guarantees every crooked and/or stupid banker a blank check on the U.S. Treasury?

Could the third and fourth elephants be Fannie and Freddie, that, pressured by the likes of Barney Frank and Sen. Dodd, to buy up the those toxic mortgages, equitize them, and sell them off to gullible bankers around the world?

The parlor needs to be emptied and aired out. Don't count on it happening.

Burton A. Johnson, MD, JD
bajvalueinvesting.com

Aug 27 11:12 AM