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Asymmetric Herding

Jul. 10, 2017 5:03 AM ET7 Comments
Frances Coppola profile picture
Frances Coppola

Ten years ago today, Chuck Prince, then chief executive of Citigroup (C), dismissed fears of a financial crisis. "When the music stops, in terms of liquidity, things will be complicated", he said in an interview with the Financial Times in Japan. "But as long as the music is playing, you've got to get up and dance. We're still dancing".

He wasn't dancing for long. Less than a month later, the first bank failed. Over the weekend of 27th-29th July, IKB Deutsche Industriebank AG (OTC:IKBDF), one of Germany's key "Mittelstand" lenders, was bailed out by a consortium of German banks after credit markets refused to provide it with liquidity. The music had stopped.

The reasons for IKB's failure are now all too familiar. Anxious to diversify beyond its traditional core market of German small and medium-size businesses, IKB had set up an SPV called Rhineland Funding Capital Corporation. Rhineland issued US dollar-denominated commercial paper and invested the proceeds in US subprime mortgage bonds and derivatives. In a prescient comment, the Wall Street Journal observed:

IKB is just one of many banks that set up companies to use this strategy. They're usually off-balance-sheet so that banks don't have to set aside capital to cover the liabilities.

Maturity mismatch and no capital - we now know this is a recipe for disaster. But at the time, everyone was doing it. The next bank to fail was Britain's Northern Rock.

Like IKB, Northern Rock had created an SPV, called Granite. Granite's job was to convert Northern Rock mortgages, some of them subprime, into bonds and sell them to international investors, thus raising the funds for more mortgage lending by Northern Rock. It worked well - until the market for subprime mortgage-backed securities started to fail in late 2006. After that, Northern Rock became increasingly dependent on issuing short-term commercial paper, because Granite could

This article was written by

Frances Coppola profile picture
Frances Coppola worked in banking for 17 years as a business analyst and project manager, running business and systems projects for (among others) RBS, Nat West, HSBC, Midland Bank and SBC Warburg (now UBS). Her banking experience encompasses retail and investment banking, front office, operations and settlement, but her particular area of expertise is financial control and risk management. She is particularly proud of the fact that RBS still produces its financial and regulatory reporting using a group consolidation system that she designed. Frances is now a writer and commentator on banking, finance and economics. Her blog Coppola Comment is widely read and her writing has featured on the Financial Times, City AM, The Economist. The Guardian and a range of online publications. She also writes for the online magazine Pieria and occasionally for the ICAEW, and she is a frequent commentator on banking matters for the BBC. Frances has an MBA from Cass Business School with a specialism in finance and risk management. And since financial people can be creative too, Frances is also a professional singer and singing teacher. She has a B.Mus from London University and is an Associate of the Royal College of Music. She also has two teenage children and not much time to do the garden any more!

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