Voodoo banking

Elite athletes often use performance enhancing drugs to boost performance. Voodoo banking operated similarly, enabling banks to enhance short-term performance whilst risking longer-term damage.

By Satyajit Das

(pages 17-23 of printed journal)

CitiGroup recently announced that it was seeking Board members who had 'expertise in finance and investments'. What was the previous experience and expertise of the CitiGroup Board and senior management - the one that has registered more than US$50 billion in losses? Banking, especially investment banking, has delivered strong returns to shareholders in recent years; but the 'high' returns of financial stocks and the future earning prospects need careful examination.

Displacing the traditional banking model

Until the early 1980s, banking was highly regulated. It was the world of George Bailey, played by Jimmy Stewart in It's A Wonderful Life. Community banking was the rule. The banker could dip into his 'honeymoon money' to stave off a potential bank run. It also fueled jokes - the '3-6-3' rule was to borrow at three per cent; lend at six per cent; hit the golf course at three p.m.

Once deregulated, banks evolved into complex organisations providing varied financial services. Deregulation brought benefits for the economy, including better access to capital and more varied investment opportunities; and for the banks, growth and higher profits.

Over the last 15 years, increased competition - within the industry and increasingly from non-banking institutions - and the reduction of earnings from the standardisation of products, forced banks to rely on 'voodoo banking', or performance enhancement to boost returns. Focus on risk-adjusted returns - introduced in the early 1990s by JP Morgan and Bankers Trust - changed the 'business model'.

Traditionally, banks made loans that tied up their capital for long periods, for example, up to 25 to 30 years in a mortgage. In the new 'originate to distribute' model, banks 'underwrote' the loan, 'warehoused' it on the balance sheet for a short time, and then parcelled it up with other loans and created securities that could be sold to investors, a process known as 'securitisation'. The bank tied up capital for a short time until the loans were sold off and then the same capital could be reused and the process repeated. Interest earnings over the life of the loan could be discounted back and recognised immediately. In this way, banks increased the 'velocity of capital' - effectively 'sweating' the same capital harder to increase returns.

In the traditional model, banks earned the net interest rate margin over the life of the loan - this was their 'annuity' income. Yet, when loan assets are sold off and the earnings recognised up-front, banks need to sell off new loans to maintain earnings. This creates pressure on banks to find 'new' borrowers. Initially, credit-worthy borrowers without access to credit in the regulated banking environment entered the market. Over time, banks were forced to 'innovate' to maintain lending volumes.

New markets for borrowing

Banks created substantial new markets for borrowing in the following areas:

Retail clients - expanding traditional lending (housing and car finance) and developing new credit facilities (credit cards and home equity loans);
Private equity - providing borrowings in leveraged buyouts and sundry other highly leveraged transactions; and
Hedge funds/private investors - providing (often) high levels of debt against the value of assets.

Banks increasingly also outsourced the origination of the loans to brokers, with large 'upfront' fees providing the incentive.

The expansion in debt provision relied increasingly on complex mathematical models for assessing risk. It also relied on collateral - whereby the borrower puts up a portion of the price of the asset and agrees to cover any fall in value with additional cash cover. The model allowed banks to expand the quantum of loans and allowed extension of credit to lower-rated borrowers. Banks did not plan to hold the loan on a long-term basis and were only exposed to 'underwriting' risk in the period before the loans were sold off. Where the loan was collateralised, the agreement to 'top up' the collateral whenever the asset value fell was considered to provide ample protection.

The growth in this type of lending was underpinned by favourable regulatory rules, as the capital required was modest; as well as optimistic views of market liquidity and faith in models.

Casino banking

Banks also increased their trading activities, especially in derivatives and other financial products. Initially, this was targeted at companies and investors seeking to manage financial risk. Over time, they focused increasingly on creating risk, allowing investors to increase returns and companies to lower borrowing costs or improve currency rates. As profit margins eroded, banks created even more complex and exotic products, usually incorporating derivatives. These increasingly became a way to provide additional leverage to customers.

The development of hedge funds was especially important, which borrowed money against securities offered as collateral. These used derivatives extensively, traded frequently and aggressively boosted volumes. Prime broking services - such as bundling settlement, clearing, financial and capital raising - emerged as a major source of earnings for some banks.

As wealth and sophistication grew, investors increasingly sought investments other than bank deposits or even equity, bonds or mutual funds. Banks created or purchased wealth management businesses such as asset managers and private banks to service this requirement. The clients of the wealth management units were also major purchasers of securities or financial products created by the banks.

Major banks expanded into emerging markets where similar products could be created and sold to a new client base. Global banks had significant advantages over local banks in terms of intellectual property and (sometimes) capital resources. Profit margins in emerging markets were also larger.

Banks also increased their own risk-taking. Traditionally, banks took little or no risk other than credit risk, yet over time they took on market risk and investment risk. Whereas originally, banks traded financial products primarily as 'agents' standing between two closely matched counterparties, they soon became principals in order to provide clients with better, more immediate execution and increased profit margins. This increase in risk-taking was also dictated by business contingencies. Advisory mandates - mergers and acquisitions and corporate finance work - were conditional on extension of credit. Banks increasingly 'seeded' or invested in hedge funds to gain preferential access to business.

Clients often sought an 'alignment' of interests, requiring banks to take risk positions in transactions. This evolved into the 'principal' business, as banks increasingly made high-risk investments in transactions, rolling back the clock to the days of JP Morgan. Banks convinced themselves of this strategy on the basis that the risks were acceptable - it was their deal after all! It seemed they believed that the risk could be always sold off at a price, that markets were liquid, and (the real reason) returns were high.

Regulatory arbitrage as a business model

Enhanced revenues, through growing volumes and increasing risk, were augmented by increased leverage and adroit capital management. 'Regulatory arbitrage' evolved into a business model. Required risk capital was reduced by creating the 'shadow' banking system - a complex network of off-balance sheet vehicles and hedge funds. Risk was transferred into the 'unregulated' shadow banking system, and the strategies exploited bank capital rules. Some or all of the real risk remained indirectly with the originating bank.

Banks reduced 'real' equity - common shares - by substituting creative hybrid capital instruments that reduced the cost of capital. These structures generally used high income to attract investors, especially retail investors, while disguising the (less obvious) equity price risk. In some cases, banks used these new forms of capital to repurchase shares to boost rates of return. For example, CitiGroup repurchased US$12.8 billion of its shares in 2005 and an additional US$7 billion in 2006.

Banks increasingly 'hollowed out' capital and liquidity reserves, reducing them to minimum levels. Concepts of 'purchased' capital and 'purchased' liquidity grew in popularity. The theory was that banks did not need to hold equity and cash buffers as these items could always be purchased in the market at a price.

Thus, bank profits in recent history were driven by rapid and large growth in lending, trading revenues and increased risk-taking. Banking returns were underwritten by an extremely favourable economic environment - a long period of relatively uninterrupted expansion, low inflation, low interest rates and the 'dividends' from the end of communism and growth in international trade. Bankers would argue that the source of higher returns was 'innovation'. However, John Kenneth Galbraith, in A Short History of Financial Euphoria, noted that:

Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design... The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.

Not-so-perfect future

There are reasons for caution regarding the outlook for banks.

The asset quality of major banks remains uncertain. Svein Andresen, Secretary General of the Financial Stability Forum, which is made up of global regulators and central bankers, recently told a conference of bankers in Cannes: 'We are now 10 months through this crisis and some of the major banks have yet to make disclosure in [crucial] areas.'

Despite significant write-downs, sub-prime assets remain vulnerable. There are substantial differences in valuations. Further losses are likely to merge in portfolios of commercial property, consumer loans and private equity loans as the global economy slows. Bank balance sheets have changed significantly. Traditional commercial bank assets consisted primarily of loans and high quality securities. Traditional investment bank assets consisted of government securities and the inventory of trading securities.

In recent years, asset credit quality has deteriorated. High quality borrowers have dis-intermediated the banks by financing directly from investors. Banks also hold lower quality assets to boost returns. Bank balance sheets now also hold investments - private equity stakes, principal investments, hedge fund equity, different slices of risk in structured finance transactions and derivatives of varying degrees of complexity. Sometimes, the assets do not appear on the balance sheet, being held in complex off-balance sheet structures with various components of risk being retained by the bank. Moreover, further write-downs in asset values cannot be discounted.

Banks require re-capitalisation in order to deal with the consequences of the financial crisis. The capital required is in excess of US$1,000-1,500 billion (50-75 per cent of total global bank capital prior to the crisis) to cover losses. Capital is also needed for assets returning onto their balance sheet as the vehicles of the 'shadow banking system' are unwound. This capital is required to restore bank balance sheets. Additional capital will be needed to support future growth. Availability of capital, the high cost of new capital and dilution of earnings will impinge upon future performance.

Earning! What Earnings?

The aftermath of the financial crisis may be expected to have the following consequences for the earnings prospects of banks.

Earnings growth in recent years has been driven by a rapid expansion of lending - both traditional and, as shown above, disguised forms such as securitisation and derivatives activity. Bank balance sheets have expanded at rates well above GDP expansion. Lower volumes in the future will mean lower earnings.
Lack of lending capacity may also affect other activities. Corporate finance and advisory fees are driven by the capacity to finance transactions as well as co-investing in risk positions. Lower origination of lending-driven deals may reduce this income significantly. Banking fees for leveraged finance deals are down 90 per cent.
The use of complex financial products - usually referred to as 'structured finance' - has contributed strongly to earnings in recent years. Securitisation, including CDO (Collaterised Debt Obligation - a type of asset-backed security) activity, has been a major growth area. Volumes have collapsed. The slowdown in structured finance has complex effects. Banks generated large earnings from off-balance sheet vehicles in the shadow banking system. These vehicles provided banks with the ability to 'park' assets and reduce capital requirements. They also provided significant revenue - management fees, debt issuance fees and trading revenues. Recovery in these earnings is unlikely any time soon.
Trading revenue has also been a bright spot. Increased volatility and a much wider bid-offer spread have generated increases in both client-driven and proprietary trading earnings. Several factors may limit trading income. Revenues may diminish as investors and borrowers curtail their use of such instruments, preferring simpler products that are less profitable to the bank. Trading revenues relied heavily on hedge funds and financial sponsors. Hedge fund activity is likely to slow down through redemptions, consolidation and reduced leverage. Reduction in financial sponsor activity will limit revenue from this source.
Banks have increasingly relied on proprietary trading to supplement earnings. This increases risk and depends on the availability of capital. It relies on the availability of people to trade with and liquidity. Concern about counterparty risk and reduction in market liquidity in some products increases the risk of this activity and reduces its earning potential.
Future earnings will also be affected by the availability of risk capital. The banks may not be able to access capital to the extent needed. The demise of the shadow banking system will mean that purchased capital will not be available. Regulators may also increase capital level requirements for some transactions, exacerbating the capital problem.
Risk models in banks are a function of market volatility. The low volatility regime of recent years reduced the amount of capital needed. Increased market volatility will increase the amount of capital needed. This may restrict the level of risk-taking and, therefore, earnings potential.
Higher costs will further limit earnings recovery. Bank funding costs have increased. Most firms have been forced to issue substantial amounts of term debt to fund assets returning to balance sheet and protect against liquidity risk. To the extent that these costs cannot be passed through to borrowers, the higher funding costs will affect future funding.
Banks have issued high cost equity to re-capitalise their balance sheets. Hybrid capital issues paying between seven and 11 per cent per annum will be a drag on future earnings. Highly dilutionary equity issues - often at a discount to a share price that had fallen significantly - will impede earnings growth per share and return on capital.
Banks also face additional short-term costs. Litigation and prosecution present likely, but unknown, costs. In the longer term, banks face higher regulatory and compliance costs.
Accounting factors may further affect any earnings recovery. For example, bank balance sheets have substantial goodwill on acquisition as future income tax benefits - particularly as a result of the losses in the last year. The carrying value of these assets may need to be adjusted substantially as the market environment changes.
FAS157 (Financial Accounting Standard establishing the basis for assessing 'fair value' on accepted accounting principles) allows the entity's own credit risk to be used in establishing the value of its liabilities. Changes in the entity's credit standing are therefore reflected as changes in fair value. This results in gains for credit downgrades and losses for credit upgrades.
As credit spreads increased, banks revalued their own borrowing - which were now trading below the original price - allowing them to record large gains. If markets stabilise and the credit spreads for banks improve, then banks will have to reverse these gains. There may be significant unrealised losses especially on new debt issues by banks at high credit spreads since mid-2007.

From 'go-go' banks to 'no-go' banks

Investors are looking for a rapid recovery in bank earnings. Earnings may recover but the 'gilded age' of bank profits may be difficult to recapture. Glamorous banks reliant on 'voodoo banking' may find it difficult to achieve the high performance of the 'go-go' years.

Banks with sound traditional franchises that have avoided the worst excesses of the last 10 to 15 years will do well in the changed market environment. Interest rates that they charge customers have increased. Bank deposits have become far more attractive than other investments. Stronger banks have also benefited from a 'flight to quality' in attracting deposits.

Elite athletes often use performance enhancing drugs to boost performance. Voodoo banking operated similarly, enabling banks to enhance short-term performance whilst risking longer-term damage. The big question remains: will the recovery graph in bank stocks take the form of 'V' or 'U'? With the various bailouts, central banks and governments have signalled that major banks are 'too big to fail'. This is a necessary but insufficient condition for the recovery of bank earnings and stock prices. And so, we may well see the recovery taking the form of an 'L' (Kristen ITC font) - note the small upturn at the far right of the flat bottom.

© 2009 Satyajit Das. All rights reserved.

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A condensed version of a lecture given at the Melbourne Centre for Financial Studies and the Financial Services Institute of Australasia on 12 February 2009.

Mr Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall). At the time of this publication, the author or his firm did not own any direct investments in securities mentioned in this article, although he may be an owner indirectly as an investor in a fund.

Volume 5 APRIL 2009