B2BB - Back to Banking Basics

I have read much on the complex causes of the Banking Crisis but rarely have I heard an explanation as clear and compelling as that offered by Guy Ashton Head of Global Equity Research at Deutsche Bank at the school’s Stock Broking Society tonight.

Even a simple banking system based on maturity transformation - attracting short term deposits and lending longer term and at higher rates of interest - contains within it stresses and strains. namely the chance that a sizeable number of depositors will ask for their money back and borrowers will default on some of their loans thereby reducing the value of the asset book created by the banking system.

But these stresses have been multiplied many times over by the process of securitisation (i.e. parcelling up debt, creating an asset and selling it on) together with the willingness of banks to borrow from the wholesale money markets and use the capital of the bank to lend on multiple times. The scale of bank leverage has been astounding as the nature of lending has evolved in response to an era of low interest rates and investors anxious to achieve higher yields.

Banks have been borrowing heavily, so too have domestic consumers as have the hedge funds – the borrowing boom has many causes – aided an abetted by a light touch regulatory regime and an accommodatory approach by central banks eager to cut interest rates at the merest whiff of trouble.

And now the ‘innovative banking model’ is coming tumbling down. The bubble of borrowing is over, banks around the world are engaged in frantic attempts to de-leverage and the collective loss of nerve has frozen the wholesale money markets and is scaring the living daylights out of those banks who do not have a national sponsor (an implicit guarantee from a sovereign government that ‘this one is not going to go bust’!)

The depth and scale of the credit crunch is now visible in every nook and cranny of the domestic and international economy. The mortgage market has collapsed; corporates are cutting their capital spending (CAPEX) in many cases restricting their investment to maintenance levels. The cost of shipping goods around the world is collapsing (witness the sharp fall in the Baltic Dry Freight Index) so too is the world price of oil and iron ore. All of these are symptoms of a steep slow-down in global economic growth and activity.

When your house is on fire, it is probably best to put the fire out first even if you have generous fire and contents insurance. This might usefully be applied to the immediate banking crisis. There will be a huge regulatory and political backlash and more than a whiff of media and public desire for retribution. But what matters is working through the crisis over the next few days and then letting the traditional tools of macroeconomic management impact on confidence, demand, output and jobs in the real economy.

Mr Ashton handled dozens of questions! Ranging from prospects for China (growth likely to slow towrda 7 per cent or lower); to whether developed countries will experience a liquidity trap with monetary policy ineffective in the face of collapsing confidence. Is the investment banking model now defunct? Will we see the return of the Glass-Steagall Act?

Will we see the end of multi-million dollar bonuses for bankers? (probably not, banks are adept at getting around any direct intervention on renumeration). What happened to Iceland – there are parallels with the Tulip Mania of the 18th century. Which bank will blink first and go to the government for a fresh injection of capital – the mark down on share prices suggests that the banks will have to blink eventually.

Was allowing Lehman Bros to fail a mistake in hindsight? To what extent have the media accentuated the collapse in consumer confidence. What is it like to live in a recession?

Banks have failed in their handling of risks – casinos are better at it! For a decade or more the retail and investment banking system has been engaged in an excessive borrowing spree and now the reckoning is being experienced. It will be very painful and it will last for years.