Why are commercial bankers still being blamed for the Global Financial Crisis and concurrent Great Recession?

A James Alexander post

One answer is that they don’t help themselves. The captains of (the financial) industry are often extremely arrogant and always extremely well paid. Many of their employees seem to be so greedy that sales practices and general client dealings sometimes aren’t fair or even lawful.

However, these characteristics don’t really differentiate senior bankers from the captains of non-financial industries, and the sales practices of non-financial companies aren’t always completely ethical or lawful.  Businesses and businessmen in general aren’t perfect. No one is. Not even public servants.

The mostly generalised failure within the banking sector in the GFC showed that bankers were incompetent, didn’t it? Well partly yes, but mostly no. Can most bankers be incompetent, but not most non-financial CEOs? Seems odd when these leaders are largely drawn from the same talent pools of top schools and colleges, and mostly meritocratic corporate structures.

For sure, bankers should be very prudent about their balance sheets. Banking is different to almost all other industries as it has so much debt (deposits, commercial paper and bonds) in relation to its equity, which then goes to fund the assets (cash, loans, other people’s bonds). The assets to equity ratio, otherwise known as leverage, is very, very high, often 20x or more. For non-financial companies debt is rarely above 2x or 3x equity. Small downward changes in the value of a bank’s assets can wipe out the equity, in fact at 20x leverage a mere 5% cut in the value of their total assets does just that. Hence, the need for banks to be prudent when it comes to both the leverage ratio and the riskiness of the assets. However, this is nothing new, it just leaves them exposed to recessions but not more so than many other domestically-focused sectors.

Sure, there were changes in global banking regulation, in particular the Basel 2 reforms, that allowed many banks to become much more levered than under Basel 1 – on a non-risk weighted leverage ratio basis. This is because Basel 1 risk weightings were replaced under Basel 2 with much more risk-sensitive, almost always lower, risk weightings, allowing much bigger non-risk weighted balance sheets. The problem with this as a cause is that US banks failed in the GFC despite their regulators sticking with Basel 1 ratios and continuing to use non-risk-weighted leverage ratios as a back up. Consequently, it is hard to blame Basel 2 banking regulation for encouraging banking imprudence.

Bankers also need to be pretty certain about their lines of funding (those deposits, commercial papers and bonds). If a particular bank is struggling with asset quality its funding will dry up and it will suffer a liquidity squeeze. When times get tough more generally and there is an increase in the demand for money from consumers and firms, all banks find their funding getting trickier too, and in turn they also end up going more short term in their funding as they search for liquidity, and they too seem to increase the overall demand for money.

Such a systemic liquidity crisis is a different phenomenon to an idiosyncratic one even though it runs through the same scenario for any individual bank. Reckless and incompetent banks do crash occasionally but for lots of banks across a country to suffer liquidity crises there must be a more general cause, like a badly handled recession. Each individual bank looks poorly run as it hits the general liquidity squeeze, making the bankers seem incompetent even though there is a more general cause.

The squeeze is largely invisible to the general public, but bank CEOs struggling for life and then being sacked make a terrible sight. Hindsight then kicks in and abuse and scorn pours in as it is easy to be clever after the event. Sure, there were many poor banking practices and many who identified them in 2006 and 2007: the sub-prime boom in the US, the outsider bank growth in the UK (RBS, HBOS and NRK), all had their critics at the time.

However, what was most noticeable about the roll call of bank failures in the US and UK was that it was the most relatively leveraged, the most poorly run banks that fell first – those closest to sub-prime mortgages in the US or most leveraged in the UK, in 2007. Then much bigger more diversified, but still relatively less well run banks in 2008. It was if a tide was going out, steadily exposing those furthest from the shore, but all banks were in banking sea regardless.

But why did the liquidity tide just keep going out and out? Well, the liquidity tide, the funding of the banks, is also a function of the demand for money. And the increasing precariousness of the banks was feeding something of a panic, that in turn led to an increasing demand for money, worsening their situation. Macroeconomists know that in a sticky wage and price world, an increasing but unmet demand for money will have very negative real world consequences.

When nothing was done by the monetary authorities to counter the liquidity squeeze, and markets began to expect nothing would be done, the squeeze got worse. In the US, by the time Lehman Brothers failed, Merrill Lynch and Citi were failing too. Next up would have been clearly under pressure Morgan Stanley, and then Goldman Sachs too. The big two universal banks were under pressure too of course, BoA and JPM. JPM would have been last man standing as it operated so close to the NY Fed, but it would have fallen too, if the Fed had done nothing. It seemed to me that the Fed only reacted when it realised that any monetary policy would be unimplementable as there would be no primary dealers left solvent. Were all these bankers really incompetent? It appeared so, but wasn’t in fact what was really going on.

If this Market Monetarist narrative is correct the abuse and scorn should have been reserved not for the commercial bankers but for the central bankers not responding to the liquidity squeeze.

However, what sane central banker would want to hold their hand up and take the same sort of blame as the commercial bankers? They cannot ever admit their mistakes, the game is too serious. In fact, they paint themselves as saviours, earning millions of dollars giving speeches and sage advice.

Commercial bankers either don’t want to go there and criticise the central bankers for their failures as the central bankers are also their main regulators and largely “off-bounds”, indeed most commercial bankers don’t even really realise what happened in the GFC. In the early days many even positively encouraged the squeeze on their more vulnerable competitors – see the mutterings from Lehman’s about conspiracies against them. Banking leaders at Barclays were vocal in ridiculing the Libor quotes of peers as the system struggled to show proof they weren’t short of funds. One’s immediate reaction is to think that there was just no honour amongst thieves, but it just showed a lack of class and inability to realise that the banks really were all in it together.

Bankers just don’t help themselves. Even now, many are calling for rate rises, to “normalise monetary policy” despite money in no way being loose. Most likely, they are just following their Chief Economists, who in turn make up the consensus of economists who always think rates will normalise in the next six months or so. Bankers just aren’t that special, neither deserving of excessive respect nor excessive ignominy.

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