A V Rajwade: The banking illusion

What looked like a liquidity crisis is turning out to be a solvency crisis for western banks.

I was hoping that, after the trillions of dollars poured into the western banking system by central banks and governments, a semblance of normalcy would return to the banking system in the New Year. However, the last couple of weeks’ developments in both the United States and Europe suggest that all the bad news is still to come out.

Consider first what has happened to Citibank, perhaps the most globalised of them all. Just about a decade back, the merger of Citi and Travellers, the insurance group, effectively buried the separation of commercial and investment banking, mandated by the 1930s-era Glass Steagall Act (the Act itself was repealed later). The bank has always been aggressive in its operations, often treading on the very edge of regulatory boundaries. Post-merger, it has not had a smooth decade. It was first penalised by the regulators for its role in the dotcom and telecom bubbles; it was then caught in the Enron and Worldcom scandals — and a little later in Europe’s Parmalat. The Japanese authorities shut down its private banking activity for regulatory infringements. Then came the bond-trading scandal in Europe, and a regulatory estoppel of further acquisitions. All this was before the continuing losses in credit derivatives.

It has already received $90 billion of funding from the Fed/US government, over and above a $300 billion guarantee for the weak assets on its books. It declared a loss of $8 billion in Q4, the fifth successive quarterly loss, and may need further support. It has effectively decided to sell the investment banking unit (Smith Barney) to Morgan Stanley. This, plus some other planned sales, would reduce the size of the bank by about a third. Would this be the end of its trouble? Keep your fingers crossed. Meanwhile, as a result of these developments, Vikram Pandit, the chief executive, and, indeed, the board itself, are attracting a lot of flak. Last week, a new chairman was appointed and Robert Rubin, the former treasury secretary, resigned from the board. Clearly, all is still not well with the giant, 350,000-employee behemoth.

Nor with its west-coast rival, Bank of America (BankAm), which acquired Merrill Lynch only a few months back — and that is the unit where major problems are cropping up. Merrill Lynch declared an operating loss of $21 billion in the fourth quarter of 2008, and BankAm has had to seek government equity of $20 billion, besides a guarantee for losses on impaired assets of the order of $120 billion, mostly on Merrill books. Quite apart from this, BankAm would face one more problem in digesting Merrill: The latter’s employees earn an average of $250,000 a year, as against barely a fourth of that in BankAm itself — this when most of the problems are in Merrill.

Things are not better across the Atlantic. The Royal Bank of Scotland has suffered a loss of £28 billion, and would need further capital injection from the central bank/government. (Having worked with the State Bank of India more or less immediately after its nationalisation, and when it still had a strong Imperial Bank culture, one had always thought that the Scots, who, rather than Englishmen, had manned Imperial Bank, were highly conservative. The 21st century Scots are evidently made of sterner stuff.) Deutsche Bank has also declared a fourth quarter loss of $6.33 billion in its “investment banking operations”, actually proprietary trading losses (trading is of course a euphemism for speculation).

For the major investment banks, bad assets on their books may represent only a part of the problem: Banks in both the US and Europe are being sued for mis-selling complex products to investors, and other malpractices. Deutsche has been sued by M&T Bank for selling an investment in a CDO structured by it, even as it was encouraging others to short the same fund, as reported by the New York Times. In Europe, both UBS and HSBC have been sued by investors for having placed custodial funds with Madoff. In the fourth quarter, Merrill Lynch settled one dispute paying out $475 million. More such cases could well follow. By one estimate, more than a hundred cases involving $400 billion losses have been filed against financial firms. Modern banking has obviously gone far away from the traditional intermediary role, of taking deposits for lending money to consumers and businesses.

And, all these problems and losses are before taking into account the fact that recession leads to a sharp increase in non-performing consumer and business loans. Increasingly, what looked like a liquidity crisis is turning out to be a solvency crisis for the western banks. (Keynes was obviously right when he described banking as an illusion — so long as the illusion persists that the depositor will get his money back and the banks will recover their assets, everything is fine). Right now, of course, nobody is even talking of the deteriorating quality of central bank balance sheets as a result of the kind of assets they are buying.

avrajwade@gmail.com