Citigroup recently announced that it was seeking board members who had “expertise in finance and investments”. What was the expertise of the Citi board and senior management that has registered more than $45 billion in losses?
Until the late 1970s/early 1980s, banking was highly regulated. It was the world of the “3-6-3” rule: borrow at 3%, lend at 6%, hit the golf course at 3pm.
Once deregulated, banks evolved into complex organizations providing varied financial services. Deregulation brought benefits for the economy (better access to capital and more varied investment opportunities) and the banks (growth and higher profits).
Illustration: Malay Karmakar / Mint
Over the last 15 years, increased competition (within the industry and increasingly from non-banking institutions) and the reduction of earning from the commoditization of products forced banks to rely on “voodoo banking”—performance enhancement to boost returns.
Traditionally, banks made loans that tied up their capital for long periods, e.g., up to 25-30 years in a mortgage. In the new “originate to distribute” model, banks “underwrote” the loan, “warehoused” it on their balance sheet for a short time and then parcelled it up with other loans and created securities that could be sold to investors (“securitization”). 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 recognized immediately. Banks increased the velocity of capital, 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—or, “annuity” income. When loans are sold and earnings recognized upfront, banks need to make new loans to be sold off to maintain earnings.
This created pressure on banks to find new borrowers. Initially, creditworthy borrowers without access to credit in the regulated banking environment entered the market. Over time, banks were forced to “innovate” to maintain lending volumes.
The model allowed banks to expand the quantum of loans and extension of credit to lower-rated borrowers. Banks did not plan to hold the loan long term and were only exposed to underwriting risk in the period before the loans were sold off.
Banks also increased their trading activities, especially in derivatives and other financial products. Over time, they increasingly focused 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 exotic products, usually incorporating derivatives.
Banks also increased their own risk-taking. Over time, banks became principals in order to provide clients with better, more immediate execution and also increase profit margins. In some banks, this evolved into a model where the bank acted purely as “principal” rolling back the clock to the days of JPMorgan and Co.
Enhanced revenues (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. 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. The 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 returns. For example, Citigroup repurchased $12.8 billion of its shares in 2005 and an additional $7 billion in 2006.
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.
John Kenneth Galbraith, in A Short History of Financial Euphoria, noted: “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.”
Elite athletes often use performance enhancement drugs to boost performance. Voodoo banking operated similarly, enabling banks to enhance short-term performance while risking longer-term damage.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives. Comments are welcome at firstname.lastname@example.org