Critical conduits

We’ve come to learn, over the past few months, that banks are not typical businesses. They are basically huge conduits for distributing capital from savers and investors to other business that need to borrow in order to grow, for example, by financing the purchase of new equipment or facilities. As they are the trusted ones who manage the lifeblood of modern economies, they are critical to our economic welfare.

Private regulated entities

Western economic policies assume that private entities are more efficient and effective at distributing capital compared to governments or public agencies. While this is probably true, especially if we consider cases from the past, it does not preclude the importance of strict oversight of these businesses. Free market principles may lead us to believe that, as banks are businesses, they should be left to manage their own activities freely – that government intervention is not desirable.

On the contrary;  due to their critical importance to the economy and the systemic risk to it if they fail, intervention is necessary, at least at a regulatory level. If the state obliged to step in and bail out banks in the event of a crisis, the banks bear special responsibilities and should concede to more transparency and restraint.

Shareholder pain

The owners of the banks, its shareholders, gain handsomely during times of economic growth. In a normal, cyclical economic downturn, their gains are reduced in terms of lower dividend payments and lower share prices, however, this would normally recover once the economy recovers. The financial crisis of 2008/2009 is not, however, a typical cyclical economic downturn – see review here. Instead of a downturn and corresponding fall in bank share prices, some banks have collapsed and others are on the brink.

The lack of effective oversight from financial regulators have given banks the freedom to speculate excessive amounts of capital in risky asset classes including various types of derivatives, subprime mortgage-backed securities and collateral debt obligations. The unexpected fall in stock markets means that banks are now suffering from large losses on their balance sheets. Banks are required to maintain certain capital adequacy ratios, and their shrinking capital bases results in non-compliance with these minimum ratios.

To increase their capital, they issue new share either to private investors or the government. Issuing new capital effectively decimates their profits (or more likely increases losses) in the case of an issue of preference shares with high interest rates, or dilutes existing shareholder value by issueing new ordinary shares.

Bank shareholders, therefore, have suffered like a shareholder of any company would. Many of us would not feel any pity for shareholders, however, we are all affected by drops in both public and private pension funds. We are all shareholders in some sense.

Banking casualties

The list of banking casualties of the crisis reads like the who’s who of global finance:

Bankrupt, nationalised or forced into acquisition

US	AIG, Merrill Lynch, Lehman Brothers, Bear Stearns, Fannie Mae, Freddie Mac, Washington Mutual, Countryside, Wachovia
UK	HBOS (Bank of Scotland, Halifax), Royal Bank of Scotland, Lloyds, Northern Rock
Eurozone	Hypovereinsbank, Anglo Irish Bank, Fortis…

Bailed out or at risk of collapse / nationalisation

US	Citigroup, Bank of America, Wells Fargo…
UK	Barclays…
Eurozone	Allied Irish Banks, Bank of Ireland, Erste Bank, Raiffeisen Bank, Societe Generale, Unicredit, KBC Bank, HSH Nordbank…

Also the Icelandic banks Glitnir, Landsbanki, Kaupthing, although relatively small, have the dubious honour of being the main actors in the ongoing crisis in Iceland – the largest suffered by any country in economic history relative to the size of its economy.

Another banking collapse worth mentioning is Anglo Irish Bank in Ireland – primarily a lender to property developers and construction companies. It was nationalised following a staggering fall in their share price and lack of confidence in them by the financial markets. Read more here.

The Privileged Class

The privileged class is not shareholders, but bank directors, board members and top executives who continue (apart from Lehman Brothers) to receive exorbitant salaries. Even in the few cases where these have been cut and bonuses eliminated, they know that the cutbacks are temporary and will continue in the realistic expectation that their fat pay cheques will be restored in the future. Only in a few cases have bank directors, board members and top executives they been dismissed from their positions. This privileged class wins handsomely in good economic times but is not sufficiently penalised in downturns due to the systemic importance of banks and the government’s (understandable) reluctance to allow a major bank to collapse.

Fallout

The double impact of the need to preserve capital and the reluctance to lend to other banks in fear of possible toxic assets that they may hold on their balance sheets has frozen lending throughout the economy. Business need capital for expansion, as mentioned above, so there is medium term impact on economic growth. In many cases, some solid business need access to short term finance for its working capital to fund normal daily operations andsatisfy maturing short-term debt. Suddenly finding that they have no access to capital, companies have responded by cutting back on investment, laying off staff, and, increasingly, by declaring bankrupcy. The economic impact from the financial crisis is massive.

See also an article about where the responsibilty lies here.