Stark staring bankers...5 oct 98/special comment from the financial times....
After a catalogue of errors bankers are relying on governments to provide a solution to the global financial turmoil, says George Graham
They try to disguise it, but they are panicking." Thus one Latin American finance ministry official described the long-faced bankers who are in Washington, DC for this week's parade of economic talk-ins, ranging from the meeting of the Group of Seven largest industrial countries to those of the World Bank and International Monetary Fund.
In recent years, the Bank/Fund annual meetings - the cause of their presence in Washington - have been little more than a social opportunity for commercial bankers, with perhaps the chance to lobby the assembled government finance officials for a chance to run their bond issues or manage their foreign exchange reserves.
This year is different. Now, bankers are waiting anxiously to find out what, if anything, finance ministers and central bank governors can come up with to stem the panic that has swept through financial markets.
"This could be the most momentous meeting ever," said Jan Kalff, chairman of ABN Amro, the Dutch bank, and one of a host of senior bankers who have converged on Washington for the annual meetings. "It is worse than 1987, because it is more broadly spread. Contagion, that awful animal, goes on and on and no-one is able to stop it."
Proposals from President Bill Clinton and Robert Rubin, the US Treasury secretary, to establish an expanded facility to provide emergency finance for countries in crisis drew a merely cautious welcome.
"The proposals certainly deserve not only our close attention but also our strong support, presuming, of course, that these proposals will be put forward in sufficiently effective detail," said Bernhard Walter, chairman of Dresdner Bank.
But Frank Newman, chairman of Bankers Trust, the US investment bank, warned that making more money available would do nothing to stop the contagion unless the G-7 and the IMF took a firm stand against Russia's default on its internal debt and Malaysia's abrupt unilateral imposition of capital controls.
"People are worried that any country could behave like Russia or could behave like Malaysia. To the extent that the IMF and the G-7 do not stand tall against that kind of behaviour it increases the contagion."
At the same time, the bankers are asking themselves where they went wrong. A year ago, when the financial crisis was still largely confined to a few Asian countries, it was possible to blame deficiencies in local economic policy or financial institutions. Since then, a series of disasters, culminating this month in the near collapse of Long-Term Capital Management, a US hedge fund, has thrown the spotlight back onto the banks that lavished so much money on borrowers who now appear so deeply flawed.
"There is a general theorem about loans: for every borrower there is a lender, and if you have a bad borrower, you maybe have a bad lender, too," said Joseph Stiglitz, chief economist of the World Bank.
How could the world's biggest international banks, with their sophisticated systems for assessing credit and advanced mathematical models for measuring risk, have made such a string of mistakes?
"When they say: 'There's one born every minute' what you didn't know was that they're talking about bankers," quipped Everett Ehrlich, a former senior official in the US government.
In Asia, unchecked lending in US dollars to Thai, South Korean and Indonesian banks and companies turned suddenly sour when devaluation slashed the value of their local currency earnings, leaving borrowers unable to cover their unhedged foreign currency obligations.
Western banks did not repeat that mistake in Russia, insisting on solid collateral to back their loans. Unfortunately, that collateral took the form of GKOs, Russian treasury bills which became worthless when the Moscow government defaulted - a step few banks had even contemplated when writing their risk models.
Again, banks did not make the same mistake in their dealings with LTCM. They took the best possible collateral for their loans, in the shape of securities issued by governments of the largest western countries. But by bowing to LTCM's conditions and taking no margin on these loans, they allowed the hedge fund to build up such vast exposures that even this impeccable collateral could not be called in without risking a fire sale that the bankers themselves feared might have plunged financial markets even further into turmoil.
"I am really surprised that no-one ever sat there and said: 'Let's assume for a moment that we had to unwind this position? Could it be done?'" said Mr Kalff.
Many banks made all three of these mistakes, to a greater or lesser extent. And in a few cases, the effects have been more sweeping than mere financial loss.
At Barclays, the acknowledgement of £250m of losses in Russia undid much of the UK bank's painful work during the previous 12 months to convince shareholders that it had extracted itself from the more high risk and low return businesses of its BZW investment banking subsidiary.
UBS, Europe's largest bank created by the merger earlier this year of Union Bank of Switzerland and Swiss Bank Corp, suffered much deeper damage from its bungled exposure to LTCM. The disclosure of a SFr950m (£413m) charge drove the share price down by a third in less than a week, and led to the departure of Mathis Cabiallavetta, its chairman, and three other senior executives.
Only institutions such as the UK's Halifax or Germany's Bayerische Hypo- und Vereinsbank, which have turned their backs on international investment banking in favour of domestic retail banking and mortgage lending, were able to show a smiling face in Washington this weekend.
Among the culprits blamed for the banking industry's catalogue of errors is overdependence on advanced mathematical models, many of them derived from the Black-Scholes options pricing formula, for measuring and pricing risk.
Leading investment banks have spent fortunes developing models to calculate their "Value at Risk", a theoretical estimate of the maximum loss they would be likely to sustain from the effects of market swings on a particular investment portfolio over a specified period. These models have gained such credibility that they are now recognised by the Basle Committee of banking supervisors for calculating market risk.
Indeed, the Basle Committee has recently agreed to reopen its 10-year-old capital adequacy rules, which require banks to hold a capital cushion equivalent to at least 8 per cent of their assets, after adjusting for risk by a crude formula. The goal is to allow banks to use their internal models for gauging credit risk in the same way that they may already do for market risk.
The trouble is that credit risk models are still in their infancy in comparison to market risk models.
Some of the most widely used VAR models, for example, are incapable of accounting adequately for liquidity - for the fairly obvious problem that if you try to cut your losses by unloading securities when the market falls, you may drive the market down even further.
"The problem is that regular risk management systems, particularly for market risk, take as their starting point that there are markets. In a financial crisis, there is no liquidity and no market, and that turns market risk into event risk and credit risk," said Cees Maas, chief financial officer of ING, the Dutch banking and insurance group which last week announced plans to cut 1,200 jobs in its ING Barings investment banking operation.
Mr Kalff, his compatriot, agreed: "You have always to bear in mind that these models work on the basis of assumptions. For a long time these assumptions may be correct, but you always need Fingerspitzengefühl [an instinctive touch]. The risk is that people start to believe blindly in their models."
Blind belief, however, is not driven by the models themselves, but by more basic emotions such as human greed.
"If many banks experienced losses in Russia, this doesn't mean that their risk management system doesn't function. In fact, it means they decided that their risk appetite was greater," said Georges Blum, until recently chairman of Swiss Bank Corporation and chairman of the Institute of International Finance, a Washington-based grouping of banks, securities houses, insurance companies and fund managers.
Mr Blum worries that today's bank executives and traders have lived off the fat of the land for so long that they have forgotten the harsh lessons their predecessors learned in past crises.
"Each generation has to learn for itself. We had too long a time of booming markets, and we had a generation which had not been confronted with downward cycles, and they have to learn," he said in Washington this weekend.
If those 10 boom years have blunted bankers' perceptions of risk, they have also provided them with the sinews to survive their mistakes. The 1988 Basle capital adequacy rules set banks a higher standard of financial strength, and the profits of recent years have helped most of them to meet it.
The combined equity base of Europe's banks has more than doubled since the beginning of the decade, while US banks' equity has tripled. UBS's SFr950m write-off on LTCM amounts to only 3 per cent of its equity.
That is little comfort to bankers whose certainties have been so severely shaken during the last few months. The losses they have suffered on their emerging markets investments have left them cutting credit lines wherever they can, pulling back capital and investing it for safety in G-7 government securities. Few are willing to return into what now appear to them to be shark-infested waters. |
