The bigger they are Oct 26th 2000 From The Economist print edition

Are big banks in America and Europe heading for another crisis?

BTHEY may have invented a better mousetrap,B muses David Gibbons, Bbut I doubt it.B Mr Gibbons is the man responsible for looking at American banksB credit riskBthe risk that those to whom they lend may go bustBat AmericaBs Office of the Comptroller of the Currency (OCC). For all that the banks he oversees seem to have found a way of generating huge profits fairly safely, Mr Gibbons think that they have been underestimating their risks. The OCC is only one of AmericaBs myriad bank regulators, but, along with the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC), one of the more important ones. And whereas the Fed seems sanguine about American banksB prospects, Mr Gibbons has been sounding insistent alarm bells for the past couple of years.

The biggest, most sophisticated banks claim that they are now well managed and understand their risks better, and investors seem to believe them: the prime example is the mighty Citigroup, a global financial-services firm, which currently has a market capitalisation nearly six times as big as the top ten banks put together a decade ago. But Mr Gibbons and some of his counterparts in other countries remain unconvinced, and their doubts are understandable. There have been too many banking crises in recent years to put much faith in banks. Just think back to the Latin American debacle of the 1980s; the savings-and-loan trouble in America in the early 1990s; the insolvency of many big Scandinavian banks around the same time; the huge problems at FranceBs CrC)dit Lyonnais; and, last but not least, JapanBs rumbling, hugely expensive and still unresolved banking crisis.

Here comes trouble There are now signsBtentative for the moment, but worrying enough alreadyB that big banks are messing up again. Three problems stand out. The first is that problem loans in America are increasing, even though the economy is still bowling along at a fair rate. The second is that recent turmoil in the capital markets may well have caused difficulties for some of the commercial banks that have been rapidly expanding their investment-banking businesses in recent years. And one reason for this is the third problem: the banksB huge lending exposures to telecoms firms.

Take the last one first. The worries here involve mainly Bconcentration riskBBthe risk that banks have too many eggs in one basket, and if the telecoms basket breaks, so will the banks. Most, though not all, of these worries are in Europe. But they involve not only European, but also some American banks. Under the aegis of the Financial Stability Forum (FSF), a committee of the great and the good formed after the financial crisis that followed RussiaBs default in 1998, regulators have started to take a close look at banksB exposure to telecoms.

BritainBs Barclays offers a good example of the depth of some banksB involvement. At its peak, Barclays had telecoms exposures of some $20 billion. Most of these were (and still are) to just three companies: Vodafone, British Telecom and Orange. Its exposures have now been reduced somewhat, thanks partly to regulatory pressure. But regulators are still trying to tot up the overall size of large banksB exposures; whether they took those positions in a way that demonstrated adequate risk management; and whether, if some telecoms companies went belly up, they might threaten the lives of their lenders too. Regulators do not as yet have any good answers, though one of them says the sums amount to Bmany tens of billions of dollarsB. There are myriad ways in which banks can acquire such exposures, so building up a comprehensive picture is fiendishly difficult.

Still, since investors have lately shunned all manner of high-tech stocks, not least telecoms, it seems a pretty safe bet that those who have been most active in the syndicated- and bridging-loan markets have been left with the biggest exposures (see charts). Those banks with weak investment-banking franchises and poor distribution, which have been using their balance sheets to try to muscle into the business, are probably the most exposed.

Their problem is that after the exuberance of late last year and earlier this one, investors have become increasingly reluctant to buy telecoms assets of any sort. The price of their shares has dropped, and the yield of their bonds has risen steeply (see chart). The worries have centred on the $300 billion or thereabouts that telecoms firms have had to or will have to fork out on buying third-generation licences and on building the infrastructure. Rating agencies have already sharply downgraded telecoms companies because of the huge amount of debt they have had to take on. BanksB ability to reduce their exposures to telecoms companies will depend on investors regaining their appetite for such debt. Since such firms have been issuing masses of debt to pay for mobile-phone Internet ventures, which may or may not earn them a profit some time in the distant future, this may take time.

The longer that investors eschew telecoms assets, the worse the situation becomes for the banks that have lent to such firms. If telecoms firms are unable to float their mobile-phone arms, for example, they will find it well-nigh impossible to reduce their debt levels. And if they fail to do so, rating agencies, although they have given telecoms firms a period of grace, will eventually have little option but to downgrade them again. The effect will be, first, to make new finance more expensive, which will put further pressure on the telecoms firmsB ratings. Second, it will sharply reduce the price of their debt in the secondary market. For banks which have lots of this stuff tucked away in their trading books (banksB loans are not generally valued at the market price), this would mean even bigger losses.

The biggest telecoms borrowers are generally erstwhile national telecoms monopolies, such as British Telecom, France Telecom or Deutsche Telekom. For the moment, all have fairly steady cash flows with which to service their interest payments. Unless things get dramatically worse, European regulators think that none of this should be life-threatening.

Crossing the pond But if they are relatively comfortable about banking in Europe, the same is not true for banking in America. BItBs an area we have been following, and a number of regulators have concerns,B says one member of the FSF.

At first sight, that seems odd. American banks are better capitalised, bigger, more diversified, more profitable and more sophisticated about risk management than ever before. If you believe them and the Fed, that is.

Mr Gibbons, for one, is unconvinced. In particular, he worries about American banksB phenomenal profitability. Over the past four years, banks in America have made, on average, a return on equity of 16.5%. In international terms, that is a stunning result. How have they managed it? By taking ever more risk, thinks Mr Gibbons. And for that, thank some of the recent changes in financial markets.

The first is deregulation. In many ways, this has been a good thing. Since 1994, banks have been free to spread their wings across state borders, making them less susceptible to problems in any one region. Thanks to a loosening of the division between commercial and investment banking dictated by the Glass-Steagall act, commercial banks have also been able to get into the investment-banking business. J.P. Morgan almost reinvented itself as an investment bank (though not, it transpires, a particularly successful one: it has just been swallowed up by Chase Manhattan, a bigger bank that also has investment-banking pretensions).

But there is a downside to deregulation. It has been behind just about every banking crisis of recent times. Banks have opened their coffers and lent as if there were no tomorrow, either simply because they were able to do so, or because they felt they had to stop new entrants to the market eating into their business, or both.

America is no exception. In fact, it may turn out to be worse, for three reasons: the countryBs love affair with equities, its marvellously sophisticated capital markets, and the cult of the new economy. The three are connected. Investors have piled into shares in recent years, leaving them richly valued by historic standards even after recent falls. But any company whose profits have not grown rapidly has been shunned, making it vulnerable to takeover as well as rendering worthless the vast piles of stock options given to senior management. To avoid that fate, bank managers, long thought of as sober sorts, have, in effect, tried in all sorts of ways to turn banking into a high-growth business. They have bought other banks, slashed costs, gone into pastures new and taken more risk, in many different guises.

Some 60% of American banksB profits still come from lending. As many of the more creditworthy companies have gone to the capital markets in recent years, so the quality of banksB loan portfolios has been sharply reduced. The extent of this decline has been disguised by a booming economy.

Banks, which themselves have become more leveraged (by taking on more debt compared with their equity), have lent to companies that, in turn, have also become more leveraged. At book value, the debt-to-equity ratio for AmericaBs non-financial companies has risen from 72% in 1997 to 83% this year, according to Mr Gibbons. At market value, this has contributed to a huge increase in the risk of default over the same period, according to KMV, a research firm.

LetBs leverage A good example is the syndicated-loan market, where the proportion of so-called leveraged loans (bridge loans) has climbed rapidly. Regulators define such loans as those where the borrower has debt of three-and-a-half times equity or more. In 1993, some 7% of new syndicated loans were leveraged; by the first quarter of this year, the figure was a troubling 36%.

Although the number has now dropped a little, that is scant consolation: the old loans made on easy terms are still on banksB books. And the problems are now starting to show up. In early October, the three biggest bank regulatorsBthe Fed, the OCC and the FDICBreleased figures showing a sharp deterioration in the quality of syndicated loans. In total, they reported, loans that were, or might be, problematic came to some $100 billion. The worst of theseBso-called BclassifiedB loansBtotalled some $63 billion, a 70% increase on the previous year (which itself saw a 70% rise from the year before). The only industries to fare well were, perhaps unsurprisingly, oil and natural gas.

Michael Mayo, until recently the top banking analyst for Credit Suisse First Boston, thinks that leveraged lending has been responsible for the recent increase in bad or problematic loans at a raft of American banks, including Bank of America, FleetBoston Financial, Bank One and Wachovia.

There are other signs of risk-taking. In the past few years, banks have started to take more private-equity stakes in companies. Chase Manhattan is the best-known and biggest such investor. But Bank of America, FleetBoston Financial, First Union, Bank One and Wells Fargo all have big venture-capital operations. Many of these stakes are in high-tech firms. Since Nasdaq commenced its fall in March, profits from such operations have tended to disappear. In its latest results, Chase wrote down $563m in its venture-capital portfolio. Its shares fell precipitously.

How much, you might ask, do other American banks rely on such stakes, or on other capital-markets business that they may be ill-equipped to handle? The markets have been abuzz with rumours about losses at some banks (mainly investment banks) in the high-yield (junk) bond market recently. The most talked-about banks, Morgan Stanley Dean Witter and Deutsche, deny they have had big problems, but they are unlikely to be the only ones to have suffered. Most banks in this market carry large positions, and the market, as well as falling sharply, has almost dried up: bids on many issues are almost impossible to come by.

A stockmarket crash or a long bear market would cause still more problems. For example, will the mutual-fund industry prove as lucrative if the stockmarket enters a bear phase? The example of bond mutual funds, which suffered huge redemptions because of a bear market in corporate bonds, suggests not. And the present jittery market is already causing big headaches for banks with large overheads. The market for initial public offerings has ground to a halt, as has that for secondary offerings.

Consumer finance is not necessarily a money-spinner any longer either. Mr Mayo, for one, thinks that consumer loans might be the next big problem for banks. Already, he points out, banks have had to write down a fair amount of lending on cars because banks were too optimistic about the residual value of the cars that backed the loans. Worse might be to come in other areas.

One potential worry is sub-prime lending: loans to people with a bad credit history. Again, although the growth in this business has fallen off lately, banks still have on their books the loans they have already made. Then there is the credit-card business. Charles Peabody, an analyst at Mitchell Securities, is especially worried about credit-card debt. In the mid-1990s regulators came down hard on unsolicited card offerings. Since then the industry has largely ignored regulatory admonitions. Mr Peabody thinks that consumers are using credit cards to maintain a standard of living they cannot afford. BSuch increasing debt burdens are unlikely to prove sustainable,B he says. That would be especially true if the economy were to slow down drastically.

Mortgages are another difficult area. Many banks have transferred credit-card loans to home-equity loans, which are tax-deductible for the borrower and offer collateral for the lender. But, as with car loans, their attraction depends on property prices holding up and the economy continuing to thrive. If they do not, things might turn ugly. BBig banks seizing homes is not a pretty sight,B says Mr Mayo.

Not all of the risk taken by banks has been so visible. Take the financial alchemy that goes by the name of securitisation. Big banks have sold bundles of loans to investors who want assets that have a specific credit quality. The apparent effect is to take loans and risk off banksB balance sheets and thus free up capital. In fact, although it does free up capital, it shifts very little risk from banksB balance sheets, say many regulators. That is because banks have to put aside less capital for the same risks. The Basle committee that considers the rules governing banksB capital ratios is now trying to rework them, mainly because it thinks too many banks have found ways to get round the existing capital rules.

Did you say capital ratio? If that is so, and most regulators think it is, it raises questions about how much store should be set by American banksB capital ratios. For the big banks, these now average a seemingly healthy 10.4%, 2.4 percentage points higher than the regulatory minimum. If banks have taken on so much more risk, both visibly and invisibly, they should have more capital. But in risk-adjusted terms, the number is almost meaningless.

In a recent report, Keefe, Bruyette & Woods, a securities firm that specialises in banks, found it Binteresting that so many chief credit officers (and other senior bankers for that matter) have decided to retire or resign in recent monthsB. The implication seems to be: get out while the going is good.

All of this, it is worth noting, comes at a time when the American economy has been booming. After nine straight years of economic expansion, perhaps some deterioration in credit quality is to be expected. But the extent of that deterioration is beginning to look more than a little worrying. And what would happen if AmericaBs economy went into recession?

Defaults in the bond market are already at their highest since the recession of the early 1990s. Those who have tapped the bond markets are, presumably, the better borrowers. So why have there not been more problems from those that have borrowed from banks? And why, given that problem loans are rising, have banks not put more reserves aside?

The two are not unconnected. Defaults in the bond market are a relatively straightforward process. Defaults to banks, in contrast, are rather more negotiable. It is largely up to the bank to decide when a borrower has problemsBand unless forced, it is not in its interest to do so, because its shares would be hammered. So even though problem loans have now been rising for the past eight quarters in a row, some analysts think that the numbers produced by regulators still underestimate the scale of the problem.

Nor, therefore, should it come as a surprise that banksB reserves against bad debts are at their lowest since 1986; indeed, according to Mr Mayo, adjusted for risk and for banksB greater off-balance-sheet exposures, they are at their lowest in 50 years.

More of a surprise is the extent to which American regulators disagree about the reserves which banks should put aside against doubtful loans. The Securities and Exchange Commission (SEC), AmericaBs main stockmarket watchdog, dislikes banks putting aside reserves unless bad loans are actually piling up. This is because reserves can be used to manipulate profits. Banking regulators advocate much greater caution. BBanks get the impression from the SEC that they shouldnBt be putting aside money against potentially problem loans,B says one of them. And the SEC is more than a little powerful. BThey are unbelievable,B says the same regulator. Banking regulators and the SEC signed an agreement trying to iron out their differences about such matters last year, but it has had little effect.

So there are worries aplenty in both Europe and America that banks may have, once again, overstretched themselves. In America, the problems will probably be containable as long as stockmarkets do not crash and the economy does not go into a recession. In Europe, banksB problems will be resolved if investors regain their taste for telecoms. But in both regions, these are big BifsB, and unless they come right, banks look vulnerable.

Moreover, some of the biggest lenders to telecoms companies in Europe are those American banks that have taken lots of risk back home. Chase Manhattan and Bank of America are two that spring to mind. They must be keeping their fingers crossed that their mousetraps really are better, and the mice no bigger than they were.

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-- Martin Thompson (mthom1927@aol.com), November 02, 2000