Via Oliver Wyman,
The Financial Crisis Of 2015
John Banks was woken by his phone at 3am on Sunday 26th April 2015. John worked for Garland Brothers, a formerly British bank that had relocated its headquarters to Singapore in late 2011 as a result of what Garland’s CEO had described as “irreconcilable differences” between the bank and the UK regulators. The last three years had been the most exciting of John’s life. Having led the bank’s aggressive expansion into emerging markets wholesale activities, he had recently been promoted to its executive committee.
John picked up the phone. It was the bank’s legal counsel, Peter Thompson, calling. He had dramatic news. Garland Brothers, one of the world’s oldest banks, would tomorrow declare bankruptcy. As he lay there in his spacious air-conditioned bedroom, unable to return to sleep, John tried to reconstruct the events of the last four years.
Planting the seeds of failure
At the beginning of 2011, the global economy was showing signs of finding a "new normal". With the exception of a few smaller troubled economies, the world had returned to positive growth, and Western stock markets had returned to their levels prior to the Lehman crisis. Banks had started lending to each other again, becoming gradually less reliant on central bank funding. Insurers had rebuilt their capital positions back to pre-crisis levels. Ireland had joined Greece in the list of peripheral Euro countries requiring a bailout, but there was a general sense that the broader contagion problems had been contained.
New bank (Basel III) and insurance (Solvency II, in Europe) regulatory regimes had been introduced and were designed to avoid a repeat of the sub-prime crisis. Banks were phasing in the new tougher controls around capital, liquidity and leverage, albeit over a relatively relaxed timeframe. The Basel Committee's impact study had estimated that the largest banks needed to raise a total of €577 BN to meet the new standards, and several banks came to market in 2011 with multi-billion Euro rights issues.
Beneath this relatively calm surface, however, trouble was brewing. Stakeholders in financial services firms wanted lower risk, but shareholders were still demanding high returns. Executives felt their institutions were holding more capital than they needed, and they were struggling to find investment opportunities that satisfied their shareholders' return requirements. Despite attempts by central banks to inject liquidity into the system, loan growth in Western economies had ground to a halt as consumers continued to deleverage and companies remained reluctant to invest, uncertain of the future interest rate, tax and regulatory environment.
The ability of banks to generate fee income by re-packaging credit books had been eliminated by punitive new securitisation rules. New consumer protection laws prevented the sale of complex derivatives to many customers. Proprietary trading by banks had been outlawed in many jurisdictions.
The talented and ambitious employees of Western banks found themselves under-utilised in an industry that was starting to resemble a utility. They needed to find new outlets for their creativity and drive.
Disappearing into the shadows
Talent began shifting into the shadow banking sector. During the low interest rate environment of 2011, investors were desperate for alternative investments with additional yield. Assets under management in the shadow banking sector grew rapidly during 2011. Asset managers were promising "inflation busting" returns but many of the strategies were based on the short-term growth prospects of the hottest markets and often employed leverage to maximise gains.
New types of specialist loan funds disintermediated the highly regulated banking sector by matching borrowers and investors directly. These funds tapped into the long-term liquidity pools of pension funds and insurance companies. Their pitch books described such investors as "advantaged holders of illiquid credit". Lacking their own distribution channels, these funds relied on outsourced origination, either through banks or networks of "hungry" agents. Credit discipline was poor. Even at this early stage, the pattern was familiar, but regulators did not intervene. Because the asset flows were global and did not have banks at their centre, no single regulatory body felt responsible.
Go East (or South) young man!
Other restless Western banks and bankers moved, not into the shadows, but into the heat of emerging markets. In contrast to the anti-banking sentiment growing in the West, many emerging markets jurisdictions were still viewed as "banker friendly". At the same time, growth opportunities in emerging markets had already encouraged some banks to base their growth strategies on these markets. In early 2011, several small international banks closed down their Western wholesale subsidiaries and re-located them to Singapore or Hong Kong. Garland Brothers was the first British bank to make the move, giving up its UK base when it decided to relocate its headquarters to Singapore in late 2011.
Western banks tackled the emerging markets in different ways. Those that had already established deposit and customer bases in emerging markets continued to grow organically, employing a well-tested and consistent set of risk standards across markets regardless of regulatory inconsistencies. Other Western players, such as Garland Brothers, that were struggling to find an edge, employed unorthodox techniques to build a presence in the faster growing markets. Some began to build large wholesale divisions in Asia and set up complex legal entity structures to take advantage of inconsistencies across regulatory regimes.
Sales of complex derivatives were once again producing a large proportion of many banks' income. Lacking an emerging markets deposit franchise, many of these Western banks started to fund their emerging markets lending activities via the wholesale markets or by tapping domestic funding sources in the West. Problems in the Eurozone meant that many European banks were paying 200-300bps above LIBOR for funding back home, and there were few opportunities in Europe to lend out such funds profitably. European banks found that lending to emerging markets banks and governments was one of the few ways of generating a positive margin over their rising cost of funds. This was part of a general trend among Western banks of moving down the credit spectrum to pick up yield.
Based on favourable demographic trends and continued liberalisation, the growth story for emerging markets was accepted by almost everyone. However, much of the economic activity in these markets was buoyed by cheap money being pumped into the system by Western central banks. Commodities prices had acted as a sponge to soak up the excess global money supply, and commodities-rich emerging economies such as Brazil and Russia were the main beneficiaries.
High commodities prices created strong incentives for these emerging economies to launch expensive development projects to dig more commodities out of the ground, creating a massive oversupply of commodities relative to the demand coming from the real economy. In the same way that over-valued property prices in the US had allowed people to go on debt-fuelled spending sprees, the governments of commodities-rich economies started spending beyond their means They fell into the familiar trap of borrowing from foreign investors to finance huge development projects justified by unrealistic valuations. Western banks built up large and concentrated loan exposures in these new and exciting growth markets.
The banking M&A market was turned on its head. Banks pursuing high growth strategies, particularly those focussed on lending to the booming commodities-rich economies, started to attract high market valuations and shareholder praise. In the second half of 2012 some of these banks made successful bids for some of the leading European players that had been cut down to a digestible size by the new anti- "too big to fail" regulations. The market was, once again, rewarding the riskiest strategies. Stakeholders and commentators began pressing risk-averse banks to mimic their bolder rivals.
The narrative driving the global commodities bubble assumed a continuation of the increasing demand from China, which had become the largest commodities importer in the world. Any rumours of a slowing Chinese economy sent tremors through global markets. Much now depended on continued demand growth in China and continued appreciation of commodities prices.
The bubble bursts
Western central banks pumping cheap money into the financial system was seen by many as having the dual purposes of kick-starting Western economies and pressing China to appreciate its currency. Strict capital controls initially enabled the Chinese authorities to resist pressure on their currency. Yet the dramatic rises in commodities prices resulting from loose Western monetary policies eventually caused rampant inflation in China. China was forced to raise interest rates and appreciate its currency to bring inflation under control. The Western central banks had been granted their wish of an appreciating Chinese currency but with the unwanted side effect of a slowing Chinese economy and the reduction in global demand that came with it.
Once the Chinese economy began to slow, investors quickly realised that the demand for commodities was unsustainable. Combined with the massive oversupply that had built up during the boom, this led to a collapse of commodities prices. Having borrowed to finance expensive development projects, the commodities-rich countries in Latin America and Africa and some of the world's leading mining companies were suddenly the focus of a new debt crisis. In the same way that the sub-prime crisis led to a plethora of half-completed real estate development projects in the US, Ireland and Spain, the commodities crisis of 2013 left many expensive commodity exploration projects unfinished.
Western banks and insurers did not escape the consequences of the commodities crisis. Some, such as the Spanish banks, had built up direct exposure by financing Latin American development projects. Others, such as US insurers, had amassed indirect exposures through investments in infrastructure funds and bank debt. Inflation pressure in the US and UK during the commodities boom had forced the Bank of England and Fed to push through a series of interest rate hikes that forced many Western debtors that had been holding on since the sub- prime crisis, to finally to default on their debts. With growth in both developed and emerging markets suppressed, the world once again fell into recession.
Judgement day for sovereigns
The final phase of the crisis saw the US, UK and European debt mountains emerge as the ultimate source of global systemic risk. Long-term sovereign yields had been gradually rising during the last few years, but analysts had assumed that this was because of increasing inflationary expectations. With the advent of the new commodities lending crisis, rising sovereign yields were suddenly being attributed to the deteriorating solvency of the sovereigns. Their high debts, combined with increasing refinancing costs, made it apparent that the debt burden of many developed world sovereigns was unserviceable. It was judgement day for sovereigns.
Those sovereigns that were highly indebted and needed to roll over large amounts of short-term debt were forced to either restructure their debts or accept bailout money from other healthier sovereigns. This period, which spanned 2013 to 2015, was the single biggest rebalancing of economic and political power since World War II.
The final irony in the tale was that the large sovereign exposures that the banking system had built up as a result of the new liquidity buffer requirements left the banking system, once again, sitting on the edge of the abyss.
Our unemployed protagonist
As John ran through these facts it became clear to him that not enough had been learnt from the sub-prime crisis. Bankers had gone chasing the next rainbow only to find another pot of toxic waste rather than a pot of gold. The new wave of regulations had proved ineffective at stopping another bubble from forming. John was struggling to understand what he should have done differently. Heads would certainly roll. But who was really to blame this time around?