Monthly Commentaries

Solving the Banking Crisis. – February, 2009

The mind-boggling pace at which taxpayer funds are being used to prop up the global banking system without any apparent success has many questioning the validity of this exercise and then lapsing into despair at the prospect of a very remote and feeble recovery. Restoring confidence to the banking system is more complex than simply throwing money at it and a better understanding of some of the operating dynamics may imbue us with the patience necessary to let current efforts run their course. International banking standards have always accommodated leverage, requiring banks to maintain capital ratios of 8% to 10% of risk-weighted assets. In buoyant markets, banks significantly increased their leverage by selling off some of their assets to related, non-bank companies at a profit. This boost in capital from an apparent profit could then be levered 10 to 12 times to acquire additional assets.

Bankers further contended that their inventories of derivative products were highly liquid and warranted only a negligible risk weighting. Consequently, when the sub-prime mortgage tsunami hit, properly calculated bank capital ratios were a miniscule 2% to 4%. A markdown in asset values of this nominal percentage would wipe out a bank's entire capital. To add insult to injury, the massive de-leveraging that ensued exposed excessive leverage among many bank counterparties - other banks, insurance companies, mutual funds, hedge funds, commodity traders and other investors - limiting banks' ability to realize on their claims. The potential for a domino-style collapse threatened the financial system worldwide and is the primary reason for the current credit freeze and the ensuing economic downturn. Despite massive capital infusions from private and public sector sources, banks remain understandably reluctant to lend to homeowners with limited job security; to companies with uncertain prospects in a contracting economy or to other banks of questionable financial stability. The contract of trust has been shattered.

Meanwhile, bank profitability from operations is strong and capital ratios have been restored. Assets of questionable value are gradually being unwound, although this is a delicate and time-sensitive process. Do it too quickly and you precipitate a collapse - wait too long and there's little value remaining. The market is impatient with this process, assigning an extreme liquidity penalty to these assets. Citigroup, for example, has capital of $140 billion, but the market capitalization of its common shares is a mere $8 billion. For new lending we need government sponsored stimulus packages to break the impasse. They alone have the credibility to initiate and finance projects that can create large scale employment. They will work with the banks and partner with large private investor groups both to extend the reach of these undertakings and to limit the strain on the public purse. Improved employment will gradually restore confidence, trust, savings and lending. The sooner we start, the better. Peter Sacks Managing Partner