The False Premises Behind Crisis Management

Key weapons in the armory of bank regulators include the concept of a resolution mechanism for defaulting banks and the principle of segregation of “casino” banking from its allegedly more stable bedfellow, retail banking.

Key weapons in the armory of bank regulators include the concept of a resolution mechanism for defaulting banks and the principle of segregation of “casino” banking from its allegedly more stable bedfellow, retail banking.

The powers to be have created an incredibly heavy bureaucracy in the event of a major bank default in Europe. Even an extended weekend will hardly be long enough to get the main players together around a table or over a conference call. There is a genuine challenge for regulators to translate the theory of resolution into practice in an inevitably turbulent market. The whole concept of resolution is similar in thinking to the assumption that a CCP, in a crisis, would be able to unwind, in an orderly fashion, the defaulted positions on one or two of its largest clients. In reality, without detracting from the need for plans and the value of the work undertaken to date, it is apparent that any resolution process will not work as planned. We have also no precedent; in the last crisis, the preferred resolution was to sell the delinquent parties to stronger banks. But subsequent litigation and government action, as well as antipathy to the “too big to fail” bank, means that avenue appears firmly closed.

Another part of the regulatory armory is based around the Volcker rule. Like a lot of the new vocabulary in the regulatory lexicon, the concept is simple but the reality is absurdly complicated. Volcker calls for the segregation of proprietary trading from retail banking. In other markets, there is talk of ring fencing as if there is a clear dividing line between the needs of the retail clients, most likely including the SME sector, and those of the large corporate and financial institutions.
Even as a signed up member of the cynics’ society, I could never have foreseen the outcome of the Volcker process. Who could design a new structure involving five different regulatory agencies, 963 pages of verbiage and 2826 footnotes at the last count? It is no wonder that Volcker is commonly known as the Lawyers Relief Act in the U.S.!

There are two logical scenarios that could activate the resolution process for a bank. The first and simplest is a crisis unique to the bank. But it is hard to imagine such an event. In a small bank, fraud could easily create a one-off event. But in the systemically important world of big banks, fraud is unlikely to drive an institution into resolution. Losses from trading are a potential unique cause for default, although the leverage ratios now imposed on banks, even in the less onerous form agreed by the regulators under pressure from Continental Europe’s cosseted national champions, would appear to limit the likelihood of these bringing a major institution to the brink.

In reality, a major default is likely to be due to a systemic event impacting a sector, or at the least a market segment, rather than a single institution. The last crash was exactly that. Investment banks were hit by leverage, substantial and unhedged open positions and poor credit analysis. The defaults were few; the entities teetering on the edge were many. Commercial banks were also hit by a common set of problems. These ranged from an almost criminally negligent abandonment of the basic rules of sound credit management through to the creation of substantial pools of trading risk, based on little more than a poorly understood belief in the power of 99.9% certainty.

The financial collapse of the future is thus unlikely to be a one-off institutional event. It is more than likely to be a linked series of defaults. Partially due to the renewed politically inspired pressure to lend, to the SME sector especially, the dual challenge of the financial sector remains one of credit quality and over-dependence on the value of property and other financial assets. As such, the carefully scripted concept of an orderly unwind of an institution in line with its resolution plan appears more wishful thinking than genuine reality.

Linked to the resolution mechanism is the concept of segregating casino banking from the apparently low-risk retail banks (although the latter were a good part of the problem of the last crash). Some form of ring fencing or segregation is needed. Some control is necessary to ensure the taxpayer does not support all activities of the banks, as occurred in the last crisis. The trouble is well scripted; quite simply it is no easy task to segregate into neat pots the banking activity that could be guaranteed by the state and that which will be left for resolution to the private sector—hence the well-meant Volcker rule and the tortuously complex world that it has spawned. Again, the sheer complexity almost guarantees that it will not succeed; the cracks will be filled but only after events that hopefully will not be the cause of crisis either by themselves or in tandem with other related or unrelated circumstances.

This is all-important for the custodian world. We straddle the world of investment and commercial banking. Our clients hold assets with us and across our network of agents and are concerned that if there is a crisis, they could lose access, rather than perhaps title, to their assets. They use us for treasury activity and any resolution will surely test the risk in products ranging from foreign exchange in flow through hedging instruments and onto the residual OTC activity they can still undertake with us. Clients have concerns about concentration risk, evidenced in the regulatory focus and concern on the desirability of big-ticket outsourcing agreements. And paradoxically, the sanguine response to the latter concerns by the industry reinforced my fears about the effectiveness of resolution planning.

Everyone is planning for an orderly world, where a crisis is an event unique to a single entity. Those are easy to resolve. We need to get together and plan for the much more difficult and potentially likely scenario of a systemic collapse affecting multiple institutions. And, strange as it may seem to some of the planners, that is not going to be a world where all are calm, where altruism triumphs, where deep pockets open and where financial markets are stable as they contemplate the chaos around them.