“More solvability does not automatically help a bank during a liquidity crisis, which the United States mortgage crisis happened to be”. My response to the Op-Ed of Thomas Gomez, master student in Economics at the Utrecht University

This morning, an Op-Ed was printed in De Volkskrant, written by Thomas Gomez, a master student in Economics at the Utrecht University. 

In this Op-Ed, Gomez argued in favour of drastically increased capital buffers at the Dutch and international banks, in order to prevent a future banking crisis from occuring again in The Netherlands and beyond.

Although I sympathize with most conclusions of his article, Gomez oversimplified the circumstances which led to the US mortgage crisis. Consequently, he missed the real point causing this devastating economic crisis – the overnight vanished liquidity in the US Mortgage Backed Securities market – by a few lightyears. 

Therefore I print his Op-Ed article integrally, while adding my comments to it.

Here is the translated version of Thomas Gomez’s Op-Ed, accompanied by my comments:

Banks should strongly increase their capital buffers

Thomas Gomez: In the aftermath of the financial crisis, there have been many conversations about invigorating the supervision upon the banking industry.

The bank lobby, however, obstructed essential changes in the heart of the bank supervision. Banks still have too small capital buffers. In order to make the banking industry safer, this ought to change. With larger capital buffers, banks will stay out of trouble more easily. And when government intervention is inevitable, it will cost less tax money.

My comments: As this article in the Financial Times shows, Gomez’ remark about the banks watering down the Basel III agreements on bank supervision is true indeed, albeit not so drastically as he seems to state (see red and bold text):

Aimed at preventing a repeat of the 2008 bank collapses, the “liquidity coverage ratio” (LCR) announced on Sunday marks the first time that global regulators have sought to require individual banks to hold enough cash and easy-to-sell assets to allow them to survive a short-term market crisis. The measure is the second critical plank of the Basel III reform package. Tougher new capital rules began to be phased in this month.

But the final rule approved by the supervisors of the Basel Committee on Banking Supervision is significantly more flexible than the draft version put forward more than two years ago. Banks will be able to count a much wider variety of liquid assets towards their buffers, including some equities and high-quality mortgage-backed securities.

The calculation methods have also been changed in ways that will significantly reduce the total size of the liquidity buffers many institutions have to hold against outflows from possible depositor runs and corporate and interbank credit lines.

Also the second part of his remark, about the capital buffers for the bank is partially true, as the following table with the annual data of 2014 for the four largest Dutch banks shows: 

Leverage ratio of the large Dutch banks at the end of 2014
Data courtesy of: ING, ABN Amro, Rabobank and SNS Bank
Click to enlarge

What makes this chart very peculiar, is the fact that the non-stateowned banks ING Bank and Rabobank are actually much BETTER funded than the stateowned banks SNS Bank and ABN Amro. This should be a warning signal towards Finance Minister Jeroen Dijsselbloem, who is the owner in chief of these last two banks.

A sourish conclusion could be, that we all know who is the lender of last resort for these aforementioned two stateowned banks: ‘Jan met de Pet’, also known as the Dutch ‘Joe Sixpack’. He is the one who has to ultimately foot the bill when investments of these stateowned banks go awry.

Thomas Gomez: Before the financial crisis, the buffers were so small, that even small losses on assets could bring a bank to the brink of demise. During the collapse of the US residential real estate (RRE) market, this led to ubiquitous distrust between banks, preventing them from lending to each other. Due to the small capital buffers, the banks had to sell large quantities of investments to compensate for losses, in order to stay financially healthy. 

This had fierce consequences for the rest of the industry, causing the crisis in the financial system to leap to the rest of the economy, with a worldwide recession as a consequence. Securitized mortgages were the spark for the crisis, while they were seen as totally safe in the eve of the crisis.

My comments: The first sentence of this paragraph is true, albeit not for all Dutch banks. As the following table with the 2008 balance sheet data for the aforementioned banks shows, 2 of the 4 banks had an almost ‘suicidal’  leverage in their balance sheets and SNS Bank was also very poorly funded. 

The Rabobank, however, was funded quite reasonably in those days and did hardly change its solvability ratio during the last seven years.

Leverage ratio of the large Dutch banks at the end of 2008
Data courtesy of: ING, ABN Amro, Rabobank and SNS Bank
Click to enlarge

Excerpt of ING's consolidated balance
sheet for Q3 and Q4 of 2008
Data courtesy of : ING Bank
Click to enlarge

I show here both the 2008Q3 and 2008Q4 data of the ING Group (see the Excel table, as well as the excerpt of the balance sheet), in order to make clear that no less than €6.7 billion in equity had "melted away" during this three month period alone. Would the €10 billion in state-aid to the ING Group not have been handed out during 2008Q4, the bank and insurance conglomerate could have become technically bankrupt in those days.

The red and bold sentence in this paragraph shows one of the main problems of this article: its oversimplification. 

Essentially, the US mortgage crisis was not caused by a lack of solvability, as Gomez seems to argue in his article, but due to the fact that the market for mortgage backed securities (MBS) virtually ceased to exist overnight. This earth-shaking event gave a devastating blow to the confidence in each others assets, between the banks.

In other words: the mortgage crisis in the United States started as an acute liquidity issue and not as a solvability issue. This is a big and very important difference.

Here is a short summary of the events in those days: 

Mortgage Backed Securities or MBS’s were bundles of mixed mortgages, originating from specialized US mortgage banks and institutions (a.o. the infamous semi-governmental organizations Fannie Mae and Freddie Mac), with a certain, standardized maturity rate. 

In order for the issuing banks to sell these mortgages to other investors and get them off their own balance sheets, these bundles were packed together in a security (i.e. the MBS) and subsequently rated by one of the three US rating agencies: Standard & Poor’s, Fitch and Moody’s. In hindsight, it has become crystal clear that many of the issued ratings in those days were overly optimistic and even ignorant.

As these MBS securities offered very good yields, in combination with a seemingly limited risk (many of the MBS's had AAA-ratings), these were extremely popular among both sellers and buyers of securities. 

It is important to realize that the MBS securities were available in three risk categories: Prime, Alt-A and Subprime loans:

• Prime mortgages were 'normal' mortgage loans to people with a stable financial position and income, for which all the paperwork was in perfect order. Although the housing prices had soared in the US during the years before 2008, most of these mortgages and the people behind them were sufficiently solid, from a financial point of view;
• Alt-A mortgages already carried much more risk. These mortgages – also known as ‘liar loans’ – were mortgage loans, issued to small entrepreneurs and other less financially solid customers. These were people, whose income was not so certain or people who could or would not provide the necessary financial records to prove their financial soundness, during the acquiring process of a mortgage. Consequently, these mortgages were much more often a question of (misplaced) trust, than the prime category; 
• The real problem, however, were the subprime loans. These were mortgages, issued to people of extremely doubtful financial soundness.
  They were for instance without a job or did not have sufficient income to pay the interest rates and amortization for their mortgage.
  
  The concept behind the subprime loans was that the value of their houses (as collateral) would always be sufficient to pay back the loans, even when the houseowner would not be financially sound after all. This was a blatant misjudgment, to say the least… 

In the years before the crisis, the MBS securities had been sold to everybody and their sister – including the Dutch large banks – as an almost fully liquid asset. They were considered to be virtually without any risk: the Prime loans, but also the dangerous Alt-A and even the Subprime loans. It was an accident waiting to happen…

Merely overnight, a few United States banks ‘found out’ that the prices of the collaterized US Residential Real Estate (RRE) would not go up forever after all and that the number of defaults among the Alt-A and especially Subprime loan holders started to pose a serious risk for the future value-at-maturity and tradeability of these loans.

A series of fire-sales actions started at a few banks and in a panicked response the liquidity of the MBS market totally dried out overnight, leading to the devastating demise of Lehman Brothers.

As a consequence, all banks holding large packages of Alt-A and subprime MBS loans (which were many of them), were virtually stuck with an enormous bunch of ‘toilet paper’ on their balance sheets. 

And to make things worse, they knew that many of their colleagues had the same bunch of toilet paper on THEIR balance sheets. These – slightly simplified – circumstances led to the dramatic stagnation in interbancary loans of 2008; not the poor solvability of the banks, although the fact that the banks had decreased their capital buffers to the bare minimum, did not help to say the least.

The conclusion remains, however, that the crisis started as a liquidity crisis and not as a  solvability crisis. Even a leverage of 1-10 (equity vs assets) or less would not have helped a bank, when it would have had a vast amount of poor MBS securities on its balance sheet in those days. The market for MBS’s was simply… dead!

Thomas Gomez: Since then things have hardly changed. The capital demands have been slightly increased, but they are still dependent on the risks that the banks take in their daily business. This risk is – among others – more or less decided with the help of risk models of the banks themselves. 

This is seen as one of the causes for the crisis. The models painted an overly optimistic picture, allowing the banks to keep their buffers small. Also the required risk rates for the risk-based capital demands are very hard to estimate. Securitized mortgages were the cause for the crisis, while they had been seen as perfectly safe before this very crisis.

My comments: I happen to disagree with this paragraph. Since those wild days in 2008, the banks fully implemented Basel II and made a start with the implementation of Basel III.

Basel II was aimed at getting better insights in the risks of the banks assets, as well as the bank’s underlying pawns and collateral. 

Basel III – albeit slightly watered down as the aforementioned FT article showed – laid down sturdy directions and guidelines, with respect to the required solvability and liquidity of the banks and systemically important financial institutions. Especially the guidelines with respect to the required liquidity ratios of banks are a strong improvement, in comparison with the situation in 2008.

Especially ING, but also the other banks, took a critical look at their assets, securities, pawns and collateral and made substantial write-offs on it, were applicable. Was it enough? I really can’t say that... Yet, I am convinced that the risks of assets and asset categories are now more visible and understood than in those days in 2008.

Even more important, however, is the fact that the risk awareness of the banks, the supervisors and the general public has dramatically changed since then.

As Nout Wellink, the former president of the De Nederlandsche Bank told me at BNR Newsroom:

“Taken apart from the ING, the system in those days was that a bank was assessed upon its solvability ratio, the so-called capital quote. The assets were measured against the lended amounts, which were risk-weighted. When the risk-weighted collateral was taken into consideration, everything was considered to be correct, for this particular bank and other banks.

What wasn't correct, however, was that the collateral for some lended amounts had a risk-weight of 0, like sovereign bonds from the euro-countries. Such were the international regulations in those days, also those from the European Commission

and the international authorities.

These regulations seduced the banks to use their available equity at the most efficient way, which means in practice: with a giant leverage.  This led to the litterally exploding balance sheets in those days: the banks thought that this was without any risk.”

I am convinced that the total lack of risk awareness, among the banks, the rating agencies, the supervisors and even the general public during the eve of the US mortgage crisis, will never show up again within our lifetime. 

The world learned a very costly and valuable lesson in those days. Things aren’t yet far from perfect, but I am convinced that they have become better during the last seven years, as supervision has been intensified and does not trust the banks on their smile alone anymore. 

The implementation of Basel II and Basel III will help to further reduce the remaining risks at the banks balance sheets

Thomas Gomez: In the Basel III agreement between international supervisors, a capital ratio is required which is risk-independent: banks should at least finance 3% of their investments with equity. This is much too low. In the crisis, banks suffered lossed that amounted to more than 6%. When banks invest more with equity, they will have more money to lose, leading to a more balanced choice between risk and yields.

My comments: Again this is a simplification of the Basel III regulations. The mentioned 3% leverage ratio is only the non-risk leverage ratio for assets. 

On top of that, banks have to keep a minimum capital buffer of 4.5% of their risk-weighted assets (loans, mortgages, derivatives etc.), plus an additional 2.5% as a capital conservation buffer. When the amount of credit is soaring in a dangerous fashion, the banks can be forced by the authorities to keep between 0 and 2.5% of their risk-weighed assets in the form of equity, as an additional countercyclical buffer.

And last, but not least: Systemically Important Financial Institutions (i.e. SIFI’s) are forced to keep an additional capital buffer with a size of between 1% and 2.5%, depending on their systemic importance.

Of course, all these risk-based ratios are dependent from the quality of the collateral and pawn in hands of the banks, as well as the importance and risk-appetite of the bank in question. Yet, it will be too simple to say that the banks are still allowed to be dramatically underfunded, when the Basel III rules have been implemented in 2019. 

One of the main problems for SME (small and medium enterprise) lending at this very moment is, that the risk appetite of the banks is still very low at this moment. At the same time, the risks posed by SME loans are still too high. This is the reason that SME lending is still faltering in the first place.

And although I sympathize with Thomas Gomez’ plan to elevate the non-risk capital ratio to 6% or even higher, this would make it so much harder for banks to become profitable and prosperous again in the future, that it would bring many banks in very deep trouble.

Investors would be very reluctant to buy bank shares, as the profits and dividends in exchange for their investments would probably remain very low. And perhaps, it could be that the banks would take even bigger risks with their investments, in order to still make a healthy profit; in spite of the reduced leverage ratios.

Thomas Gomez: Supervisors should force banks to issue new stock at fixed moments and to stop paying profits to their shareholders for a certain period. Thus, the capital buffers would be raised, while at the same time it prevents the banks from selling their investments, in order to meet those stricter capital ratios. The acquired capital could be used productively, for instance for new loans.

The heart of the bank supervision should be reassessed. Banks should be forced to finance 10% of their investments with equity, independent of the risk. A comparison with historical data and other industries suggest that even higher ratios would not be unthinkable. In the US, large banks are forced to maintain a capital ratio of 6%. While this is a step in the right direction, more is required to make the banking industry safer.

My comments: Some of his remarks are so naive. When the banks would be forced to issue new stock at fixed periods and at the same time they were strictly forbidden to pay dividends to their investors, which investor would be enthusiastic to buy or keep this stock anyway; even at gunpoint?! Dilution is an inevitable consequence of this silly proposal.

As I stated before, when banks are forced to fund 10% of their investments with equity capital, I am certain that either their risk appetite and hunt for profits will become greater or they will not invest anything at all and certainly not SME companies.

I agree with some conclusions of Thomas Gomez and I agree that the current capital ratios are not ideal yet. Yet, I am convinced that the unintended consequences of Gomez’ plans will be even worse for the banking industry, than the current situation already is.

And my most important conclusion is that a stronger solvability will not help one bit against an acute and severe liquidity crisis, as the US mortgage crisis turned out to be. That is one of the most important lessons from the mortgage crisis in 2008