Ernst’s Economy in discussion at BNR Newsroom: Investigating the downfall and nationalization of SNS Reaal, pt II

This is the second part of my blog, dealing with the last BNR Newsroom of 2013, in which the downfall and nationalization of SNS Reaal was discussed with a number of experts from politics, the banks and universities.

In the second part, the guests were: 

• Arnoud Boot, Professor Corporate Finance and Financial Markets of the University of Amsterdam;
• Michiel Scheltema, lawyer and chairman of the committee, which investigated the downfall of DSB Bank;
• Wouter Koolmees, politician of the D66 progressive, liberal party in The Netherlands.

Paul van Liempt was of course the distinguished and savvy anchorman of this BNR Newsroom.

Paul van Liempt, presenter of BNR Newsroom
Photo copyright of: Ernst Labruyère
Click to enlarge

The interview with Arnoud Boot, Wouter Koolmees and Michiel Scheltema

Paul: Michiel Scheltema, do you see parallels between the downfall of DSB Bank and that of SNS Reaal?

Michiel: The lack of coordination during the rescue of SNS Bank, was something that I was familiar with in the days of DSB Bank. Also at DSB Bank, coordination was very hard to find.

The cooperation between De Nederlandsche Bank (Dutch National Bank) and the Finance Ministry was already better during the nationalization of SNS Bank, than it had been in case of DSB.

By the way, DSB should never have had their banking license, as there was too little counter weight in place against ‘the powers that be’ at the bank (i.e. Dirk Scheringa). 

The commercial pillar of the bank was strong, but the financial and prudential supervision was very weak. DNB can be blamed for the fact that they did give the banking license to DSB after all. On top of that, even after the banking license had been handed out to DSB, the supervision by DNB remained poor.

This SNS case does bring back memories from the past.

Michiel Scheltema, Chairman of the
investigative committee for DSB Bank
Photo copyright of: Ernst Labruyère
Click to enlarge

 The current supervision has become much stronger, with Klaas Knot at the helm of DNB. Expertise in banking affairs became much more important. DNB sends its people to meetings of the Board of Directors of the big banks, as a matter of fact.

Paul: Are there really improvements in the supervision at the moment, Arnoud Boot?

Arnoud Boot:Definitely! Something has happened, of which many people thought it couldn’t happen. The crisis showed us that many things can happen within the banking industry. 

This industry has the ability to shipwreck the whole economy. The problems, which started in the US, could plummet the whole financial industry. 

Nout Wellink admitted eventually, that he didn’t see things come. This was actually true for the whole industry and for almost all worldwide supervisors.

The banks came out of the dotcom crisis remarkably well, in contrary to the stock exchanges, which lost a massive amount of money, and the insurance companies. Consequently, the supervisors thought that the banking industry had found a new and succesful business model, which protected them from harm.

The policy makers thought that the banking industry was ruled by a new paradigm, since 2002. By removing products from the balance sheets and selling the risks to the market, through securitized debt obligations, people thought that the risk profile of banks had become fundamentally lower. 

However, as a consequence of the deployed warrants, the risk came knocking at the backdoor of the banks.

In contrary to today, people and supervisors thought that securitization would lower the risk for the banks.

Ernst: What astonished me, was that certain securities and collateral were on the balance sheets of banks, against (nearly) 100% of coverage value. I am talking about collateral like mortgages and sovereign bonds of countries in the Eurozone. Was not something really wrong with the risk awareness in those days?!

Arnoud: This was the Euro-experiment at work, with dogmas like: 

• The Eurozone is stable; 
• We mutually trust our governments and act friendly to each other; 
• We don’t steer too much upon rules. 

The result of this was, that not putting the sovereign bonds of the euro-zone countries on 100% coverage value, would be seen as an act of mistrust.

The fact that sovereign bonds from all Euro-zone countries were put on the balance sheet against 100% coverage value, came from the dogma that the mutual creditworthiness within the Eurozone should not be doubted at all. This was actually a political compromise and very naive in hindsight.

Ernst: But were not ALL securities and collateral overvalued in those days?!

Arnoud: That might be true, but at least the other securities and collateral were subject to certain capital demands.

What was in fact counterproductive, however, was that Basel II alowed that the own rating models of the banks were used for the valuation of securities and collateral. 

In other words: banks were allowed to decide themselves, how much money they lended on the securities and collateral that they received from their customers. These models were fundamentally wrong, however.

Arnoud Boot, Professor Corporat Finance of
the University of Amsterdam
Photo copyright of: Ernst Labruyère
Click to enlarge

First: Some things were missing in those models that were important in hindsight.

Second: There had been a stable period of ten years. After such a long period, all risks will be underestimated by the people involved. Every parameter in the large banks' valuation models underestimated those risks.

Third: The fundamental conceptual flaw of these models was, that spreading risks does not matter anymore in times of crisis. All risks go in the same direction actually: down the drain! 

These models were based on the concept that – as a consequence of diversification and spreading risks – the risks would eliminate each other. This works fine, except… when it is really necessary: in times of crisis!

Paul: How do you judge the call for more measures and better supervision in politics these days.

Arnoud: The reason that we are now in a crisis, is that politicians massively subsidized debt before the crisis occured: 

• through the Mortgage Interest Deductability (MID) in The Netherlands;
• through the National Mortgage Guarantee (NHG); 
• and through allowing Jumbo mortgages with a 125% loan-to-cover value ratio. 

You were actually “robbing yourself”, when you didn’t have a jumbo mortgage with 125% loan-to-cover ratio and NHG, as the government gave you such big tax breaks for it.

Politics did nothing in the fifteen years before the crisis started. Of course, politicians are right, when they state that DNB supervised insufficiently and that bankers can be blamed for the crisis. However, they are guilty as well. 

The ’mountain of mortgages’  was actually created by the government.

Wouter Koolmees: I agree with the analysis upon the MID. Stimulating debt had been the bedrock of the government for a long time.

The same mechanism was in play, at the time of the so-called “Loan Shark policies”: “fiscal friendly” policies from insurance companies, which carried such high expenses, that it was virtually impossible to build up a decent lump sum amount with those. 

The Dutch government actually created the fiscal framework that enabled such loan shark policies.

The fiscal stimulation of debt has been the starting point of the government. This also had consequences for the balance sheets of the banks. And now everybody is deleveraging: the banks, the government and the citizens. 

This will take a long time to do and it will hurt deeply.

Paul: Is it enough that we make the supervision upon the banks more strict? Or is it only the starting point of a solution?

Wouter: The most important thing is that banks have more capital and buffers, in order to be able to fight a series of misfortunes. As a state official at the Dutch finance ministry, I had to deal with ABN Amro and ING Bank.

Wouter Koolmees of D66
Photo copyright of: Ernst Labruyère
Click to enlarge

Especially ING was a special case. This bank almost defaulted as a consequence of a relatively small portfolio of American Alt-A mortgages; (only)to the tune of €25 billion. This bank had simply too little capital and buffers to be able to deal with a relatively small financial blow.

Paul: Dolf van den Brink, according to you the capital buffers were not the most important problem, right?!

Dolf van den Brink: That is more or less correct. More than a 4% capital ratio is not necessary, in my opinion. The main problem of the banks resided on the DEBIT side of the balance sheet, where the loans and collateral are managed. 

In the past, even banks and financial institutions with a capital ratio of 35% defaulted, like for instance the Nederlandse Handels Maatschappij. Even with a very high capital ratio, you can take so much risk – during the hunt for yields and margin – that you might default anyway. That happened in the past.

Arnoud: The risk on the debit side (i.e. the quality of the loans) should be mitigated, as a small capital ratio is then not that important anymore. We are in favour of bringing the current banks back to the core of banking: knowing your customer and knowing his needs! Then there is no room for opportunism anymore.

The intrinsical opportunism in transaction-based banking – with its strong attachments to the financial markets and its lack of customer-knowledge – changed the risk profile of banks so much, that it turned them into time bombs.

A sufficiently high capital ratio alone is then not enough for mitigating the inconstancy of the financial markets. You have to fight the inconstancy itself, in order to prevent the downside risks on the debit side of the balance sheet from coming in play.

Summarized: you should not have too much risk at the debit side of the balance sheet and – on top of that – you should have sufficient capital on the credit side of it, in order to mitigate risk.

Paul: Is that the core of banking, Michiel Scheltema?

Michiel: I do very much agree with this. And the relation with the customers of the bank should be the core of the bank philosophy AND strategy. 

Banks must realize how society is thinking about their modus operandi. Banks do not realize sufficiently what their customers want. In meetings of the Board of Directors, the subject should be more often ‘the customer’.

Paul: Are you pleased that De Nederlandsche Bank is visiting boardroom meetings these days?

Michiel: Definitely. The younger generation is also much more aware of the necessity of a customer-centred policy. However, many banks are acting too defensively yet.

Arnoud: We have been talking about models. Models are meant as input for the decision process; they are not the decision itself. 

The decision itself must be based upon judgment. That went wrong at SNS Reaal, with respect to the supervision of DNB. DNB should have asked SNS: “What if the value of SNS Property Finance would be cut in half, how you are going to deal with that?!” 

The whole idea that the models worked fine during the crisis, is a misconception.

An important question is, how a bank can regain the trust from society. ING, for instance went much more into a dialogue with society than the other banks. That dialogue is crucial.

Michiel: If we don’t want to have a "choking" banking regulation and supervision, with 0% room for innovation and improvisation, then the banks should develop new and innovative products. 

And these products should be made with the interests of the customers in mind. That innovation is very necessary for the banking industry.

Wouter: A lot happened during the last five years: from Europe as well as national politics. Still a lot must be done, with respect to putting the customer in the centre and increasing the capital ratios of the banks. Still, there has definitely been progress in the process of protecting the customer.

The ban on commissions, which were only rewarding the sellers of products, is such an example. However, bankers and politicians are not the only guilty party in this crisis. That would be much to simple.

Ernst: The banking industry is in a split position currently. At one hand, politics is busy with mitigating risks within the banking industry. At the other hand, the same politicians are lobbying for handing out more loans to Small and Medium Enterprises (SME). These two goals can’t be combined at the moment, as most SME companies have a poor health currently, right?!

Wouter: That is indeed a devil’s dilemma. And there is actually little demand for credit now, as the economy is doing poorly. Still, we think that banking should become safer. There are many good reasons to build up solid capital buffers, in order to prevend 2008/2009 from happening again.