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The Bankers are not to blame - so who is?

Posted on Jan 13, 2011 by Sandy Finlayson  | 0 Comments

The term “Banker” derives from “bianchere”, the merchants who sat on benches in medieval Florence and Venice taking surplus capital from those who had it and lending it to those who needed it in exchange for a rate of interest commensurate with the risk involved. Over the centuries this simple process of transferring capital from those who have it to those who need it has generally operated as a force for good. It facilitated the industrial revolution and the enormous growth in living standards enjoyed by Western societies as well as the dream of home ownership enjoyed by many millions of people. We all know lots of bankers, decent honourable people involved in the straightforward business of banking based on the “4C principles”, namely:- Character, Collateral, Cash flow and Credibility. Many of them have been badly hurt in the financial crash with the loss of their employment and in some cases their lifetime savings. How can it be that so many giant financial fortresses, once thought impregnable, could have been reduced to rubble in such a short space of time? The bankers have been left to clear up the mess, of which more later, but the tragedy itself was brought about by many other actors who fall into a number of distinct categories:- • The Politicians The appeal of the Glass-Steagall Act which was implemented after the Wall Street crash in 1929 to segregate “narrow banks” and “casino banks” and the desire of the Clinton administration to extend home ownership to all is regarded by many as the starting point for the events which subsequently unfolded; • The Quants The majority of us would not regard a synthetic CDO2 insured with CDSs and a AAA rating as a natural home for their money. These toxic structures have been developed over the past thirty years by mathematicians and physicists employed by the banks. They are based on probability theory and are the ultimate in financial alchemy chasing the holy grail of completely risk-free lending. Unfortunately, they proved to be a deadly virus which infected and nearly destroyed the global financial system. Readers of this article should be aware that these toxic financial structures are still being created and sold today. Bad drugs with lethal side effects are withdrawn from sale with attendant consequences for the company which developed them. Unfortunately, no such strictures apply to deadly financial instruments. • Mortgage and Finance Brokers The City and Wall Street discovered there was so much money to be made in creating and selling these toxic products that the market exploded. Vast amounts of new debt had to be created to meet the insatiable demand to invest in these toxic structures. This was achieved through an army of mortgage and finance brokers who were incentivised to sell debt to those who did not understand it and could not afford it (the so called NINJA - No Income No Job No Asset) mortgages and the explosion of credit card debt. It led to fraud on an industrial scale with “liar” mortgages (false income declarations) becoming the order of the day. • Regulation There was an astonishing failure of regulation. Over the past twenty years the Basel regime has been developed to ensure that banks maintain a tier one capital ratio of 10%. Unfortunately the banks did not regard this as an “efficient” use of capital and devoted much ingenuity to finding ways of bending the rules as far as they could without actually breaking them. RBS for example had £0.02 of capital of every £1 of lending and it was by no means unusual. The net result was that all of the resilience which should have been built into the system was deliberately designed out of it in order to maximise short term profits. While all of this was happening the explosion of toxic structures took place outside the regulated banking system in the “shadow” banking system and over the past twenty years the “shadow” banking system became as big as if not bigger than the regulated system. The global financial system therefore gradually became a bit like an iceberg. The regulators could see what was going on above the surface but had no visibility whatsoever over the vast shadow banking system containing the virus which has had such a deadly impact on the global financial system. • The Ratings Agencies Those involved in buying toxic assets relied absolutely on the ratings placed on them by the Ratings Agencies in the same way that a house buyer relies on a valuation. Unfortunately, the Ratings Agencies were paid by those to whom they gave the rating, giving them a massive conflict of interest. It is now clear that, in many cases, they had little or no idea of the risks involved and did not carry out the level of analysis which they should have done. • Proprietary Traders The toxic structures created by the Quants had to be sold and traded for which the services of proprietary traders are required. These are the individuals employed by the banks to deal in these toxic products earning vast bonuses for their efforts in doing so. The expression “socially useless” has entered the lexicon of the English language to describe the activities of the “proprietary traders” who are involved in dealing in these products. These are the people who are still today earning enormous bonuses for perpetrating instability in the financial system and doing something which may, to in many cases, be “socially useless”. • The Directors Much has been written about the financial collapse in America but business writers in the UK have been much slower off the mark. However, it becomes increasingly clear that the directors of those financial institutions which have failed, had no idea what they were doing. There is evidence everywhere of arrogance, ego, hubris, incompetence, ignorance and in some cases down right criminality. It is increasingly clear that the directors of the banks which failed had absolutely no idea of the risks inherent in the businesses for which they were responsible and which were being undertaken by their employees on a day by day basis. There was a colossal failure of governance and it is right to ask whether any individual should be expected to accept the responsibilities and risks associated with sitting on the Board of a company which is simply too big and too complex for any one individual to understand. • You and Me In the final analysis however we cannot just blame the financial community. We did not need to take on the levels of debt which we have done but it was like giving heroin to junkies. Easy credit was just too hard to resist and far too many of us have fallen into the trap of taking on far too much debt. • The Consequences As soon as the American housing market turned down investors started to realise that many of the toxic structures which they had been sold were just that, resulting in the freezing of the inter-bank lending market and a run on the clearing banks. This has meant that the banks ran out of money, many had to be wholly or partly nationalised and they have had to focus on working out their toxic assets and re-building their battered balance sheets rather than engaging in the business of banking. As a result, savers have witnessed an enormous decline in their savings income and borrowers have found themselves increasingly under attack by banks looking for increased margin and early repayment. • Breach of Covenant Most loans are made with lending covenants, being the ongoing conditions which must be fulfilled by the borrower in order to avoid a default. The banks are now going through all of their Facility Letters and Term Sheets looking for evidence of breach of covenant. This is the “trigger” which gives the bank the opportunity either to demand immediate repayment or alternatively to demand an increase in the lending margin. The borrower may find himself confronted with the option of re-negotiating his facility on less favourable terms or accepting an Independent Business Review (IBR) which could result in a much less favourable outcome. • The IBR Term Sheets and Facility Letters usually give the bank the right to conduct an IBR if they are concerned about the possibility of breach of covenant. This gives the bank the right to appoint a large accountancy firm of its choosing to conduct a thorough review of the business and make a confidential report to the bank. The borrower has no say in whether an IBR should or should not be carried out, no influence over the appointment of the firm of accountants and no control whatsoever over the price charged for the IBR which will simply be debited against the borrower’s account. The borrower may not even be given the opportunity to review the IBR which is prepared for the benefit of the bank and not the borrower. • Trust and Relationships Good business is largely dependant on the mutual trust, respect and relationships which are built up over many years. Unfortunately major financial institutions have seen their reputations destroyed overnight and the mutual trust and relationships built up between senior and well respected bank managers and their customers has been completely destroyed. The more the clearing banks now invest in an army of major accountancy firms to conduct IBRs and lawyers to look for evidence of technical breach of Term Sheets and Facility Letters the longer it will take them to regain the trust and confidence of their customers. • Can we Manage without Banks It is a basic truism that you cannot finance an equity risk with debt. The business world has learnt the dangers of over-leverage and there is an enormous need to increase the availability of capital to SMEs so that they can build their businesses without having to resort to debt. Happily, the Government has listened and has responded to the concerns of business in its response to the “Financing a Private Sector Recovery” paper. In time, this may gradually allow us to rebuild our business base with a proper balance between debt and equity. In the meantime, the banks would do well to remember that their very future depends upon their ability not to engage clever lawyers and accountants to find and trigger technical breaches of covenant but to restore the trust and confidence of the business community. • Holding to Account About forty years ago the distillers company was the largest company in Scotland. They diversified into pharma and licensed in a drug called thalidomide which ultimately cost the company its independence. The concept of product liability originated in Paisley with the famous case of Donoghue and Stephenson about a snail in a bottle of ginger beer. Trust and integrity should be at the heart of the financial services industry and there is no reason why it should be exempt from the basis tenets of product liability. Customers who have been sold bad products by their Bank should not find themselves intimidated. If the Bank was responsible it should bear its share of the responsibility. We must ensure that we learn all the lessons which need to be learned from the financial collapse so that it cannot happen again. That can only be done by identifying those who are responsible and bringing them to account, at the same time ensuring that many decent honest individuals and businesses do no find themselves innocent victims simply because they have been in the wrong place at the wrong time. Sandy Finlayson Senior Partner

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