A huge, unexpected decline in profits. A sharp and equally unexpected rise in corporate bankruptcies. A sudden nationwide plunge in personal wealth. These are the classic early signs of a banking crisis, of the sort that has happened roughly every decade in America and has also become increasingly common in the rest of the world over the past quarter-century. Among the victims have been Britain, Scandinavia, France, Turkey, Thailand, South Korea, Mexico, Japan and Argentina.
Even without the tough economic environment, it would not have been surprising if the terrorist attacks of September 11th had caused system-wide banking failure, by disrupting the transmission of payments between banks and creating an atmosphere of fear. Yet in the event, banking and the broader financial system proved remarkably resilient. This is worth celebrating. Research into the banking crises of the past 25 years suggests that they typically cost around 25% of GDP to put right. How did things, so far, turn out so much better this time?
Clearly, after the horrors of September 11th, fortune smiled in adversity. The war on terror proceeded as planned, and there were no immediate follow-up attacks on American soil. Consumers remained confident and carried on spending, keeping both the economy and the financial system stronger than had seemed possible straight after the attacks.
It also turned out that the system was better prepared to survive the attack than might have been supposed. The elaborate precautions taken to deal with the supposedly devastating millennium computer bug, which until recently had been ridiculed as a waste of money, proved to have been an invaluable “stress test” for the financial system. They ensured that back-up systems and emergency procedures were in place when the disaster happened.
But luck was not the only reason why things turned out better than expected. Both the authorities and the market participants also showed remarkable skill in restoring the financial system after the attacks. Inevitably, there were unexpected heroes, including the usually despised local telephone company, Verizon, whose employees laboured impressively to reconnect downtown Manhattan. The interbank payments system slowed for a while after the attacks that Tuesday morning, but did not break. The bond market reopened on the Thursday. The New York Stock Exchange trading floor was back in action on the following Monday.
Textbook Response
The Fed and other central banks played their parts to perfection. In effect, they allowed unlimited lending, and suspended normal prudential requirements for banks to set aside capital against loans. Banks increased their lending to provide short-term finance for companies suddenly deprived of access to the commercial-paper market. If ever there was a time to flood the system with liquidity and deal with the consequences later, this was it, especially given the technical difficulties faced by some banks (notably the Bank of New York) in clearing payments.
Had the market started to fear that some payments would not be cleared, the resulting panic could easily have taken down one or more big global banks and many of their clients as well. The Fed, and some foreign regulators, took on enormous credit risk. But so long as the liquidity was withdrawn (which it was as soon as the need had passed), for once there was no concern about creating a moral hazard. Banks would hardly leave themselves recklessly exposed to the after-effects of a terrorist attack simply because they expected the Fed to come to the rescue.
For a crucial moment, regulators everywhere turned a blind eye to rules — for example, on solvency for insurers — that would have caused chaos if rigidly enforced. New York and London proved more interchangeable than expected. Many firms were able to shift their operations to London immediately, flying lots of staff over from America. Britain’s Financial Services Authority helped by giving instant authorisation to the workers when they arrived. Most of the banks, brokers, stock exchanges and other firms that operate the financial system also suspended their usual practice of competing at every opportunity, pulling together in the interest of the system as a whole. This has not always happened in past financial crises.
Not quite everything went smoothly. The Bank of New York discovered it had been unwise to keep its main back-up facility only two blocks from its head office. Other firms have taken note. In New York, back-up facilities are now being placed in New Jersey or even farther afield. In London, banks based in the City are opening back-ups in Canary Wharf a few miles away, and vice versa.
Is that far enough apart? “If something takes out both the City and Canary Wharf at once, there will probably be more to worry about than the health of the financial system,” says one regulator. Another explains that thanks to the steps taken after September 11th, the financial system is now “inoculated against every terrorist act, short of nuclear or other weapons of mass destruction”. That will have to do.
Bigger, Broader, Stronger
In America and the richer European countries, in particular, the financial system has undergone huge changes over the past decade. Some of them help to explain why the recent calamities did not do more damage. But not all of them are for the better, and some raise new dangers.
For the most part, the industry leaders today are no longer banks, but financial-services companies. Their activities extend far beyond traditional commercial-banking tasks such as taking in savings and making loans. Many now engage in investment-banking activities such as underwriting bond and equity issues, advising on mergers and acquisitions and, crucially, selling on loans to other investors (by organising syndicates, buying credit derivatives that pay out in the event of a default or issuing securities bundling loans together).
Enron’s use of such techniques may have given them a bad name, but many banks seem to have used them to reduce their exposure to credit risk — the traditional way they lost money — so they could remain active in the more profitable business of arranging credit for clients. Asset management, for both institutions and individuals, also accounts for a growing share of revenues, and is expected to become much more significant over the next five years. So, too, is the sale of insurance products.
A decade ago, continental European banks were typically engaged in a broader range of activities than their American counterparts, which under the Glass-Steagall act, now scrapped, had to make a choice between commercial banking, investment banking or insurance. But the big multinational financial-services firms today have gone much further than the European firms of ten years ago. They are certainly much bigger than any previous financial businesses, as measured by the latest market capitalisation of the top 15 firms compared with the 1990 figure.
A bigger balance sheet makes it easier to absorb the sorts of losses that J.P. Morgan Chase suffered when Enron went bust. There are hardly any triple-A rated banks left, but with the exception of Japanese banks — many of which might face bankruptcy without the implicit support of the government — the world’s big financial firms are mostly well-capitalised. This is thanks in part to regulatory pressure, notably through the Basel capital-adequacy standards, and in part to growing market sensitivity to the financial soundness of lenders. Today, the big financial firms mostly have more capital relative to liabilities than regulators require, though recent losses may have reduced the cushion.
Growth has been achieved both organically and through a wave of mergers and acquisitions. M&A has been particularly important in helping the big financial firms to become genuinely international in their operations. In America, where until the 1980s many banks faced severe prohibitions on expanding across state lines, M&A has also helped reduce the exposure of individual firms to any one local economy. In the 1980s, a failure like Enron’s would probably have taken down the Texas banking system. But Texas Commerce Bank, one of the company’s long-standing bankers, was long ago absorbed into J.P. Morgan, which is able to cope with bigger-than-expected losses from Enron without any serious threat to its viability. Argentina’s main banks are part of institutions based in Madrid, Boston and New York, which probably gave the country more time to deal with its problems than it would otherwise have had. Unfortunately, it did not use the breathing space to best advantage.
Overall, today’s bigger financial institutions are finding it easier to heed the old advice about not putting all their eggs into one basket. Their exposure to credit risk is now geographically diversified and balanced by exposure to risks in other lines of business which, they hope, are not closely correlated with the credit cycle. More of the credit risk has been shifted to other investors who, at least in theory, are able to suffer losses without the troublesome consequences for credit creation, and thus economic growth, that big losses in the banking system have often caused in the past. The emergence of thriving public-debt markets has anyway reduced the economy’s dependence on bank credit.
The recent bout of bubble-bursting and the huge sovereign and corporate failures of Argentina and Enron seem to have more in common with financial crises in the half-century before the first world war, when the damage from bank failures to other sectors was limited, than with the failures in the 1930s and recently in Japan, when the damage done to banks affected every aspect of the economy. Even so, there remains plenty to worry about.