What exactly is wrong with the banks? A year and a half after the credit crisis started, this may seem a bizarre question. But there is actually still a lot of confusion about what’s the matter. Indeed, that confusion – displayed on endless television programmes and around countless dinner tables – is adding to the sense of crisis. Fortunately, governments seem finally to be waking up to the threat. Last weekend’s meeting of the Group of 20 finance ministers said its key priority was to tackle problems in the financial system head on.
Normally bank crises come in two types: liquidity and solvency ones. Indeed, a severe liquidity crisis erupted after Lehman Brothers went bankrupt last September. But emergency action by authorities around the world stopped that. Depositors and other counterparties are no longer pulling their money from banks.
So are we now in a solvency crisis? Have the authorities merely postponed the evil day? This is the zombie theory of the current crisis, enunciated by the likes of Nouriel Roubini, the bearish professor of New York University’s Stern School.
Under the zombie theory, the financial landscape is being haunted by the living dead. They would be insolvent if only they recognised the losses they are going to get hit by as the economy deteriorates. The two main US culprits are Citigroup and Bank of America, though some cast the net much wider.
Such zombies are damaging the economy because they are so desperate to avoid bankruptcy that they are shrinking their balance sheets, starving customers of credit and overcharging those to whom they do lend. On this theory, the world will endure a no-growth decade, like Japan in the 1990s.
This is an exaggeration. Banks will suffer massive losses as a result of the crisis. But today’s banks have been much faster to recognise their problems and refill their capital coffers than Japanese banks were.
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The situation in the US is usefully summarised in a paper by Douglas Elliott, a fellow at the Brookings Institution. Banks and brokers have already effectively raised $530bn in capital.
Meanwhile, they will collectively earn another $500bn in the years 2008-2010 before write-offs. That $1 trillion buffer will be enough to absorb the $900bn of losses estimated by the IMF and the $1tr forecast by Goldman Sachs – and still leave them with the same amount of capital that they started with.
In the UK, there have also been huge bailouts.
In the last few weeks, HSBC has raised $18bn of new equity privately, while RBS and Lloyds have received massive guarantees from the government which should protect them from catastrophe. Barclays is the only bank over which a question mark remains.
Corrosive uncertainty
But this doesn’t mean that everything is OK. The key problem is the huge amount of uncertainty about how bad the losses will get – particularly in the US. That’s largely a function of how far house prices fall and how much unemployment rises. Roubini, for example, currently estimates that losses among US banks will reach $1.8tr.
That would sink some big institutions, even after factoring in the earnings that they will be racking up in the meantime. The banks seem to share some of this uncertainty. Despite their confident predictions that all is fine, they are worried and reining in lending.
Some caution is healthy, after the excesses of the credit boom. But, in their desire to shrink their balance sheets, weak banks could make it harder for borrowers to roll over their debts. This affects individuals with credit cards, companies that need to refinance and borrowers in emerging markets. If they can’t get finance – or fear they can’t get it - they will tighten their belts or, in the extreme, go bust.
Of course, the bank crisis is not the only reason why confidence is shot to bits; rising unemployment is also to blame. However, the endless torrent of bad news about the banks has had a corrosive effect. The result is that people and companies don’t want to borrow – even when banks are willing to lend. Again, some borrower restraint is welcome after past extravagances. But even those who didn’t splurge out have become more cautious. So investment is being slashed and people don’t want to buy homes or cars. That’s unhealthy.
Judgment Day
Essentially, the banking crisis has become a confidence crisis caused by uncertainty over whether the banks will survive. The prime goal of policymakers should therefore be to end that uncertainty. They have already started to do this. But the job is not complete.
The Obama administration, in particular, has not yet been able to show that the banks are protected against the worst-case scenarios. To be fair, Tim Geithner said on February 10 quite a lot about what the administration wants to do. The US Treasury Secretary said he will set up a fund in partnership with the private sector to buy up the banks’ toxic assets.
He promised to give undercapitalised banks preferred shares that convert into ordinary shares if the banks’ equity falls too low. The administration has also suggested that it might need another $750bn to bail out the banks – on top of President George Bush’s $700bn programme, not all of which has been spent.
Such a package of measures should be enough to put the banks out of harm’s way. But until the details are spelt out, nobody can be sure. The stress test that will determine which banks need capital and how much won’t be complete until the end of April. The numbers behind the toxic asset fund haven’t been worked out either.
This information vacuum has further increased the uncertainty. All sorts of new solutions and scenarios – such as nationalisation – are being thrown into the public arena. There is also concern that bailing out Wall Street has become so unpopular that Congress won’t give President Barack Obama any more money.
The delay until the end of April was a mistake. That said, we are where we are. The priority now is not to compound the error through any more dithering. Geithner said at the weekend that more details would be revealed on the toxic asset fund shortly. Provided the scheme adds up, that will be progress.
Meanwhile, April 30 has been set as a sort of Judgment Day. It is vital that, at that point, President Barack Obama clearly separates those that need support from those that don’t – and secures adequate funding from Congress to achieve this task. His goal should be to make it impossible from that date for anybody to argue credibly that the world is still being stalked by zombies. If uncertainty is dispelled, confidence – and, with it, the economy - might then rebound.
