Rocky Banks

2011-SEP-03

The banking crisis of 2008 alerted us to the risk of a systemic collapse of the banking system. Today these fears again seem very real, with concerns over the European banks and the share prices of banks everywhere having taken a big hit recently. Splitting the banks into domestic lending and investment banking has also returned to the top of the political agenda in Britain this week.

There is a contrarian adage that when no one expects an event, it might happen, and when an event is commonly expected it might not happen. This could apply to the much-heralded banking collapse. But since the Bear Sterns and Lehman crisis the banks themselves have been busy rebuilding their core capital and adjusting their business activities in line with the new Basle III regulations and the Dodd-Frank Act in the US. In Britain, regulation of the banks has moved back from the FSA to the Bank of England, where it belongs. Both the banks and their regulators, having had a very nasty shock three years ago, have taken big steps to avoid a second crisis.

It is not as difficult for central banks to prevent a collapse of the banking system as many observers believe. The key to it is to buy time, which the Bank of Japan did in the 1990s when it faced a collapse of the major Japanese banks. Banks are also major beneficiaries of monetary inflation, which partially justifies the quantitative easing policies of the Fed and Bank of England. Furthermore, financing governments has always been a lucrative activity, contributing to gross returns on capital of as much as 20% for the investment banks. It only requires a few years in this monetary environment to rebuild healthy capital ratios.

Today, the European banks pose the biggest risk to the global financial system, as the sovereign debts of the weaker nations edge towards default. But even here, the ECB is not toothless, and can do much to prevent a Europe-wide banking crisis, working with national central banks to ensure liquidity is always available for the banks that need it. This is already happening with Greece’s banks, which have seen a steady withdrawal of deposits since Greece’s first bail-out.

The real test will be an actual sovereign default, which is a genuine concern. But here again, money that is withdrawn from one bank perceived to be in trouble and deposited in a stronger competitor merely gets recycled to back to the first bank, if not through the money-markets, through the central bank. The ECB may have to copy the Bank of Japan twenty years ago, by pretending that banks’ individual problems don’t matter, because they are back-stopped by the central bank. After a while, depositors, bond-holders and investors might stop worrying, if only because nothing happens and the crisis is no longer news.

However, it would be wrong to be complacent about the substantial risks facing the global banking system, and there is still the possibility of a second systemic crisis. But the bigger crisis by far, which is beyond anyone’s control is in government finances, which ironically, should continue to be a source of substantial profits for the banks – so long as they survive.