Even in a week when there are plenty of other stories (poorly executed terrorism, Brexit negotiations, scandalously flammable buildings, hung parliaments) the news that four Barclays executives are being charged with fraud has made the front pages today.
I am not going to discuss the case itself. It is a prosecution brought by the Serious Fraud Office over the recapitalisation of Barclays using Qatari money in 2008; the SFO reckon there was misrepresentation and some other malfeasance. I’m not going to discuss it for two reasons: first, it’s obviously sub judice so I could get myself in some hot water; second, because it will be a case of such bewildering complexity (acres of accounting reports, emails and memos, internal legal opinions etc.) anything I said would just be ill-informed speculation.
But I am prepared to say this: I am sure that a lot of the complexity that will undoubtedly surface in this affair was magnified hugely by the stress and panic under which the deals were done. The banking system was falling to pieces. Banking executives, politicians, regulators and central bankers in a number of countries had to think quickly. They made some pretty bad errors – worst of these being the decision by the US authorities to allow Lehman to fail – but that is to be expected from humans acting under stress.
Could the crisis have been handled better? More importantly could future crises be handled better? (You’d have to be unforgivably optimistic or deluded to think that another will not occur.)
Regulators are trying to make sure that they are. Their efforts go along three main paths. One, to make sure banks have more capital and that crises are therefore less likely; two, to make trading (especially of derivatives) less bilateral and more exchange-based; three, to make banks easier to ‘resolve’ in the case of crisis so that they can fail without systemic consequences.
All of these steps probably won’t hurt but I doubt that in a real panic they would be sufficient. For one thing, how much capital is enough? Ratios have improved but I am not convinced that – in a meltdown – the extra percentages will be that helpful. There were banks runs and panics in the 19th and early 20th Centuries when capital ratios were multiples of where they are now.
Exchange trading is a decent step in the right direction but it might result in the largest exchanges becoming the ‘too big to fail’ transmission mechanism of a future crisis. I am also profoundly unconvinced by the efficacy of ‘living wills’. If my town is being attacked by flesh-crazed zombies, my fear is not diminished by the comforting thought that their funeral arrangements are all in order.
So what to do?
One suggestion that I have made in print (but which has not, as far as I know, been embraced by any government) is to make explicit the implicit put option that governments are already short to systemically important banks.
The implicit option is the market’s expectation that a government will step in to recapitalise a big failing bank if it looks like its failure might bring down the system. Despite all the effort by regulators in the last nine years, this option is emphatically still in existence. Is it really feasible that the German government would let, say, Deutsche Bank go under? Or the British government let Barclays go?
One problem with the implicit option is that the market is never completely sure that it will be triggered – witness Lehman Brothers. Net effect? Uncertainty in conditions of panic. Another is that the government (the taxpayer: that is, you and I) don’t get paid for it.
My proposal (which I dubbed the Option Based Recapitalisation Charge or OBRC) is that the implicit is made explicit. Each year a bank’s home government would sell a systematically important bank a very low strike put option on its equity in sufficient size to bring its capital ratios back up to regulatory minimum if the stock price collapsed. The terms of the deal would be public knowledge.
The advantages would be numerous. In quiet years, the option premium would be paid to the government and it could set aside the money to help offset negative effects from a future crisis. If a crisis occurred, in the panic it would be totally transparent where the government support would kick in for any bank. Uncertainty would be replaced by certainty.
Another advantage would be that, because the option premium would be driven by the volatility of the bank’s equity, and because that volatility is damped by the market’s perception that the bank is conservatively leveraged and capitalised, the fee (the option premium) would be linked to bank riskiness. The safer the bank, the lower the fee.
Now I’ve heard some criticism of the idea. From people who dislike government interference, the prospect of explicit state support is an anathema – to them I point out that the transaction (the option) would be done at market prices and that in extremis state support is implicit anyway.
Another critique from the other end of the political spectrum is that it would put a huge contingent liability on the state’s balance sheet. That might make borrowing harder. To those folk, two points. First, the liability’s there already. Second, if the market looks at the state’s commitments and decides that it doesn’t like the effect on the state’s creditworthiness, maybe that’s a signal for it to sort its banking system out? (Certainly, there is one historic instance where this might have helped. Clue: the country has lots of volcanoes and its citizens chow down on puffins.)
But this argument brings us back to where we started. There’s nothing to say that it has to be the bank’s home state that sells the option. Another state, or group of states might step in. Or maybe the huge pools of money sloshing around in sovereign wealth funds could be used? The only condition would be that the money is definitely there if required and that the home government is fine with the identity of the option seller. Norway would probably be fine for most western governments. Others, less so.
So imagine that, back in 2008, this scheme had been in place and that the seller of the OBRC options to Barclays had been Qatar (signed off and approved by the British government). The deal would have been agreed in calmer times. The recapitalisation via an option exercise would have had the same net effect as the deal that was actually done, but, crucially, it would have been agreed transparently in advance.
More certainty; more transparency; same recapitalisation.
And, I’m guessing, 100% fewer court appearances.
Buy the new edition of Kevin Rodgers’ book ‘Why Aren’t They Shouting?’ at Amazon.
June 20, 2017 at 8:47 pm
Agree very much Kevin that banks should be paying some sort of premium based on their own risk rating in order to have the right to stay in business should another extraordinary season like that great financial crisis fall upon us. Meanwhile, here in the UK we still seem to have that anomaly, the Financial Services Compensation Scheme, which allows high risk, shoot from the hip type of operations to garner the same cover for their retail depositors that much safer institutions do (remember Icelandic banks anyone?) and still has not been reformed.
Regarding motivations, unfortunately our industry displayed enormous greed all the way in the run up to, during and after the crisis. I think Lord Myners is bang on when he says there was fear about being nationalised by a government labelled Labour and what impact that could have on individual, especially senior, bankers’ bonuses. Although Barclays bankers may have operated with themselves in mind first regarding the shenanigans with their Qatari financing, I think the biscuit still has to go to John Thain, who managed to pay the Merrill Lynch bonuses a month early ahead of the BoA purchase in December 2008. After losing $21.5bio in Q4 2008, they managed to take some $3-4bio out of the firm for themselves after the BoA takeover had been announced.
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July 6, 2017 at 12:59 pm
Your knowledge on this is much deeper than mine, but who actually has pockets deep enough to actually pay out in real, not rehypothicated, currency units on said judgement day? Think AIG. Once the avalanche started no one actually had equity/assets. Certainly none trusted even the cleanest of dirty shirts, and the said shirts were loath to spend whatever cash they had without knowing where the bottom lay. Whatever pledges are made, they would be renegotiated at cents in the dollar I’m sure. Even the ultimate saviors of 2008, the Chinese, printed paper with little actual equity, simply creating the mooring lines tethering our present, larger, bubble.
I’ve always wondered what would happen if the puffin eaters option was exercised in (a) systemically important financial center(s). Would it be two years of pain, and then back to normalcy like Björkistan did? I think I’m willing to try, as what happened the last time ain’t workin’.
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July 6, 2017 at 1:10 pm
Any country with its own fiat currency is fine. UK, US. Germany and France – not euro issuers but decent credits – would be fine. Germany could certainly afford the euro 30 billion it w9uld need f0r DB. And if a country isn’t in a position to backstop: don’t let your banking system get so big, risky and concentrated. The key thing is that the option already exists.
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