Risk in everything
Recent events have led to a better understanding of how the banking system
works. The main foundation of the banking industry is that it is built on
confidence. This enables banks to borrow short and lend long – something they
would not encourage their customers to do. Banks also borrow heavily – with a
gearing ratio of eight times their capital – and again this is a lot more than they
would ever allow their corporate customers to do.
Northern Rock has been a classic example of how quickly things can go wrong
when the trust disappears. We have seen the first serious ‘run’ on a UK bank for
over 100 years with too many depositors asking for their money back at the same
time. Northern Rock’s funding structure did make it very reliant on the money
markets for funding, but the reality is that any bank in the world is exposed to
liquidity risk in one form or another. No bank could pay all its depositors back if
they all asked for their money at the same time. That change occurred when the
first goldsmith holding deposits on behalf of his customers started to lend money.
It was at that point in time he became a financier rather than a simple depositary,
which was the beginning of the banking industry as we know it today.
Despite these structural weaknesses, the banking system works well, most
of the time. Given time banks would be expected to be able to repay their
depositors as the loans they had made were repaid. As long as everyone
believes this there is confidence and it all works. Banks get on with managing
and pricing the credit risk of their loan portfolios in order to be able to do this.
Which leads to another fundamental of banking and financial markets – there is no
return without risk and certainly no additional return without additional risk. The
question the lender, or investor, must ask is whether the return is adequate. In
some cases, the return may be very good for the additional risk as demonstrated
most vividly by the hedge funds in past years. But seasoned investors always
remember the madness of crowds. The moment any financing technique becomes
very popular, the chances are that someone is getting rid of risk very cheaply.
In good times there is always the temptation to do a deal at a slightly finer price.
And if you do not do it, you may have to stand on the sidelines and not do any
business at all. That is why margins get eroded. This has been exacerbated in
the last few years as the securitisation and layering of debt has encouraged yield
compression more than ever. As a result credit has simply been trading at the
wrong price; wrong for the investor/lender that is.
With hindsight this is easier to see. Now bankers and investors are overreacting
to the obvious and have rushed out of markets as quickly as they rushed in. That
is why right now some perfectly sound borrowers are having to pay more to find
lenders and some are finding it impossible to find any lenders at all if the dreaded
words ‘structured’ or ‘asset backed’ are part of the deal.
But markets have short memories. Good quality borrowers are still able to
borrow and the markets for sensible securitised deals are already returning.
Will margins for borrowing return to the same levels? Probably not. The clever
structuring of debt encouraged compression of margins on each slice but it also
means there was insufficient regulatory capital supporting the debt that had
been packaged in various forms. This comes back to bank balance sheets as
standby lines are called. The regulators have seen that and under Basel II banks
will not be able to ignore these liabilities.
Perhaps the most important lesson of recent events is that liquidity risk is just
as important as credit risk. The phrase ‘cash is king’ is as true for banks and
SIVs (Special Investment Vehicles) as it is for corporates. And the lessons for
corporates are the same as ever. If it does not make sense, do not do it. And,
there is no additional return without additional risk; if there was they would not
sell it to you.