Banking on Failure: Who Understands Banking Risk?

WORLDWORKS by Joe PimbleyEditor’s Note: This is the next in a Continuing Series of Articles by Joe, as excerpted from his Book;“Banking on Failure” co-authored by Laurel McDevitt.

Previous excerpts for Chapter 5 discussed the Risks of High Leverage and Funding Mismatch, the Role of Quality and Transparency of Assets, and Government Support.

[su_dropcap style=”flat”]O[/su_dropcap]PINIONS ARE GENERALLY not provable – otherwise we wouldn’t call them “opinions.” Our opinion is that nobody truly understands banking risk beyond a few superficial platitudes. In direct, private conversations with several credit rating agency bank analysts from more than one firm, we’ve heard statements approximating “nobody really understands banks.”

In other discussions with bank analysts both inside and outside credit rating agencies, we do also encounter those experts who defend their ability to gauge the default risk to bank creditors. Yet our experience is that these analysts cannot provide satisfactory answers to basic questions pertaining to risk assessment. Examples of such questions are: “why are you comfortable buying the bonds of, say, Citigroup at its current balance sheet leverage?”; “at what higher leverage level would you be uncomfortable with the Citigroup default risk (and why)?”; “how do you measure Citigroup’s funding mismatch and what does this measurement tell you about default likelihood?”; and “what is your view of the competence, relevance, and effectiveness of the Citigroup Chief Risk Officer and why do you hold this view?”

One difficulty in posing such questions is that they are not consonant with the mainstream paradigm of banking credit analysis. In other words, this is not how the analysts think. Typical bank analyst answers to the leverage question would be “Citigroup is stronger than it was two years ago” or “Citigroup exceeds its regulatory capital requirement.” The first answer is “good to know” but does not answer the question of why the current leverage level is acceptable. The second answer strikes at the core of bank analyst philosophy.

Bank credit (to a greater extent than equity) analysts focus on a large bank’s relationship with its regulators. In the U.S., the principal relationships are with the Fed and the current and proposed rules of the Basel Committee on Banking Supervision (BCBS) – also known as Basel II and Basel III. Hence, if a bank such as Citigroup complies with capital (leverage) and other requirements of its regulators and is otherwise cooperating with all the reviews and minutiae of the regulator relationships, the bank analysts are comfortable. Stated differently, bank analysts for private investors and firms effectively sub-contract much of their analysis to the bank regulators. While some of these private analysts would hotly deny this statement, neither can most of these analysts give good answers to the basic questions without citing the authority of the regulators. (We’ve never met analysts who do not rely on bank regulatory rules and statements, but we acknowledge the possibility that they exist.)

Beyond simply leaning on the regulators “to do the heavy lifting” of bank analysis, there exists the unspoken, perhaps even sub-conscious, sentiment “if the bank complies with regulators, it will be bailed out if it begins to fail.” In more than one conversation with long-time credit rating agency veterans, we asked what their firms had gotten wrong with the Lehman single-A credit rating in 2008. Instead of a reaction such as “we didn’t look hard enough at their funding,” we heard angry denunciations of the Fed for failing to save Lehman (and their credit ratings)! The SEC had been Lehman’s primary regulator in the years up to and including 2008. The SEC had imposed Basel II capital requirements on the U.S. investment banks and Lehman was in full compliance.

Our point here is not simply to criticize the “rely on the regulator” approach for the credit analysis of large banks. From the standpoint of private investment firms and credit rating agencies, this approach may arguably be the best choice. After all, it is true that a bank in conflict with, or in defiance of (!), its regulatory requirements is in peril. Neither is it unreasonable to project that a large bank in compliance with all regulatory mandates for “safe banking” will receive government (bailout) support, Lehman notwithstanding. Rather than criticizing, then, we are merely arguing that “rely on the regulator” is an apt description of typical credit analysis for large banks.

Do the regulators themselves understand banking risk? If “yes,” are these same regulators effective in implementing and encouraging the techniques that produce safety and soundness for large banks? To the first question, bank executives would certainly respond “no!” – as long as there are no regulators in the room to hear that answer.[1] As insiders with years of banking experience, the executives know the “weak spots,” the “wishful thinking,” and the “skeletons in the closet.” Regulators tend to miss all three and focus instead, for example, on whether the bank has its own capital model with stochastic recovery or other details of minor importance.

For the second question regarding effectiveness of bank regulators, we defer to Sheila Bair, former head of the U.S. FDIC, in her book Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself (Free Press, 2012). Bair’s central theme is that she and her team at the FDIC had the right approach to banking supervision in the Credit Crisis beginning in 2007, but the other U.S. bank regulators (the Fed, Office of Thrift Supervision, Office of the Comptroller of the Currency, and others) and the U.S. Treasury Department were slow, wrong, conflicted, and generally ineffective. Her solution is to create a super-regulator to oversee and eliminate the conflicts and dysfunctions of the first line of regulators. While we don’t see the financial world and its necessary repairs in the same terms as Bair,[2] we do believe she’s chronicled powerfully the fallibility and questionable banking expertise of bank regulators.

One further difficulty of banking credit analysis stems from the nature of bank failure. When banks fail due to “run on the bank,” the failure is often a “bolt from the blue.” There is little warning because we really have no widely accepted run-on-the-bank measurement to make months or years in advance of the failure. In hindsight, the media and some analysts may identify ersatz “causes” that hide our inability to foresee these short-term funding failures. When Drexel (Drexel Burnham Lambert Inc.) failed in 1990, the “cause” was the firm’s involvement in “junk bonds.” When Northern Rock failed in 2007, the “cause” was “too much wholesale funding.” When IndyMac failed in 2008, the “cause” was “Senator Schumer citing the bank’s fragile condition.”[3] While these “causes” may have differing levels of plausibility, they give only false comfort that other banks will avoid future collapses if they avoid non-investment-grade lending, commercial paper markets, and loose-lipped politicians.

[1] See, for example, J. A. Allison, “Market Discipline Beats Regulatory Discipline,” Cato Journal 34(2), 345-52, Spring/Summer 2014. Mr. Allison, a former U.S. bank CEO, states: “I don’t know a single time when federal regulators – primarily the FDIC – actually identified a significant bank failure in advance. Regulators are always the last ones to the party after everyone in the market (the other bankers) knows something is going on. Thus, in that context, regulators have a 100% failure rate. Indeed, in my experience, whenever they get involved with a bank that is struggling, they always make it worse – because they don’t know how to run a bank.”

[2] For the sake of clarity at the expense of diplomacy, we deplore the idea of creating a new regulator to oversee existing regulators.

[3] See, for example, “IndyMac Seized by U.S. Regulators; Schumer Blamed for Failure,” Bloomberg, July 12, 2008.


Joe Pimbley
Joe Pimbley
Joe is Principal of Maxwell Consulting, a firm he founded in 2010. Joe is expert in complex financial instruments, financial risk management (certified as FRM by the Global Association of Risk Professionals), valuation, structured products, derivatives, and quantitative algorithms. His recent and current engagements include financial risk management advisory, valuation and credit underwriting for structured and other financial instruments, and litigation testimony and consultation. In a prominent engagement from 2009 to 2010, Joe served as a lead investigator for the Examiner appointed by the Lehman bankruptcy court to resolve numerous issues pertaining to history’s largest bankruptcy. Joe and his colleagues discovered Repo 105 and also reported the critical importance of pledged collateral mishaps and mischaracterizations to the Lehman failure. Joe holds a Ph.D. in Theoretical Physics and is a co-author of Banking on Failure (2014), Simple Money (2013), and Advanced CMOS Process Technology (1989). He serves on several corporate and academic Boards, has written more than thirty finance articles, presented more than sixty finance seminars, and holds numerous patents for engineering inventions.

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