Banking On Failure: Junk Banks

WORLDWORKS by Joe Pimbley

Editor’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.

In an early chapter we described the financial failure of businesses. Businesses fail. It happens. Whether it’s the small local hardware store or larger firms such as Blockbuster (movie rental) or Circuit City (electronics retailer), business failure is the natural consequence of inability to sell products and services to customers in a cost-effective manner.

Banking on FailureA larger or smarter business may swoop in and scoop up parts of the failing firm and its employees on the premise that, unlike prior management, it can run the business profitably. This remedy is not painless. Shareholders and lenders of the target company take large losses. The acquisition leaves some employees out of a job.

Failure with or without such a partial rescue is traumatic for employees and investors, but what is the alternative? Should a government spend taxpayer funds in some manner to prevent or reduce losses to lenders and shareholders (i.e., the investors in the failed firm)? Of course not! Investors deserve losses when the firm fails and deserve gains when the firm succeeds.

Or should a government inject taxpayer money to forestall job losses? That’s a tougher question since it is easy to visualize pictures of (i) “employees have jobs” versus (ii) “employees don’t have jobs.” The first picture is obviously better. But the cost of maintaining jobs in this manner is just too high. The greatest cost is not the direct taxpayer subsidy to the failing company. Rather, there’s a larger social and market cost to employees and potential employers and new businesses from the employees’ retention in unproductive, failed activities.

To continue this discussion along theoretical lines of what role government should have would be fruitless. Instead, we make the practical point that government attempted to fund virtually none of the hundreds of thousands of business failures in the U.S. in 2013.[1] Though not absolute, there is a socio-political consensus in the U.S. that government does not sponsor or guarantee private sector businesses.

Banks are Different

We often raise the obvious “why not let banks fail?” question with banking experts, regulators, and other financial professionals.[2] In reply we typically hear “banks are different.” As a good and recent example, Admati and Hellwig state, “as a matter of principle,” that governments should not rescue banks but that practical concerns trump principle.[3]

Chapter 4 described in detail how “banks are different” from other corporate entities in terms of financial structure and operations, regulation, and government control and support. As a succinct recap of chapters 4-9 with new context, banks have generally been highly leveraged and prone to “run on the bank” risk due to adoption of fractional reserve banking. Over time, central banks emerged both as the “lender of last resort” to help mitigate “runs on the bank” and as agents of government. The U.S. in 1934 added explicit deposit insurance through the FDIC – a government guarantee – to dispel citizens’ fear of bank defaults. Based on the numerous bank failures of the 1930’s,[4] the Federal Reserve’s establishment as the U.S. central bank in 1913 evidently failed to bring “safety and soundness” to the nation’s banks.

depression-bankBy this point in history, it was clear that “banks are different” in the sense that government was a lender (through the Fed) and a guarantor of debt (through the FDIC). Government, therefore, had become a key investor in all banks. Other major economies established similar government-bank relationships.

Needless to say, in 2016 the public is now accustomed to the government support of banks through central bank lending and guarantee of bank deposits. This public understanding of banks’ explicit dependence on government support is, on the one hand, seemingly what government wants people to believe. Governments make relentless and ubiquitous proclamations of deposit insurance and other ad hoc debt guarantees. Modern central bankers enact extreme policies of “zero interest rates” (ZIRP),[5] “quantitative easing” (QE),[6] and “whatever it takes.”[7] Yet, on the other hand, the Fed and other central banks publicly discuss “bank stress tests” and publish “passing grades” that purport to show “banks are healthy” with the implication that government support is not necessary.[8]

If the government and regulators removed all explicit and implicit support of banks, the banks would fail quickly in our opinion. As we noted in chapter 5, it is challenging to find information or data to support or refute this statement. We find the FitchRatings result that banks would have low, non-investment-grade (“junk”) credit quality in the absence of bailout support to be the best (and only) assessment of this kind.[9] This Fitch study did not include removal of central bank “lender of last resort” and government deposit insurance support. Clearly, stipulating the absence of such support would make the stand-alone credit quality of banks even worse. We conclude that such fully unsupported banks would “fail quickly” because depositors would not choose to hold their cash in “junk banks.”

In fact, world events do show a clear confirmation of our “junk banks” thesis. The holding company of Lehman Brothers declared bankruptcy on September 15, 2008.[10] Immediately thereafter, banks “all but stopped lending to each other.”[11] Banks would not lend to other banks in the aftermath of Lehman’s failure, even for the typically short inter-bank period of 1-3 months, due to strongly negative views of bank credit quality without government bailout support.

Our statement that banks are “junk” when one strips away all government support is not a scathing criticism of bank executives. Rather, our point is that modern banks have evolved over the past century with this government support. It is entirely understandable that banks and depositors and other investors rely on the support. Banks differ strongly from non-financial corporates in this long reliance on government support.

The next excerpt for Chapter 11 will discuss the high cost of government support for banks.

Editor’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.

[1] It’s challenging to find data for annual business failures or closures. The article R. W. Bednarzik, “The role of entrepreneurship in U.S. and European job growth,” Monthly Labor Review, 3-16, July 2000, supports the general claim of “hundreds of thousands” of U.S. business failures per annum.

[2] J. M. Pimbley, “True Reform for the Financial Industry,” Maxwell Consulting Archives, September 2010; and J. M. Pimbley, “Banks are the problem: CLOs could be the solution,” Creditflux, August 2010.

[3] See chapter 5 of A. Admati and M. Hellwig, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It, Princeton University Press, 2013.

[4] One-third of existing banks failed in the early 1930’s. See, for example, J. R. Walter, “Depression-Era Bank Failures: The Great Contagion or the Great Shakeout?,” Federal Reserve Bank of Richmond Economic Quarterly 91(1), 39-54, Winter 2005.

[5] See http://www.federalreserve.gov/faqs/money_12849.htm for the Fed’s brief description and rationale of its policy of maintaining near-zero short-term interest rates from 2008 through 2014 and beyond.

[6] See, for example, our discussion of chapter 8.

[7] Mario Draghi, President of the ECB, famously said the ECB would “do whatever it takes to preserve the euro” in July 2012.

[8] See, for example, our discussion of the Fed’s SCAP and CCAR in chapter 9. Also see the ECB’s plan for “asset quality review” (AQR) of Eurozone banks.

[9] As we noted in chapter 5, we relied on two Fitch studies to reach this conclusion. They are “The Evolving Dynamics of Support for Banks”, FitchRatings Special Report, September 11, 2013. This study covered the limited period of 1990-2012; and “Fitch Ratings Global Corporate Finance 2012 Transition and Default Study,” FitchRatings Special Report, March 15, 2013.

[10] Page 2, Report of Anton R. Valukas, Examiner, to the United States Bankruptcy Court Southern District of New York, In re Lehman Brothers Holdings Inc., et al., Chapter 11 Case No. 08-13555 (JMP), March 11, 2010.

[11] M. Gilbert and M. Brown, “Interbank Lending Market ‘Died With Lehman’ Bankruptcy: Chart of the Day,” Bloomberg, June 1, 2010.

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Joe Pimbley
Joe Pimbleyhttp://www.maxwell-consulting.com/
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.