In theory, according to the rules of prudence, a bank cannot lend more than 12.5 times its capital. This rule is based on the postulate that with an 8% equity Equity The capital put into an enterprise by the shareholders. Not to be confused with ’hard capital’ or ’unsecured debt’. -to-assets ratio |2|, a bank cannot go bankrupt, because it is very likely that its losses will be less than 8%, therefore it will be able to survive. We are going to show that in reality, banks can develop activities (take risks) that go far beyond this ratio. Instead of 1/12.5 (8%), the equity-to-assets ratio is often no better than 1/20 (5%). In addition, several very large banks have a 1/25 (4%) ratio, or even 1/33 (3.33%), all the way to 1/50 (2%). We are going to show how this can be done in a completely legal way.
The Basel Committee (see text box) has introduced the idea of dropping the leverage Leverage This is the ratio between funds borrowed for investment and the personal funds or equity that backs them up. A company may have borrowed much more than its capitalized value, in which case it is said to be ’highly leveraged’. The more highly a company is leveraged, the higher the risk associated with lending to the company; but higher also are the possible profits that it may realise as compared with its own value. ratio to 3%, which is scandalously low. Authorising a bank to “lend” 33 times its capital, leaves in place a situation in which a (small) loss of 3.33% of its assets would result in bankruptcy. Such a decision is almost a guarantee that the banking crises are far from over.
|The Basel Committee and the Bank for International Settlements
Bank for International Settlements|
BIS The BIS is an international organization founded in 1930 and charged with fostering international monetary and financial cooperation. It also acts as a bank for the central banks, 55 national central banks and the ECB are members.
The Basel accords were drafted by the Basel Committee on Banking Supervision. This committee has changed since the 1980s, and today its members include central bankers from the G20 G20 The Group of Twenty (G20 or G-20) is a group made up of nineteen countries and the European Union whose ministers, central-bank directors and heads of state meet regularly. It was created in 1999 after the series of financial crises in the 1990s. Its aim is to encourage international consultation on the principle of broadening dialogue in keeping with the growing economic importance of a certain number of countries. Its members are Argentina, Australia, Brazil, Canada, China, France, Germany, Italy, India, Indonesia, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, USA, UK and the European Union (represented by the presidents of the Council and of the European Central Bank). countries under the supervision of the Bank of International Settlements (BIS, see below) in Basel. It has four main missions: to strengthen the security and stability of the financial system, to set minimum standards for prudential banking oversight, to spread and promote best banking and financial surveillance practices, and to promote international cooperation for prudential oversight. The BIS is an international organisation established in 1930, which promotes international monetary and financial cooperation. It also plays the role of the bank for central banks. Its mandate covers four areas of activity: a forum for the discussion and analysis of the monetary policies of central banks, an economic and monetary research centre, a prime counterpart of central banks for their international transactions, and an agent or trustee in connection with international financial operations. It has members from 56 central banks including those of the G10. Several committees and organisations dedicated to monetary and financial stability and monitoring the international financial system have been created within its walls, like the Basel Committee and the Committee on the Global Financial System (CGFS). |3|
Before examining this question in more detail, we are going to explain why banks are looking for high leverage, the great impact it has on swelling bank assets, the banks’ increasing need for borrowing, and the risks inherent in such activities.
With the neoliberal deregulation that began in the 1980s, there was a radical drop in the ratio between the equity (capital + reserves) that banks had to hold and the volume of their debts (the equity + debt = bank liabilities Liabilities The part of the balance-sheet that comprises the resources available to a company (equity provided by the partners, provisions for risks and charges, debts). ). For 1000 euros of capital, the number of euros that banks could borrow increased considerably, which is what is known as leverage. The banks progressively increased this leverage with the authorisation of oversight authorities. The goal was to increase profitability for shareholders, who were investing in the bank by increasing the amount of money banks borrowed. Why is the highest possible leverage an objective for the big banks? How does this process increase the bank’s profitability for the shareholders?
The notion of ROE (return on equity) gives us a key for understanding this question. In a nutshell, a bank’s equity is made up of the capital put up by shareholders |4|. 25 years ago, in theory, equity represented about 8% of a bank’s assets. For example, a bank that had €100 billion in assets (in the form of household and corporate loans, sovereign debt
Government debts or debts guaranteed by the government.
bonds, corporate bonds
Securities issued by corporations in order to raise funds on the Money Markets. These bonds resemble government bonds but are considered to be more risky than government bonds and other guaranteed securities such as Mortgage Backed Securities, and therefore pay higher interest rates.
, and other financial securities
Financial securities include equity securities issued by companies in the form of shares (shares, holdings, investment certificates, etc.), debt securities, excluding commercial instruments and savings certificates (bonds and similar securities), and holdings or shares in Undertakings for Collective Investment in Transferable Securities (UCITS).
), would have had €8 billion in capital.
In these conditions, to achieve an ROE of 15%, it would need to make a net profit Profit The positive gain yielded from a company’s activity. Net profit is profit after tax. Distributable profit is the part of the net profit which can be distributed to the shareholders. of €1.2 billion (i.e., 15% of 8 billion). To make such a net profit on assets worth €100 billion seems to be quite easy, as it represents only 1.2% of the total amount.
The ballooning of bank assets to increase ROE
Starting in the mid-1990s, a whole new range of financial products developed very rapidly, including different types of derivatives Derivatives A family of financial products that includes mainly options, futures, swaps and their combinations, all related to other assets (shares, bonds, raw materials and commodities, interest rates, indices, etc.) from which they are by nature inseparable—options on shares, futures contracts on an index, etc. Their value depends on and is derived from (thus the name) that of these other assets. There are derivatives involving a firm commitment (currency futures, interest-rate or exchange swaps) and derivatives involving a conditional commitment (options, warrants, etc.). and structured products. The big banks wanted their share Share A unit of ownership interest in a corporation or financial asset, representing one part of the total capital stock. Its owner (a shareholder) is entitled to receive an equal distribution of any profits distributed (a dividend) and to attend shareholder meetings. of this buoyant sector. They were convinced that if they did not launch operations, they would lose ground and perhaps be taken over by their competitors. The yield Yield The income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment’s cost, its current market value or its face value. on these products is relatively low – generally less than 1%. Therefore, a bank that has shareholders who want the ROE to increase from 20 to 30% is pushed to increase its assets exponentially while at the same time loaning more and more money to maximise leverage. In the example mentioned above, the bank’s assets would increase by 300% in ten years to reach €300 billion, whereas the capital would not be increased. It would still represent €8 billion, or 2.66% of the total assets. This tremendous asset Asset Something belonging to an individual or a business that has value or the power to earn money (FT). The opposite of assets are liabilities, that is the part of the balance sheet reflecting a company’s resources (the capital contributed by the partners, provisions for contingencies and charges, as well as the outstanding debts). growth was made possible by the bank increasing its debt load.
Between 2002 and 2011, banks increased their assets by 250%
According to the IMF
International Monetary Fund Along with the World Bank, the IMF was founded on the day the Bretton Woods Agreements were signed. Its first mission was to support the new system of standard exchange rates.
When the Bretton Wood fixed rates system came to an end in 1971, the main function of the IMF became that of being both policeman and fireman for globalised capital: it acts as policeman when it enforces its Structural Adjustment Policies and as fireman when it steps in to help out governments that are going bankrupt.
As for the World Bank the votes resulting in decisions are based on the amount paid as contribution by each member states. 85% of the votes are required to modify the IMF Charter (which means that the USA with 17,35% of the votes can paralyse any decision).
The institution is dominated by five countries: the United States (16,75%), Japan (6,23%), Germany (5,81%), France (4,29%) and Britain (4,29%).
The other 177 member countries are divided into groups led by one country. The most important one (6,57% of the votes) is led by Belgium. The least important group of countries (1,55% of the votes) is led by Gabon and brings together African countries.
http://imf.org |5|, worldwide bank assets increased from $40 to $97 trillion between 2002 and 2007. Between 2007 and 2011, they continued their upward climb to $105 trillion. |6|
If we consider the entire European banking sector, assets expanded from €25 trillion in 2001 to €43 trillion in 2008, or 3.5 times the GDP
Gross Domestic Product Gross Domestic Product is an aggregate measure of total production within a given territory equal to the sum of the gross values added. The measure is notoriously incomplete; for example it does not take into account any activity that does not enter into a commercial exchange. The GDP takes into account both the production of goods and the production of services. Economic growth is defined as the variation of the GDP from one period to another. of the EU! |7|
Given the severity of the crisis, we could have expected a rapid restructuring of the banking sector with the shrinking of bank assets and the closing of the weakest banks. That did not occur — the volume of assets has not decreased since the crisis erupted in 2008. |8| Whereas the volume of their assets was €43 trillion in 2008, it was €45 trillion in 2011. While European GDP experienced a slight decrease, European bank assets continued expanding and represented 370% of European GDP in 2011! |9|
Between 2007 and 2011, Deutsche Bank’s (the biggest bank in the world) assets increased by 12.4%, those of the British bank HSBC (number 2 in the world) by 22.2%; those of the biggest French bank, BNP Paribas, by 16%; Crédit Agricole’s by 22%; those of Barclays by 12%; the biggest Spanish bank, Santander’s, by 37.1%; those of the principal Swedish bank, Nordéa, by 84.1%; those of Commerzbank, the second-largest German bank, by 7.3%; those of the Italian bank, Intesa, by 11.6%; and those of the second-largest Spanish bank, BBVA, by 19.1%. Of the 18 main European banks, only three experienced a decrease in assets: the Royal Bank of Scotland (-28%), ING, the main Dutch bank (-3.3%), and the largest Italian bank Unicredit (-9.3%). |10|
Consequences of increasing leveraging
The first consequence is that banks have taken increasingly high risks |11|, which has resulted in a series of bank failures. Second, the bank bailouts by public authorities have meant that the people of Europe and the US have had to mop up the losses. In many countries (Ireland, Iceland, Spain, Belgium, the United Kingdom, Germany, the Netherlands, the United States, Cyprus, and Greece), public debt has skyrocketed since 2008 due to bank bailouts.
Nonetheless, as indicated above, six years after the beginning of the biggest banking crisis since the 1930s, governments and oversight agencies are proposing to “rein in” leveraging to 1/33. In other words, a bank that has 1 euro in equity capital can borrow 32 euros and engage in business activites of 33 euros. This kind of “control” will inevitably lead to other banking crises.
Several phases led up to the general use of leveraging.
Basel I: encouraging the deregulation banks expect
First phase: from 1988 onward, the Basel I Accords stipulated that banks must be in a position to rely on equity amounting to 8% of their operations. This means that if they have 1 euro in equity (generally shareholders’ money), they are allowed to loan 12.5 euros. This also means that in order to loan 12.5, when they only have 1 in equity, they can borrow 11.5. Compared with regulations that had been implemented since the 1930s, such a measure was already a significant move towards increasing bank activities by pushing them to lend more. Now in light of the Basel II Accords (which are discussed below), 8% seems to be a high requirement.
We should, however, qualify what has been described in the previous paragraph. Actually, the amount they can loan (on the basis of one euro in equity) is not 12.5, but 25 (as is the case for BNP Paribas), or even 50 (as is the case for Deutsche Bank or Barclays), while adhering to the Basel I recommendations (and indeed to those of Basel II, currently in force). How can this be? Because they can play on the denominator of the equity to assets ratio, since the ratio does not apply to all assets. Indeed Basel I (just as Basel II and Basel III, which are discussed below) makes it possible for banks to reduce the value of their assets depending on their exposure to risk. The value of assets is calculated on the basis of the risk they are exposed to. Securities on sovereign debt from OECD
Organisation for Economic Co-operation and Development OECD: the Organisation for Economic Co-operation and Development, created in 1960. It includes the major industrialized countries and has 34 members as of 2014.
http://oecd.org members are not supposed to be exposed to any risk at all. Loans to AAA and AA- rated banks are considered to entail a 20% risk. Basel 1 set up five categories of risk depending on the debtor: 1) States or public authorities, 2) corporations outside the finance industry, 3) banks, 4) individuals and small companies (retail), and 5) others.
How a ratio of 4% can be turned into a ratio of 10%
If the Banxia bank has 4 in equity and 100 in assets, that would represent a ratio of 4%, whereas it must attain a level of 8% under Basel 1 (and Basel 2, which applies in 2013-2014). How can it attain that ratio without changing anything? By weighting its assets as a function of the risk taken. A theoretical case will help us understand this situation: Out of those 100, it holds government bonds from countries whose rating is between AAA and AA- representing an amount of 30. It can then subtract those 30 from its total assets. Why? Because the legislation in force considers that loans to countries rated between AAA and AA- does not require any capital to offset possible losses. That leaves 70 in assets for which it must hold a sufficient amount of capital. Its capital / assets ratio (4/70) is now 5.7%, which is still inadequate.
Let’s continue the process. Of the remaining 70, 30 consist of loans |12| to banks or companies rated between AAA and AA-. In this case, since the Basel 1 (and Basel 2) rules consider that these loans represent only a 20% risk, the Banxia bank can consider that that 30 in debt only counts for 6 (20% of 30). Therefore, Banxia no longer needs to come up with equity for assets equivalent to 70, but assets of 70 minus 24 – that is, 46. The equity / assets ratio therefore improves greatly, attaining 8.7% (4 in equity for 46 in assets weighted for risk).
Now let’s assume that of the other 40 in assets, 2 are loans to companies or banks to which the rating agencies
Rating agencies Rating agencies, or credit-rating agencies, evaluate creditworthiness. This includes the creditworthiness of corporations, nonprofit organizations and governments, as well as ‘securitized assets’ – which are assets that are bundled together and sold, to investors, as security. Rating agencies assign a letter grade to each bond, which represents an opinion as to the likelihood that the organization will be able to repay both the principal and interest as they become due. Ratings are made on a descending scale: AAA is the highest, then AA, A, BBB, BB, B, etc. A rating of BB or below is considered a ‘junk bond’ because it is likely to default. Many factors go into the assignment of ratings, including the profitability of the organization and its total indebtedness. The three largest credit rating agencies are Moody’s, Standard & Poor’s, and Fitch Ratings (FT). have assigned poor scores – that is, under B-. In this case, the risk is 150%. These 2 debt assets then count for 3 (150% of 2). The equity required to counter this risk has to be calculated in terms of 3 and not 2.
Let’s suppose that of the 38 in remaining assets, 10 represent loans to SMEs. In this case, 10 counts for 10 because banks’ SME debts cannot be lightened, since the Basel authorities consider that they represent a high risk. The “risk” is 100%.
The remaining 28 in assets consist of loans to individuals. The risk for loans to individuals is 75%, and therefore these 28 assets count for 21 (75% of 28).
In this theoretical case, the equity calculated in terms of risk end up representing 40 (0+6+3+10+21) for total assets of 100. The equity / assets ratio is 4/40, or 10%.
Bingo! The bank with equity that only accounts for only 4% of its total assets can declare that its actual ratio is 10%, and it will be congratulated by the oversight authorities.
Do you think this is all just theoretical? That what has just been described does not really correspond to what the banks and oversight authorities actually do? Think again. In the next part, you will find a very real example, and there are many such examples. In the meantime, below is a table that summarizes the applicable rates for weighting risk, both in Basel 1 and Basel 2.
Table of risk weightings |13|
As indicated above, the Basel Committee places a lot of faith in the rating agencies. Yet it is a well-established fact that these agencies have been wrong time and again. They assigned ratings of AAA to AA- to companies like Enron, Lehman Brothers, AIG, RBS, and Northern Rock right up to the day they went under. Similarly, the rating agencies gave AAA ratings to toxic structured products like CDOs until 2007-2008, before they collapsed.
However, the Basel authorities have also adopted discriminatory measures regarding loans to SMEs (which of course are not rated by rating agencies, and therefore represent a 100% risk according to the established standards) and to households (a 75% risk according to Basel), which has caused banks to reduce direct credit to these participants in the real economy. A large share of loans to households has been securitized – that is, removed from banks’ balance Balance End of year statement of a company’s assets (what the company possesses) and liabilities (what it owes). In other words, the assets provide information about how the funds collected by the company have been used; and the liabilities, about the origins of those funds. sheets and sold to other financial institutions. The reason for banks’ restricting credit to SMEs and households since 2008 is that the loans they grant to them are too heavy in terms of asset weighting. Private banks have prevailed on the Basel authorities to encourage the development of securitized financial products rather than direct loans to people in the productive economy.
Translated by Snake Arbusto, Charles La Via, Christine Pagnoulle