The history of recent banking collapses is littered with tales of inadequate risk management and poor lending decisions. What is frequently forgotten is that the treasury operation plays a crucial role in any financial institution and the wrong incentives and strategy can hasten a bank’s decline.
When Northern Rock ran out of money, just weeks into the credit crunch, warning bells should have been set ringing throughout the UK banking industry. It didn’t happen. The next treasury to have been caught short was HBOS. Here was an operation that, during the good times, was one of the best at utilizing the capital markets. It played in all the leading currencies and debt sectors. In 2003, HBOS even invented a new asset class – the structured covered bond – ostensibly because it wanted to diversify its investor base. The reality was that investors were running out of credit lines for the HBOS name – a new issuer entity and investor base was a means of getting more funding.
The tale is instructive. A bank’s treasury team should be able to sound the alarm that the balance sheet’s rate of growth is inappropriate – which it clearly was for HBOS. In a prudently run bank, treasury operates in a fashion that minimizes the risk profile within acceptable parameters. At some management level an appropriate measure of capital and liquidity is selected and then the team gets on with raising it. Obviously the key objective is to ensure that the bank does not run out of money. Then should follow a common-sense approach to cost of funds and capital.
As we have discovered over recent months, simple principles were not followed in banking. And now we see the dangers.
If treasury is run as a profit centre, and the people within it are incentivized accordingly, the risk is that incentives will lead to the rejection on the grounds of cost alone of deals that provide the bank with key and capital liquidity. Throughout 2008 HBOS failed to take term funding or raise sufficient capital because it considered the cost too high. The reliance on short-end funding became perilous in the end. It is true that HBOS lost most of its money in corporate loans and big-ticket real estate exposure. Most likely, the capital hits would have pushed the bank into insolvency as the prices on illiquid assets declined. But its position was made worse by trying to fund these with short-term debt.
Throughout 2008 the market grew increasingly wary of the bank’s position – both from a liquidity and a capital standpoint. Was the fact that the HBOS treasury was part of the commercial division at the bank a factor in its demise? Maybe not. But the fact that treasury was run as a profit centre – similar to Abbey National Treasury Services 10 years ago – suggests this is not a model for the future.
The fact that virtually every large bank treasury portfolio has some structured investment and/or Icelandic bank exposure further illustrates the problem. This portfolio should consist of highly liquid, top-quality securities. It seems the guiding principle was: ‘Never mind the quality, feel the yield’. While these investments would only account for a small part of the portfolio, in a leveraged entity that quickly becomes a big problem.
In future, banks’ treasuries have to be concerned about safety rather than profit-taking. Treasury departments have a crucial role to play: they are in the best position to see and therefore manage risks across the institution. Regulators forming a new banking regimen should reinforce that role and remove incentives to take risk in the name of profit.
