Why does a business model become untenable overnight?


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What was previously a winning model has become instantly bereft of merit in the eyes of investors.

In September 2007, Anthony Ryan, assistant secretary of the Treasury for financial markets told Congress said that just as species can become extinct so can financing techniques. At that time the focus, clearly was on securitization markets and in particularly collateralized debt obligations. These tools were, alongside credit derivatives, blamed for separating the originators of risk from holders. This was a bad thing and should never happen again.

To a large extent the originate-to-distribute model, pursued with such vigour over the past decade, was predicated upon securitization. Is it really possible that banks would have to dramatically change the way they operate and return to tradition – and hold assets on balance sheet until maturity?

Then there was Northern Rock and the now infamous first bank run in the UK for over 150 years. Now there was another stick with which to beat financial institutions. Any bank with an over reliance on wholesale funding was deemed dangerous. The fixation on banks’ loan to deposit ratios now borders on obsession. The proponents of this new orthodoxy suggest that no substantial funding gap should be allowed.

So what does the new world order look like? The new version of the Bretton Woods financial system will help provide the answer but so far it seems that activity in securitized products, and structured credit and credit derivatives, in particular, will be clamped down upon.

Perhaps it will be impossible for banks to bridge the gap between the finance their customers and clients want and what savers can provide. Any hint of a substantial funding gap will be stamped upon by regulators and stock markets.

So no more slicing and re-aggregating risk to address banks’ balance sheet risks? Creditsight’s analysts point out that it is ironic that RTC – the vehicle used to solve the last US credit crisis – had securitization at its heart. Instead we will go back to those halcyon days when banks were highly conservative – even state owned. Where investment banking was simply about offering advice and perhaps the odd piece of capital markets underwriting. It’s a nice narrative, but it is a very different world and one that will struggle to meet the needs of its people.

It is worth remembering some of the factors that caused this perfect storm. Yes there was over leverage, not enough capital in the system and inappropriate risk taking by various actors. But at the heart of the crisis lies, surely, the establishment of rules that not only allowed but encouraged regulatory arbitrage. Globalization means that national regulators are impotent – that needs addressing. Aside from the amazing lack of regulation of Main Street brokers that originated such rubbish mortgages in America, it was Basle rules that ingrained a favourable treatment for mortgages into banking risk management. How many housing bubbles have there been across the globe over the years? Countless.

It was the near decade long delay of the follow up Basle that allowed the shadow banking system to overcast the real one. And why did German state banks rush headlong into capital markets businesses in the 1990s? Because they were able to arbitrage the cheap funding they received because of government guarantees to provide cheaper financing than their commercial rivals.

But if there is one factor that global institutions need to address it is the hitherto appalling risk management techniques around liquidity. The reliance on short-dated wholesale funding is at the heart of many of the problems that banks, especially, are experiencing. Note: deposits are short dated. There is nothing to stop the average retail client withdrawing money in a hurry. A bank can easily lose the whole balance sheet if there is a run.

It was short-term funding that killed HBOS. It had no problem issuing its £20 billion of term funding. The issue was that it had to find £1.5 billion every day in the money markets because it had around 75% of its balance sheet funded with maturities of one year or less. When the markets seized up it was done for.

There’s no easy solution: at its basic form, the model of banking boils down to borrowing short, and cheap, and lending long at a margin. We await with interest the regulators’ response.