US Banks Ignore Europe's Lesson on Greed?
Pity the German taxpayer.
Recent weeks have brought a slew of bad news in terms of contingent liabilities for the German state -- meaning that taxpayers are potentially on the hook for increasing amounts. Two weeks ago, European Central Bank President Mario Draghi affirmed his willingness to commit the ECB -- partly owned by Germany -- to take on added sovereign-debt risk. And last week the German constitutional court confirmed that the European Stability Mechanism is consistent with German law, allowing further fiscal transfers to the euro-area periphery.
And most recently, Deutsche Bank AG (DBK) unveiled its revamped strategy, with a new vision for its organization and growth. The German taxpayer should be very worried.
Deutsche Bank cannot fail -- in the sense of experiencing a Lehman Brothers-type bankruptcy. The German government wouldn’t allow it. With a balance sheet equivalent to about 80 percent of Germany’s gross domestic product, Deutsche Bank is too big to fail both in terms of its direct involvement with the national economy and the potential knock-on effect on confidence in German industry.
But the bank can fail in the sense that it could require future taxpayer assistance. To determine how likely this is -- and the scale of potential losses at any bank -- you need to answer three questions.
Equity Financing
First and foremost, how much capital does the bank have? In this context, capital is a synonym for equity financing, so the right question is: How much is the bank financed with shareholder equity rather than any form of debt? Sometimes people speak of a bank “holding” capital, but this is the wrong verb; it implies that capital is a type of asset, when it is actually a form of liability.
As taxpayers view banks, equity capital is critically important because it is the buffer that absorbs losses. If losses exceed the value of equity, the bank is insolvent and -- assuming there is a rescue -- the difference becomes a taxpayer responsibility.
Seen in this light, Deutsche Bank has long been a worry because it one of the more thinly capitalized global megabanks.
Its official capital ratios might seem respectable to a casual observer: At the end of the second quarter, it reported a core Tier 1 capital ratio (a regulatory measure of equity) of 10.2 percent of total assets.
The problem with this measure is that it uses risk-weighted assets. In other words, if a bank can convince itself and its regulators that it can apply lower risk weights to a given portfolio, its capital ratio will look higher.
What is considered to be a low-risk asset in the context of European banks? Typically, the sovereign debt of euro-area countries has been regarded as very low risk. But Draghi is being forced into extraordinary measures and the German constitutional court is being asked to rule on the ESM and other bailout measures precisely because sovereign debt for some euro countries has become so risky. And if you think there is a non- zero probability of the euro area breaking up, then risk-free assets have become a meaningless concept in Europe.
To evaluate any global bank today, it is much more advisable to look at its leverage ratio, the total size of its balance sheet relative to its equity, without any risk adjustments.
At the end of the second quarter, Deutsche Bank had total assets of 2.241 trillion euros ($2.93 trillion). Its total shareholder equity capital was 55.75 billion euros -- a little less than 2.5 percent of total assets. That is a lot of leverage. Bloomberg News reported that this is the least equity (and most leverage) “among the 24 biggest European banks.”
Risk Management
Second, does the bank have a good grip on risk management? None of the recent statements from the new co-chief executive officers, Juergen Fitschen and Anshu Jain, are reassuring, primarily because they don’t address the issue of Deutsche Bank’s very high leverage.
If you believe a global $2.9 trillion portfolio cannot suffer more than 3 percent losses, I have some U.S. mortgage-backed securities, euro-periphery debt, and Chinese bridges to nowhere to sell you. Or you can talk to the people at UBS AG (UBSN) who lost their jobs for this kind of hubris.
Third, does management have a convincing vision for staying out of trouble? The really worrying issue in this regard is that Fitschen and Jain remain focused on hitting a return-on-equity target.
They have set a target of a 12 percent after-tax return , a headline number that the bank says is comparable to the 25 percent pretax target set when Josef Ackermann was CEO, but may end up being sharply lower.
But as Anat Admati of Stanford University and her colleagues have explained at length in recent years, ROE is a completely flawed target for banks, precisely because it doesn’t capture the associated risks.
“Since investors must be compensated for bearing risk, higher leverage increases the required, or expected, return on equity. To judge whether a manager has created value, one cannot simply look at the return on equity; one must adjust for risk,” Admati wrote in the New York Times. “A bank manager can attempt to reach a ‘target return on equity’ by taking on more risk and by using more leverage, but this, in and of itself, does not create value. It does, however, increase fragility and systemic risk.”
If you invest in banks and haven’t followed this debate, you really need to catch up. The full set of Admati papers is here.
Germany has deep pockets, and many people lined up to put their hands in. But the wealth and the patience of the German people is limited. The country’s gross general government debt is already almost 80 percent of GDP while net debt is 54 percent of GDP, according to the International Monetary Fund’s spring 2012 fiscal monitor. German GDP is 2.65 trillion euros.
Euro RescueHmm, sounds like the mighty German banks need to follow their US counterparts and discover thy glory of collateral transformation. This way they can charge huge fees as their customers swap shady collateral in the form of Greek, Spanish, Portuguese and Italian bonds to get German bunds or US Treasuries in return.
The even bigger threat is to Germany’s influence in the escalating intra-European struggle over how to save the euro area and who will pay that bill. In the next round -- the argument about potential conditionality that may be attached to ECB and ESM support -- expect Spanish Prime Minister Mariano Rajoy to make the point that reckless German banks, including state-backed Landesbanken, contributed to the debt mess on the periphery. Northern lenders, pursuing foolish ROE targets, were not careful and pushed cheap credit on real-estate developers and governments alike.
Allowing German banks to lend recklessly within the euro area will prove to be a costly mistake, no matter who pays the final bill. Why go down the road again of pursuing high return on equity while mismeasuring credit risk?
Deutsche Bank should be instructed to raise more capital, exactly as UBS and Credit Suisse Group AG (CSGN) have been recently compelled to do. The Swiss authorities recognized that to act otherwise would be fiscally irresponsible. German taxpayers should be clamoring for their government to come to the same realization.
Of course, I'm being facetious. Collateral transformation doesn't exist in Europe as Dodd-Frank regulations don't apply there (applies to their US operations). In Europe, big banks deal with collateral risk the old fashion way, they simply hide it until the tide recedes, exposing those swimming naked.
Some US commentators, however, are praising European banks. William D. Cohan of Bloomberg reports, U.S. Banks Ignore Europe’s Lesson on Greed:
Four years after the collapse of Lehman Brothers Holdings Inc. and the near-total paralysis of capitalism’s central nervous system -- the moment fear completely overwhelmed greed on Wall Street -- we are starting to see a few glimmers of hope.
The good news: Several big banks have finally started taking steps to reform Wall Street’s out-of-control compensation system, which rewards bankers and traders with big bonuses for taking insane risks with other people’s money. The bad news: These banks are in Europe, and most of their U.S. cousins still just don’t get it.
In recent days, both Deutsche Bank AG (DBK) and UBS AG (UBSN) announced plans to change their compensation systems. Deutsche Bank said that the portion of the pay its top 150 managing directors receive in the form of deferred stock would vest after five years, instead of three, which should concentrate their minds for a bit longer. The bank also appointed an outside committee to examine its pay practices generally, and pledged to be at the forefront of change in the industry. While not yet the sort of extensive transformation that will protect the rest of us from bankers’ bad behavior, the Deutsche Bank proposals at least prove the old saw that in the land of the blind, the one-eyed man remains king.
Bonus Caps
UBS, for its part, said it is considering capping banker and trader bonuses and making them a function of the executives’ fixed salaries or of the bank’s profitability. UBS also said it was examining a five-year vesting option for stock awards, along the line of Deutsche Bank’s proposal. Credit Suisse Group AG (CSGN) and HSBC Holdings PLC (HSBA) have also taken baby steps in the direction of compensation reform.
In the U.S., though, there has been virtual silence on the topic. Bankers and traders on Wall Street still get rewarded with big bonuses solely based upon the revenue they generate from the products they sell. Just as before the financial crisis and unlike almost every other business on Earth, about 50 percent of every dollar of revenue generated on Wall Street goes right back out the door in the form of compensation. Not surprisingly, this absurd compensation system encourages bankers and traders to keep selling and trading, giving very little thought to the consequences on the rest of us for the products they sell or the big trading bets they make. As for accountability, forget it.
Worse, neither Lloyd Blankfein, the chief executive officer of Goldman Sachs Group Inc. (GS), or Jamie Dimon, his counterpart at JPMorgan Chase & Co. (JPM) -- Wall Street’s highest-profile leaders -- have said anything about changing this flawed system, while continuing to be paid tens of millions in annual compensation. Instead, Goldman cut corners by eliminating its two-year analyst program for college seniors. This is not leadership.
To his credit, James Gorman, the CEO of Morgan Stanley (MS), has at least addressed the flawed Wall Street compensation system: In 2011, Morgan Stanley’s bankers and traders had their cash bonuses capped at $125,000. Gorman said publicly, at the World Economic Forum in January, if they didn’t like it, they could just leave. Few have, and why would they? Where else but Wall Street can they get paid so much for risking none of their own money?
And just as the basic compensation structure on Wall Street remains for the most part unchanged, so too does its behavior, despite the passage of the Dodd-Frank law and the ceaseless writing and rewriting of the new regulations it mandated.
London WhaleEmbarrassed?!? Mr. Cohan, banksters couldn't care less what you, me or Main Street think of their outrageous compensation. They own both parties in the United States and will continue taking risks as they see fit until the next crisis hits, at which point they'll just ask for another bailout.
Who could forget, in the past few months alone, JPMorgan Chase’s London Whale debacle, where close to $6 billion of depositors’ money was lost in an ill-advised, obscure proprietary bet on the direction of interest rates? Or the devastating loss of confidence in the markets caused by the big banks’ manipulation of the London interbank offered rate? Or HSBC’s money-laundering scandal? Or Standard Chartered PLC (STAN)’s bookkeeping shenanigans to help Iran? Or Nomura Holding Inc. (8604)’s insider-trading scandal? These happened after the financial crisis laid bare a Wall Street culture that more closely resembled La Cosa Nostra than anything else.
Why has there been so little change, even though individual bankers, traders and executives seem to be falling over themselves in recent days to sort of accept blame for what went wrong? (The most recent example came from Anshu Jain, one of two new leaders of Deutsche Bank, who laid out a plan for an internal change of culture with the admission that “tremendous mistakes have been made. We can see times have changed and we need to change and change rapidly.”)
Part of the answer, perhaps, is that Wall Street behavior merely reflects the latest acceptable norms in society as a whole, which sadly has seen a steady decline in ethics, morality, compliance and leadership in the last generation.
Wall Street has taught Main Street the wonders of stock options and “golden parachutes” and excessive executive compensation, among other things, all of which are designed to enrich the few at the top with a minimal amount of accountability for their behavior.
We have also been inundated in the last year -- thanks to Mitt Romney’s presidential quest -- with the facts of just how easy it is for private-equity and hedge-fund moguls to make fortunes using other people’s money while minimizing the amount of taxes they pay. It’s great work if you can get it. But it all adds up to a steady stream of messages that amount to, paraphrasing the actor Michael Douglas: Greed is Good.
If the financial crisis and its aftermath have taught us anything, though, it is that greed is not always good. Not even close. If I were a Wall Street CEO, hauling in tens of millions of dollars a year, I would be embarrassed to call myself a leader while perpetuating a compensation system that continues to reward bad behavior at my firm. Until Wall Street’s leaders again have their full net worth on the line every day -- as they did two generations ago when Wall Street was a series of small, private partnerships -- the idea of real change on Wall Street remains a joke.
Take it from me, compensation in finance is way out of whack. The most outrageous examples are found on Wall Street, but the same nonsense goes on in Toronto's Bay Street and London's City. And to a lesser extent, compensation at some of our large Canadian public pension funds is extremely generous (they claim this is to compete with the private sector but most of these senior managers would never score such sweet deals if they were working in private sector).
Go back to something Anat Admanti of Stanford University said in the first article:
“Since investors must be compensated for bearing risk, higher leverage increases the required, or expected, return on equity. To judge whether a manager has created value, one cannot simply look at the return on equity; one must adjust for risk,” Admati wrote in the New York Times. “A bank manager can attempt to reach a ‘target return on equity’ by taking on more risk and by using more leverage, but this, in and of itself, does not create value. It does, however, increase fragility and systemic risk.”In other words, return on equity is flawed because it doesn't take into account the risk that banks take to achieve those returns. The same goes with any fund, including Canadian pension funds. It's silly comparing headline figures because some large Canadian pension funds are a lot more levered than others.
Nothing wrong with using leverage intelligently, but own up to it, admit it and publicly disclose the risks it presents to your bank or fund. And when you're compensating senior managers, are you compensating them based on headline performance or risk-adjusted returns? Are there significant clawbacks if someone screws up, even if they left the organization? (Of course not. What typically happens is they are paid a generous severance package to shut them up.)
The entire capitalist system has become nothing more than a financial plutocracy. Sure, you will still have companies like Apple, Google, Microsoft, Cisco and others -- actual creators of wealth -- but the big banks call the shots. When they claim we need a 'sound banking system', what they really mean is they want to perpetuate a system where those at the top of the financial food chain continue reaping outrageous bonuses no matter what the social costs.
Will this social order continue indefinitely in the future? No, at one point there will be a revolution as social tensions boil over and the masses revolt. We're nowhere near there but have a look at what's going on in southern Europe and it explains one of the reasons why the Fed took out its big bazooka last Friday (main reason was to support its banking masters). This is also a topic Bridgewater's Ray Dalio discussed on striking the right balance.
Speaking of southern Europe, watch Yanis Varoufakis on Max Keiser below, providing an update on the Greek crisis and what he sees happening in Europe. This is one of Varoufakis' best interviews but once again, he fails to acknowledge the real cancer in Greek society, namely, the culture of entitlement fostered over decades as governments bought votes by feeding the public sector beast. Austerity isn't working mainly because it has disproportionately impacted Greece's private sector.