Wall Street Magic Tricks Make Banks Look Safer Than They Are
(Bloomberg Businessweek) -- On a Friday afternoon in November, the long story of the global economic crisis reached a milestone: More than a decade after the fact, a court convicted senior executives from major banks for crisis-era crimes. Outside of Iceland and Ireland, such convictions have been rare. In Milan’s judicial complex, the judge sentenced 13 former executives of Deutsche Bank, Nomura Holdings, and Italy’s Banca Monte dei Paschi di Siena to prison terms as long as 7 ½ years. Significantly, these men hadn’t been convicted of causing any of the market losses that crippled the banking system in 2008. They’d been convicted of hiding them.
The cover-up wasn’t just worse than the crime. It was the crime. Deutsche Bank and Nomura had structured a complex set of derivatives that Monte Paschi used to erase about $800 million of red ink from its books. Today, as investors and regulators scan the horizon for the next threat, the Milan convictions are a reminder that the danger might not be visible through the fog of financial fakery.
Despite a decade of post-crisis reforms, financial companies still use tricks to obscure their true condition. Often these moves are legal. Sometimes they’re not. And sometimes they fall into a gray area that regulators haven’t yet imagined they need to police. “Don’t tell me everything is better now,” says Anat Admati, a finance and economics professor at Stanford’s Graduate School of Business. “You have to assume you’re only seeing a fraction of what’s going on in fake finance.”
In fact, tough new rules have proved the mothers of invention, and fresh examples of reality-bending financial practices keep popping up. Here’s a guide to the techniques of financial obscurantism, old and new.
• Window Dressing
In October, European Central Bank supervisors reported a curious thing happening at some of the biggest European banks. About 35 days into a hypothetical stress test period, a key measure of the banks’ ability to meet their obligations would tank, just a few days after it had been calculated to meet a regulatory requirement. In their report they called the moves “optimization” strategies.
The measure in question is the liquidity coverage ratio—basically a bank’s ability to get its hands on cash in a hurry. A ratio of 1-to-1 is the goal. The first part of that calculation is high-quality liquid assets—holdings the bank can sell quickly without taking a hit on price. The more of those a bank has, the better it can weather a storm. The second part is the expected size of the storm, measured as the cash that will likely flow out of the bank in the next 30 days.
Optimization is how banks pump up the amount of bulletproof holdings they can report. Post-crisis rules say a bank can’t count as a liquid asset any bonds it’s issued itself and still holds. Competitors are in the same fix, owning self-issued bonds they can’t count as liquid. Swapping them temporarily solves everyone’s problems. And that’s what they were doing, using short-term repurchase agreements that give each bank the right to borrow against the other bank’s bonds. This maneuver allows both sides to count the other bank’s bonds as liquid assets. The ECB declined to comment on its discussions of this issue with the individual banks.
• Losing Leverage
The financial crisis is often remembered as a mortgage meltdown. But it began with the implosion of Lehman Brothers Holdings, and that involved fake finance.
Banks are measured by the value of their assets—the securities they own and the loans they’ve issued. They acquire most of those assets and fund most of the loans by borrowing money, while using their own money, or capital, as well. If a bank has a huge amount of assets relative to its capital, that means it’s borrowed a lot—and that it could get in trouble during a financial squeeze.
Lehman was able to make its assets look smaller than they were. A few days before the end of a quarter, it borrowed money for a short time, putting up securities as collateral. It used that money to pay down other debts. It treated this deal as a sale of securities—as if it had sold an asset, settled a debt, and thus gotten smaller and less risky. But it would soon be obligated to buy back the security and take out another loan to do it, returning to the same size it was before the trick. In the second quarter of 2008, a few months before its collapse, Lehman looked $50 billion smaller than it actually was thanks to such deals, according to the findings of a bankruptcy court examiner.
The trick Lehman used is no longer possible in the U.S., where averaging of assets is required for most capital calculations, not a single snapshot. But that’s only one tactic. The lesson from Lehman? “Well, just the continued availability of accounting tricks to dress up your regulatory ratios,” says Sheila Bair, chairman of the U.S. Federal Deposit Insurance Corp. during the crisis, who spoke in an interview for the web series Bloomberg Storylines, in an episode on financial fakery. “It’s still going on.”
• Risk Hiding
Capital is a bank’s bedrock. The money the bank gets from investors when it issues stock? That becomes capital. The bank makes a profit and doesn’t pay all of it out as a dividend? What’s left is capital. The point of capital is that if some of the bank’s investments go bad, the bank can stay alive—it’s essentially the money it doesn’t have to repay to anybody.
Like the homeowner who needs to come up with a down payment on a house to qualify for a mortgage, banks must have a certain amount of capital in relation to the risk they’re taking. Where 20% equity is good for a house, regulators widely consider capital above 10% of assets as safe for banks. But bankers don’t like having so much capital—they’d rather use more borrowed money to make loans or buy investments to juice their returns on capital. One way to reduce the amount of capital they must have is to make “risk adjustments” to their assets.
Look at any big banks’ accounts, and you’ll find more than one capital ratio. There’s the one the banks highlight in their reports, which looks really good, averaging 13% among Europe’s top 10 banks and 12% among the U.S.’s top eight as of the end of the third quarter. And then there’s the one further down that comes in at about half those levels—4.7% in Europe and 6.6% for the U.S. The difference? In that first number (called Common Equity Tier 1), the raw assets are “risk-adjusted” before they’re put into the equation. Less risky assets essentially become smaller so that the relative amount of capital looks bigger. That’s right: The banks get to decide that some assets are less risky and can choose not to fully count them. Assets such as government bonds don’t count at all, meaning European banks can hold piles of Greek and Italian bonds and treat them as if they hold zero risk.
Although the adjustments the banks make in-house are supposed to be reviewed by regulators, mistakes still slip through. Earlier this year, the U.K.’s Metro Bank admitted it miscategorized some mortgage loans in a way that undercounted its assets. After it disclosed the problem, it had to raise £350 million ($456 million) in new capital.
Everybody risk-adjusts. JPMorgan Chase & Co., the biggest U.S. bank, says its capital backs up 12% of its assets when they’re risk-adjusted. The ratio drops to 6% without the adjustments. That’s because the adjustments shrink the bank’s $2.8 trillion balance sheet to $1.5 trillion. The shrinking balance sheet is more striking at European banks, which have broader leeway to use internal formulas for credit risk. Deutsche Bank AG’s €1.5 trillion ($1.67 trillion) balance sheet becomes €344 billion after risk-weighting. That helps its capital ratio jump from 4% to a risk-adjusted 13%.
• Capital Relief
Some risk adjustments sound reasonable—U.S. and German government bonds really are safe—but they’re still more art than science and wide-open to being gamed. For example, banks can pay someone to take their risk away for them. “Capital-relief trades” have in effect moved hundreds of billions of dollars off banks’ balance sheets by making it look as if loans the banks have made don’t exist. These trades essentially take the form of insurance policies guaranteed by counterparties that include hedge funds. It’s good to have insurance. The problem is, in a meltdown, those counterparties would need to be able to make good on their obligations for the trade to hold up.
A 2017 deal by Rabobank Group, the second-biggest Dutch lender, moved the risk of default on €3 billion of private loans to a Dutch pension fund. The transaction helped Rabobank cut its risk-weighted assets by €1 billion, the bank said at the time, without providing further details.
In a 2015 report, the U.S. Treasury’s Office of Financial Research found that 18 large U.S. banks had made $38 billion of capital-relief trades the previous year that could have boosted a bank’s capital ratio by as much as 4 percentage points.
Capital-relief trades are an example of shifting risk from banks into the shadows, to nonbank entities such as hedge funds that don’t get anywhere near the same scrutiny. “As regulation tightened, some of the risk has shifted to other parts of the financial system,” says Nicolas Veron, a senior fellow at the Peterson Institute of Economics in Washington. But the trades could pose a contagion risk that gets back to banks anyway. A hedge fund selling insurance often borrows from banks to finance its investments. If losses were to mount high enough, the fund might not be able to repay its lender—or the bank counting on its insurance policy.
• The Italian Job
The Milan convictions (which are expected to be appealed) of former Deutsche Bank, Nomura, and Monte Paschi bankers were the culmination of one of the most audacious known episodes of fake finance. When Paschi, the world’s oldest bank, started suffering losses toward the end of 2008, its outside investment bankers offered what seemed to be magic solutions. In the case of the deal Deutsche Bank pitched, Paschi would enter into two different trades of derivative contracts. One would be an instant winner that would extinguish current losses, and the other would be a sure loser—but far in the future.
For the purposes of the yearend reports, shareholders and regulators would have no idea there had been massive losses on the initial bet, let alone that the bill would eventually come due. Paschi had to restate its financials (and get government bailouts) after Bloomberg News uncovered the fakery in 2013. Deutsche Bank, in addition to reaping millions in fees, found a way to keep the transaction off its own balance sheet by having its components of the deal cancel each other out. Deutsche Bank, too, ended up adjusting its accounting.
The big banks don’t dispute that tougher regulation—especially higher capital and some minimum liquidity requirements—was necessary after the 2008 crisis. But they argue that the pendulum has swung too far and excessively tight rules are hampering their ability to provide credit to the economy. “How much is enough capital?” Morgan Stanley Chief Executive Officer James Gorman asked the audience at an industry conference in October. “Let’s do at least what you would have needed to get through the financial crisis without a problem. Fair start. And let’s dial it up a bit because things could get worse. Fair enough. And let’s add a buffer to that because there are always unintended things. And let’s add another buffer because we can. … Well, hang on.”
Gorman’s panel mate, JPMorgan CEO Jamie Dimon, said the post-crisis rules had addressed the lack of capital and introduced important safeguards. Lehman Brothers wouldn’t fail if it were regulated under today’s rules, he said, but banks are asking that the rules be made less onerous.
The Bank Policy Institute, a trade association representing the largest U.S. and European banks, has railed against eliminating risk adjustments in capital calculations. “It is akin to setting the same speed limit for every road in the world, whether it’s a highway or a school zone,” BPI President Greg Baer wrote in a 2017 blog post. For Stanford’s Admati, though, the metaphor misses the regulatory reality. “Risk weights help banks obscure, evermore, the totally reckless speed at which they are still driving,” she says.
To contact the editor responsible for this story: Pat Regnier at email@example.com, Robert Friedman
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