Modern Banking

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cancer in so many of Japan’s financial institutions both reflected and aggravated the country’s macroeconomic weakness from the early 1990s on. By 2001, the government had spent about $500 billion in direct support71 of the banks, or about 17% of Japan’s annual GDP, with another $200 billion in credit guarantees. Since then, it is difficult to assess the size of the fiscal injection. The expenditure has been financed by government bond issues: any tax increases would depress the economy still further (and there have been some tax cuts). This has resulted in rising government debt and fiscal deficit. In 1999 government debt as a percentage of annual GDP was 100%, climbing to 113% in 2002, nearly double the average in other G-7 economies. These figures exclude large debts recently incurred by institutions linked to Japan’s lower tiers of government.

Unemployment peaked at 5.6% in 2001, double its post-war average. For seven years from 1995, consumer expenditure fell in real terms almost uninterruptedly. It was depressed in a climate of job losses and deflation and possibly, by the prospect of higher future taxes to service the burgeoning debt of the public authorities. Official interest rates have remained very close to zero. The consumer price index fell by an average of nearly 1% a year between 1999 and 2003. Expectations of falling prices are a powerful inducement to postpone spending of all kinds.

The government macro policy options are very limited. Fiscal stimulus has not worked, though about half the increase in government expenditure has gone to the financial sector, shoring up banks and other financial firms that should have been allowed to fail. Since 2002, attempts to lower the external value of the yen, designed to strengthen the trade balance contribution to aggregate demand, have only led to some ¥7 trillion paper losses from the MoF’s reserves. Monetary stimulus (expected or unexpected) has been hampered by the zero lower bound to nominal interest rates. Generally, with an increase in the money supply, short-run interest rates will fall but in the current climate, this is not possible. One issue is whether the demand for money has a horizontal intercept or not. If it does, money is held to satiation when the nominal interest rate is zero, and there is no apparent way of inducing people to hold more.72 This was the view held by the previous Governor of the Bank of Japan, Mr Hayami. However, the new Governor, Mr Fukui, clearly thinks the Bank of Japan has a role to play. He has sent out a strong message that monetary policy will be continuously eased (i.e. printing money) until annual inflation has been positive for a reasonable period of time. This message should create inflation expectations.73 Government bond yields have risen in 2003 – 4, suggesting a declining proportion of households expect consumer prices to fall.

As this book goes to press, there are a number of encouraging signs pointing to economic recovery:

žIn January 2004, narrow money growth rates increased to 4.1%, up from 1.5% a year ago.

žReal GDP increased by 2.3% in 2003, and is forecast to rise by the same amount in 2004.

71For example, capital injections, purchase of bad assets, support for the Deposit Insurance Corporation.

72In the old Keynesian view, this is because of a liquidity trap: horizontal demand curves for bonds (bondholders expect long-run interest rates to rise). If the government tries to buy them back to increase the money supply, the price of bonds will not change, therefore interest rates cannot fall, so there is no way of stimulating investment.

73Even though the price of money is close to zero, increasing notes and coins in circulation will raise liquidity.

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The background to the problems in these three countries shares some features with Japan and South East Asia. Prior to the onset of the crises, real GDP growth rates were steady and averaged between 4% and 6% for each country. The growth of credit had been regulated by the governments, but these were removed in the early to mid-1980s. Many interest expenses were tax deductible, and the real interest rate was low and in some years, negative. Once the quantitative restrictions were lifted, there was a boom in lending, which led to a rapid rise in property and stock market prices.75 Property was the main collateral, and as property price indices soared, there was more borrowing, which in turn raised property prices. The banks were willing lenders, probably due to a combination of factors: they had just been freed from a significant number of restrictions on their activities, including rationing and controls on risk-taking. It is telling that staff were promoted for increased loan sales rather than risk adjusted return. Other factors include the illusion that collateral substantially reduces risk, and the ‘‘herding’’ problem. Thus, the non-financial firms were highly geared, and when the downturn came, bankruptcies soared. Pesola (2001) notes that in Norway and Sweden, 75% of the banks’ loan losses were due to bankruptcies in the corporate sector.

Despite the obvious credit boom, fiscal policy was loose, and monetary policy focused on using the interest rates to keep exchange rates steady – particularly in the case of the Swedish crown, against the German mark. As in Asia, the long period of relatively steady exchange rates meant currency risk was largely ignored. Attracted by lower interest rates, banks and the non-financial sector borrowed in foreign currencies. Sweden was the most exposed: about half of total bank lending was in foreign currencies. Unlike Asia, net capital inflows were not a significant contributor.

The bubbles in all three countries burst as a result of economic shocks. Norway was first in line with the sharp drop in world oil prices in 1985 – 86. The sudden implosion of the Soviet Union in 1990 caused a crash in exports by Finland and (to a lesser extent) Sweden. This led to more severe recessions in these two countries, which is evident in their GDP growth rates, which were negative between 1991 and 1993. Finland’s worst year was in 1991, when real GDP fell by 6.3%. In Sweden, the figures are less dramatic: its GDP fell by 1.1% in 1991 and 2.4% in 1993. Both countries recovered quickly: GDP growth rates were 4% in 1994. Norway’s growth rate fell much earlier, but the decline was notably smaller – 0.1% over their crisis period of 1988 – 92 (see Table 8.13).76 All three countries were raising their interest rates to protect their currencies after German interest rate increases, which, together with lower interest rates, increased the cost of borrowing. In the autumn of 1992, Sweden and Finland experienced serious runs on their currencies. This coincided with the onset of the systemic banking crisis in Sweden, though Finland had already entered its systemic phase.

Table 8.13 summarises the main features of the crisis in the three countries. There are several interesting features to point out. In Finland, Skopbank was the first to run into difficulties. A commercial bank, it was important to the banking sector because it acted as central bank to the savings banks. In October 1990 a group of savings banks provided

75Sandal (2004) points out that personal sector investment in the stock market is of much less importance than the property sector.

76Sources for GDP figures: Koskenkyla¨ (2000) and Sandal (2004).

This table was constructed from tables 1 and 2 of Sandal (2004), except the % of assets controlled by troubled banks. The figures were supplied by the Bank of Finland (Sampo Alhonsuo), Bank of Norway (Knut Sandal) and Koskenkyla¨ (2000) for respectively, Finland, Norway and Sweden.

SBF was established from the mergers of several problem savings banks.

Nordbanken was majority owned by the state before the crisis.

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LTCM was a hedge fund, a term with US origins after an investment company was set up to buy stocks and to sell them short, hence the term ‘‘hedge’’. Provided the company was for wealthy investors, it was exempt from the strict regulations imposed by the Securities and Exchange Commission.79 Until LTCM, the Soros fund was the most famous. It sold sterling short during the ERM crisis of 1992, when the UK authorities spent £14 billion trying, but failing, to keep sterling within the ERM band. John Meriwether was a highly respected trader even though he had left Salomon Brothers under a cloud in 1991. He formed LTCM in January 1993. It consisted of two partnerships. Long Term Capital Portfolio, the actual fund, was registered in the Cayman Islands to minimise taxation and avoid regulation, and Long Term Capital Management (LTCM) was a limited partnership registered in Delaware with offices in Greenwich, CT.

The hedge fund made money from arbitrage opportunities: buying low and selling high. However, the margins are low, so these funds need high volumes and require huge capital backing. The exceptionally good reputations of the founders, Merton Miller and Myron Scholes (who in 1997 jointly shared the Nobel Prize in Economics for their work on option pricing), John Meriwether and others, meant the firm was able to attract capital of over $1 billion, including personal capital committed by the partners.80

One source of profit was the ‘‘money machines’’ which had been developed while Meriwether and many LTCM employees who had worked with him were at Salomon Brothers. When securities with the same or near identical payoffs have different returns, the arbitrageurs use them to create a money machine to provide a risk-free return. One example: at Salomons, Meriwether found that newly issued 30-year US Treasury bills sold at a premium compared to those issued say 1 year earlier, with a term of 29 years. By selling 30-year bonds short and buying the older bonds, a profit could be made when the new bond (sold short) was a year old.

Another money machine was issuing a capital bond which guaranteed investors their capital at the end of say 5 years, plus, for example, the equivalent of their capital plus 110% of the rise in the FTSE 100. The financial institution issuing this instrument could hedge against any rise by buying a zero-coupon bond plus a long-term option which would pay out the equivalent amount if the FTSE does rise. LTCM arranged the option for the financial institution.

Initial profits on trades such as these increased capital to $4.87 billion by 1998. The partners were so confident that they returned $2.7 billion to investors shortly before they began to get into difficulties. In theory, the risks incurred by LTCM should not have been that high. Just before their collapse, liabilities amounted to $124.5 billion, and assets $129 billion. However, LTCM was highly leveraged with off-balance sheet items worth $1.25 trillion (Miller, 2001, p. 323). Investors were unaware of the size of the leverage and were not concerned because the firm was supposed to be profiting from arbitrage opportunities.

79The Investment Company Act (1940) was another one of the post-depression laws aimed at protecting small investors from mutual funds, which would be strictly regulated by the Securities and Exchange Commission. The company described above was exempt from the rules. Investors typically pay 1–2% annual fee plus 20% of whatever the fund earns.

80Investors had to commit at least $10 million for a minimum period of 3 years, pay fees of 2% per annum, earning 25% of the profits.

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The arbitrage positions necessitated short sales. The firm making the loan usually gets collateral (securities) plus a ‘‘haircut’’ (see Chapter 5), an additional sum amounting to about 2% of the security’s value, so if the borrower defaults, the lender gets something back. Or if the value of the collateral declines, the haircut is there to cover the lender until an additional margin is paid. However, the size and reputation of LTCM meant it did not normally pay haircuts.

A number of factors contributed to the ‘‘failure’’ of LTCM.

žThe use of a value at risk model: known as the Risk Aggregator Model (at LTCM), the problems with VaR models were outlined in Chapter 3. However, most other financial institutions using VaR are subject to additional regulations and scrutiny by regulators which complement the VaR contribution. However, LTCM had been set up to minimise regulatory constraints – it was not a bank, and it was registered in the Cayman Islands. So there was no independent body scrutinising their risk control measures. When LTCM lost money early in the summer of 1998, and breached its VaR measures, the firm claimed it was a one-off loss, caused by Salomon unwinding all positions related to the bond arbitrage operation, which it decided to close down. Nonetheless, the breach in VaR limits is an indicator, telling a firm to either sell assets or increase capital. Ironically, LTCM had just returned capital to investors. Raising capital would be difficult with increasingly volatile financial markets – this was the time when many of the ‘‘tiger’’ economies of South East Asia experienced currency and banking crises that were affecting markets around the world (see Chapter 5). LTCM took the only course open to it: it reduced its assets. Rather than cut a range of positions, a decision was taken to reduce the most liquid (and least profitable) positions.

žIn already volatile markets, under government orders, Russia devalued the rouble and, not for the first time in its history, declared it was suspending its debt repayments. Some banks heavily exposed in Russia experienced large losses, and many financial firms, having breached their VaR limits, were forced to reduce their exposures. They rushed to sell their more liquid swap and bond positions, which caused prices to fall – VaR limits were exceeded again, leading to more sell-offs. This episode provides an example of one of the problems with VaR: if most FIs are selling at the same time, there are no buyers, causing a further drop in prices. The only prices that were rising were those of safe, relatively liquid securities. Many LTCM positions involved going short on less liquid securities and purchasing the less liquid securities with about the same risk (e.g. the Treasury bill money machine explained above). The events in Asia and Russia reduced the creditworthiness of developing country/emerging market bonds, and widened the spreads between the prices of these bonds and those issued by creditworthy western governments. LTCM had bet on a narrowing of these spreads. Losses mounted and by the end of August 1998, LTCM’s capital shrunk to $2.3 billion. As its asset base declined, its leverage soared to 45.

žThe LTCM partners had always assumed their positions were, to a large extent, offsetting, but in a market where most prices are falling, this no longer holds true. Furthermore, LTCM was short on the only securities that were rising in price. LTCM was searching for more capital by August but with a flight to security, hedge funds were the last place investors were willing to place their capital. With losses of $1.85 billion in August,

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LTCM’s situation worried the banks which had exempted them from haircuts. The counterparties to long-term options can change the mark to market requirements, and raised them in an effort to secure more collateral. For LTCM it meant more capital had to be set aside, making it unavailable for other activities.

It was clear LTCM was effectively bankrupt and little could be done to stop it, short of finding the necessary capital. The LTCM portfolio was in the Cayman Islands, and the country’s bankruptcy laws, unlike the USA, did not force the immediate liquidation of all positions. This meant the key investment banks faced big losses if LTCM was declared insolvent because their capital would be tied up for years. Losses also came from the individual banks’ own exposures: many had tried to copy what LTCM was doing. For example, the arbitrage activities at Goldman Sachs gave rise to trading losses of $1 billion in the period July to September – most of it lost in August and September. The potential losses faced by the investment banks if LTCM failed prompted fears of major repercussions on world financial markets, which were already being felt. For example, the mortgage and company bond markets had more or less ceased to function because there were no investors willing to buy the high yield (but also more risky) bonds. The President of the Federal Reserve Bank of New York, Mr William McDonough, decided action was needed.

Meriwether had already been to see Jon Corzine, Co-chairman of Goldman Sachs. Corzine was anxious to absorb LTCM and agreed to try and raise the $2 billion in capital Meriwether needed, in exchange for control over LTCM’s risk management and 50% ownership of LTCM.81 On 18 September, McDonough’s phone calls to the leading investment banks confirmed his worst fears, but Corzine was able to tell him there could be a way out. Client confidentiality meant Corzine had to get Meriwether’s permission before providing details of their agreement. Meriwether refused, and asked to speak with the regulators directly, perhaps sensing that a less painful solution might come via the FRBNY. At his meeting with the FRBNY, Meriwether outlined the scenario if LTCM went under: the main point being that the counterparties to the trades (most of them investment banks) would each lose between $3 billion and $5 billion.82 Furthermore, these banks would lose even more money when the size of these losses became known, creating turmoil on global financial markets. By Tuesday, 22 September, the FBRNY had a consortium of 13 investment banks reach an agreement. They would inject $3.625 billion, the principals would be allowed to keep their stake, and would be retained at LTCM on a salary of $250 000 per annum.

Meanwhile, Corzine of Goldman Sachs had persuaded Warren Buffet to inject $3 billion into the fund, and another $1 billion came from another investor and Goldman Sachs. The deal was worth $4 billion but Buffet insisted that all the principals at LTCM had to go, along with their stake in the firm, which would be bought for $250 million.

On Wednesday, 23 September, the main investment banks and the FRBNY officials were meeting to finalise their agreement, but Corzine informed McDonough of the Buffet deal. Meriwether was faxed details of Buffet’s offer and asked to accept it. According to Dunbar (2000), Meriwether had worked out that if he refused the deal, it was highly likely the

81Plus other concessions.

82According to Dunbar (2000), p. 219, Mr McDonough later reported these figures to Congress.