As October melted into November last year, it was clear that all was not right in the financial system. For months, the debt markets had been shut to banks. As every day passed without any sign of improvement, what had become known as the “wall of debt” – a £500bn-plus pool of bonds set to mature over the next year – looked more and more of an impossible hurdle. Attempts to bolster market confidence had failed. Stress test after stress test was doing little to disprove the widely-held belief among investors that the problems of the European banking sector were vast and that bank debt was a needlessly risky purchase. Once the titans of finance, many of Europe’s largest banks now found themselves in the strange and uncomfortable position of being unable to raise money from the large institutions they had made billions of pounds from over the previous two decades. To central bankers the problems were more than bad, they were terrifying. To those charged with managing the financial system, the potential calamity they saw on the horizon was not just as bad asLehman Brothers’ collapse three years earlier – it was worse. The September minutes of the Bank of England’s Financial Policy Committee (FPC) spoke euphemistically of “severe strains” in funding markets. In part, this reflected the fact that British banks were in a relatively better position compared with many of their Continental rivals, having already spent two years cutting risk and building up capital and liquidity buffers to withstand any new shock. However, to those fluent in central banker-speak, the tone of some of the language was shocking, suggesting that despite all the preparations, the British banking system was far from the fortress that was being portrayed. “I started seeing them use the word 'threat’ a lot more. From my memory, threat was a word that was rarely used and its inclusion certainly made me sit up and take notice,” one former Bank of England adviser recalls. The hunch was right. Inside the Bank of England something close to panic had gripped the institution. Among senior managers a sense of foreboding had taken hold. A couple of months earlier, Christine Lagarde, the head of the International Monetary Fund, had revealed why everyone was so fearful. She said European banks should be forced to raise more cash, such was their perilous position. The world economy was entering a “dangerous new phase”. In late October, the Bank made clear its fears to the heads of Britain’s major lenders. The Old Lady of Threadneedle Street was worried the UK’s biggest banks could be swept away by the financial calamity it saw building up in the eurozone banking system. At a meeting at the Financial Services Authority’s Canary Wharf headquarters at the end of October, Paul Tucker, deputy governor of the Bank of England and the man responsible for the financial stability of the British financial system, shocked the assembled banking elite as he opened the private session. “Gentlemen, you could all be out of business by Christmas,” Mr Tucker, a candidate to be the next Governor of the Bank, said to his shocked audience. He went on to explain the situation he saw developing and how threatening he thought it could be to even the largest and most financially strong of institutions. Repeating the September minutes of the FPC, Mr Tucker urged all the banks to build even larger liquidity buffers and raise yet more capital. “We were left scratching our heads,” said one senior banking executive present. “As soon as I got out, I reported back what Paul Tucker had said and I immediately called my team in to go through every risk exposure we had to see if there was anything we had missed.” Others present were less than impressed by Mr Tucker’s dramatic warning and critical of the Bank’s performance in the months after the meeting. “They certainly made some strong statements to us, but they then did very little about it,” complained one banker also present at the meeting. “It was obvious the financial system was in a very difficult place, but it’s not exactly constructive to predict doom and gloom and then do nothing.” Even some of the other regulators present were shocked by the directness of the warning. “There was some flowery language,” admitted one senior regulator. Bank of England officials were not alone in their sense that something was going very wrong at the heart of the financial system. Like the pit boss of a Las Vegas casino, interdealer brokers have, in many ways, the best view of who is winning and losing in the financial markets. Acting as middlemen between the world’s largest banks on billions of pounds of trades every day in everything from foreign exchange to interest rate swaps, the brokers such as ICAP, BGC and Tullett Prebon have a better view than all but the most clued-in of regulators of what is going on in the financial system. “Very, very close indeed,” is how one senior broker now describes the edge towards the financial precipice the banking system took late last year. “We see the flows in between banks. Most interbank products are broked as 'name give up’ – foreign exchange, derivatives, they are all done this way. The bank rings up, says 'We want to do something’ and after the trade we give out the names to either side. The banks want that so they are facing known counterparties,” explained the executive. But in the autumn of last year some very odd things began to happen. “From time to time in the market, they [the banks] will say 'I want to do X, but don’t give up my name to Y’. That means they don’t want to deal with them anymore. If you start hearing that against a bank in the energy market, it doesn’t really matter, but if you hear it in FX [foreign exchange] or interest rate swaps, you think 'Hmm, blimey, this is really a problem’. “You could tell it in the autumn of 2008 as you started to hear that about Royal Bank of Scotland – they’re dead. We did start to hear that at the back end of last year.” In France, the summer months had been particularly cruel to the country’s largest banks and the fear was that the UK could be next. What happened in France last year is an object lesson in what happens when confidence evaporates. As euro break-up fears flared, attention had begun to focus on the large potential losses lenders such as Credit Agricole, BNP Paribas and Societe Generale would have should Greece exit the currency. To US money market funds stung by the collapse of Lehman Brothers, which famously led several to “break the buck” – meaning their supposedly ultra-safe investments were worth less than the amount of money their investors had placed with them – this rang alarm bells. In a matter of months, funds more than halved their exposure to the French banking system, removing a crucial short-term source of dollar funding to the banks. For the banks, this raised several problems, as they relied to a greater or lesser extent on the money market funds to provide the liquidity that supported the US investment banking operations they had all developed over the previous two decades. However, it was not just money market funds that were getting nervous about France. In mid-September, a Deutsche Bank call for clients hosted by analysts saw bankers peppered with questions from Middle Eastern companies, including oil giant Saudi Aramco, about the health of French banks. The collapse of Royal Bank of Scotland and HBOS in October 2008 provided a vivid warning of the danger of market seizure as both suffered a global run by corporate depositors that within weeks forced them to go to the Government to seek emergency funding. The move ended up costing the taxpayer more than £70bn in direct support and hundreds of billions of pounds more in state loans and guarantees. It is impossible to know the composition of a bank’s corporate deposits, however Middle Eastern wealth funds and conglomerates have hundreds of billions of dollars in cash held with banks around the world. The hint they could be getting ready to pull their money could spell death for any bank. Effectively, the problem faced by the French banks was that without a large pool of dollar denominated assets it was becoming increasingly hard for them to fund parts of their asset books that relied on frequent and plentiful access to dollar funding. At BNP Paribas and Societe Generale, the banks with the largest US operations, the decision was made to begin cutting their dollar funding needs by selling assets to reduce their reliance on short-term funding. But whatever banks were doing themselves to salvage the situation – and with the UK looking into the abyss as well – for central bankers the risks had grown far too great, and on November 30, six central banks, including the Bank of England, the Federal Reserve and European Central Bank, led by Mario Draghi, announced a co-ordinated intervention to provide cheap dollar funding to lenders. Just over a week later, the ECB went even further with the establishment of two new long-term refinancing operations (LTROs), effectively dirt-cheap three-year loans, to provide eurozone lenders with all the money they would need to keep operating and fund the debt they had maturing over the following 12 months. On December 21, eurozone banks, including some British lenders, borrowed €489bn (£384bn), immediately staving off the acute funding problems that had come close to bringing down several of them. In February, banks borrowed a further €530bn, taking the total size of the programme to in excess of €1 trillion, as the ECB allowed lenders a second chance to sort out their funding problems. Among bankers and policymakers, it was generally agreed that central banks had done enough to stave off the immediate crisis Mr Tucker relayed at that tense meeting in October. Although the banks had made it past Christmas, the cost was immense and the various schemes have not removed the fundamental problem for many banks that are still loaded up with toxic loans likely to cost them billions of euros in losses over the coming years. British banks have done more than most to come to terms with their toxic legacy, but few think they are out of the woods yet and the prospect of a new crisis is an ever-present worry for central bankers and regulators. Mr Tucker’s warning remains: “Gentlemen, you could all be out of business by Christmas.”
“Gentlemen, you could all be out of business by Christmas.”
British banks faced the financial precipice
"Gentlemen, by Christmas it could all be over".
These are the words of the Bank of England’s deputy governor at a key meeting of banks late last year.
Why was he so worried?
Monday, 20 August 2012
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