The purchaser of a portfolio of global banking stocks in the early 1990s is today sitting on a real loss. So who exactly is it extracting value from today's banks? The answer is twofold: shorter-term investors and bank management. Because banks have, over the past two centuries, migrated to a limited liability, shareholder-owned model, there is a natural tendency for owners to make riskier loans and trades and to increase the bank's assets.
|Bank of England|
That was one of the main causes of the subprime episode. Faced with the prospect of not increasing earnings, banks simply began to manufacture borrowers where none really should have existed.
The situation is exacerbated by the fact that debt is tax-deductible while equity is not, giving banks even more incentive to borrow. While the typical leverage of an American or British bank in 1900 was five or six times equity, that figure peaked at about 30 times before the crisis, and is higher still now for many euro zone banks.
Bank bondholders have been unwilling to play their role as vigilantes, in part because they quite rightly expect to be bailed out by governments if banks go to the wall.
In the past 30 years, many banks have moved to measure their performance -and set their bonuses -on the basis of a measure called return on equity, which measures profit compared with equity. What return on equity does not adjust for, of course, is risk, and it looks as if return-on-equity targets in a leverage driven business have produced a lot of risk in the form of extreme bank earnings volatility, and badly compensated volatility at that.
PS: Conspiracy, conspiracy. If you search for James Saft on IHT's web site, it comes back with " 'James Saft' did not match any documents under Past 30 Days." If you search for the column's title "Why banks take such huge risks," it comes back with all sorts of articles (about Berlusconi, among others), but not with Saft's column. However, if your search for the same title on Google, it comes back with a mirror site of the column as first result. (Lol)