16 September 2008
editorial
Johannesburg — ONE day when the US banking crisis is all over, a new textbook will have to be written to capture the lessons for the world's banking regulators.
There are perhaps at least two lessons that US regulators should already have known about from other such crises, in smaller markets such as our own. One is that once you bale out one big institution, it's perfectly rational for the market to expect that you stand willing to bale out others. That is an aspect of the classic "moral hazard" problem that regulators risk when they opt to rescue failing banks: the message they may send is that even those that have blundered will be rescued. But even if banks fail through no fault of their own, bale-outs tend to raise the expectation of further bale-outs.
The US Federal Reserve provided a $29bn guarantee for one big Wall Street investment bank, Bear Sterns, when JPMorgan agreed to buy the ailing Bear earlier this year. Then a week ago it took over mortgage financiers Fannie Mae and Freddie Mac, putting billions of dollars of public funds behind them. So it's hardly surprising that when US regulators asked the UK's Barclays to take a look at buying another desperate Wall Street investment bank, Lehman Brothers, Barclays was willing to do so only on condition it could leave behind $40bn of Lehman's "bad assets", in commercial property loans -- and that the Fed would write a guarantee to cover Lehman's trading losses for a few months until Barclays could get approval from its shareholders for the deal.
This time, the Fed balked at a guarantee, so no deal. And this is the second lesson banking regulators should know. Nothing is more damaging to an ailing bank than a walk-away by a potential bidder. If the bidder declines the deal, apparently because something is very wrong, the target bank is dead. Filing for bankruptcy was Lehman's only option. But the uncertainty about whether the Fed would stand good for the system had already spread the damage to even larger rivals -- Merrill Lynch in particular.
Unbelievably, Merrills too will now disappear from the Street, after being forced to sell itself to Bank of America. At least it was lucky enough to be bought. What will happen to the world's largest insurer, AIG, which has now also turned to the Fed for help, is unclear. Nor is it only the US's investment banking sector that has been hit: its sixth-largest commercial bank, Washington Mutual, is also looking fragile.
It's hard to know just when that textbook might be written, because for now there seems no end to the turmoil. The credit crisis is more than a year old, and banks have already written off hundreds of billions in bad assets, but still the write-downs continue, the share prices plummet, and crippled high fliers go to the wall.
Some would say banking crises serve exactly the role of clean-up agents, driving the weakest players out so that the system eventually emerges stronger. One view of the last US banking crisis, the savings and loan crisis of the 1980s, was that the Fed didn't allow enough weak institutions to fail, and that planted the seeds of the next crisis. Some consolidation on Wall Street may be a good thing after the excesses of recent years. But it has to be managed with extreme care to contain the economic fallout. At this point, the behaviour of the US regulators isn't exactly inspiring confidence.
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