Banking by its very nature should be a moral activity. It interacts with the lives of the vast majority of working people and sets obligations on the parts of both parties to lending or investing activities. There needs to be trust that both parties will uphold their share of the bargain, but what if trust in the banking system fails? In much of the so called Developed World, this is the road we have been travelling down in the recent past although it has been the lack of trust in the system by bankers themselves that has been much in evidence – and they should know.
From the 1980s onwards banks cottoned on to profitable money-making activities that today fall under the rubric “structured finance”. In the 1970s leasing finance was a growing business for major banks for financing all sorts of business capital acquisitions. This was seen as a form of “off-balance sheet financing” as frequently the asset’s economic life was acquired via leasing but only the annual leasing charges went through the accounts. In some countries where some businesses leased all their assets (such as car rental businesses) financial results were distorted by leasing arrangements because of the absence of assets and debt from financial statements. To counter this trend the accounting profession introduced an accounting standard on leasing to split leases into finance leases (converting lease payments to lease assets and lease liabilities) and operating leases (pure rental agreements). No sooner had the standard been introduced that the banking sector ran advertisements telling companies that they could convert all finance leases into operating leases hence circumventing the intention of the standard. This allowed companies to keep rising lease obligations off their balance sheets and also creating a “nice little earner” for the banks. Nothing has changed in accounting for leases in the last twenty years and by 2008 the equipment leasing sector was a $650billion industry in the USA alone.
To my thinking this was the beginning of “structured finance” arrangements facilitated by the commercial and investment banking sector. It had its ultimate expression in the activities of far too many investment and commercial banks before the global financial meltdown, and their actual or near demise, and the promotion of off-balance sheet structures (including Special Investment Vehicles SIVs), structured capital management (basically tax avoidance), and structured stock financing for directors and executives.
Got a company that wants to keep debt off its balance sheets? No problem! Set up a special investment vehicle (SIV) not owned by the reporting company to ensure that there is no consolidation of its activities in the financial statements. To date Enron has been the most flagrant user of SIVs to hide both its debt problems and lack of profitability. It was clear that the banks knew quite well that they were entering into transactions that were in reality loans to Enron for hundreds of millions of dollars. That they were structured as loans to “independent” partnerships where the “owners” were executives of Enron would not have fooled the bankers who knew they were transacting with Enron.
However, not only Enron used SIVs. I came across such entities in Australia n the 1980s and I got the impression then that many companies were using them for “balance sheet management”, a euphemism for fiddling.
Fast forward to the Twenty-first Century and it appears that many banks were using SIVs also. Banks used them to evade Basle II regulations on capital adequacy, so that they could lend more than their capital could justify. The banks persuaded the regulator that the liabilities in the SIVs were offset by the values of the securitised assets in the SIVs and that these values would not fall as they were AAA-rated by Standard & Poor or Moody’s and insured by financial guaranty insurers (called monolines).
In hindsight this was not a smart move by the banks. In 2007 BNP Paribas, a large French bank, announced that it was closing down redemptions of certain investment funds as it had become difficult to value the assets held by them. Now banks generally borrow and invest extensively with each on a short-term basis. The problem for the banks, after the realisation that too many of them might be holding securities reliant on toxic sub-prime mortgages, was that they could not price other banks’ assets leading to a breakdown in the trust necessary to transact with each other and bringing credit markets to a screeching halt.
In Living with Other People, Ken Melchin used philosopher Bernard Lonergan’s “scheme of recurrence” concept to analyse commercial transactions. Such schemes can be used to describe everyday commercial transactions. The key moral element of trust must be present at each stage of the transacting process, so that it can be successfully completed and provide the necessary conditions for the emergence of the next stage. Underlying the process is the ongoing testing of the trustworthiness of the persons and structures involved in the transaction.
The need for trust indicates that commercial transactions rely on intentional processes between people. If that trust is undermined it can have profound economic consequences as the global financial crisis demonstrates. BNP Paribas’ experience was the first public episode in what we now call the sub-prime crisis. It was in part driven by banks keen to generate fees. Packaged mortgages that were securitized and sold off often contained tranches of high-risk sub-prime mortgages, on which the banks could charge high fees, mixed in with low-risk mortgages. Selling these products, often called collateralised debt obligations (CDOs), reduces bank risk as it is onsold to someone else. The view developed that if you chopped risk into little pieces and spread it around it somehow mysteriously disappeared. However, the investment arms of the banks were simultaneously buying mortgage-backed securities which included the toxic stuff they had been trying to get rid of. When it started appearing in the balances sheets of European and then American banks, banks as a group became nervous about lending to each other and the schemes of recurrence necessary for effective transacting within the banking sector broke down.
The problem for the banks now is that the value of the assets in the SIVs has probably plummeted whereas the liabilities have remained unchanged. According to the IMF bank writedowns of "toxic assets" could soon reach $US4 trillion. The recovery rate for what were classified as safe, low-risk mortgages has been as low as 32 per cent whereas the recovery rates on the high-risk mortgages has been as low as 5 per cent.
The scale of the problem has been breathtaking as it could have taken down the international financial system except for the intervention of governments prepared to spend billions of taxpayer dollars to salvage a system that is obviously flawed.
Structured finance however was not limited to setting up SIVs. When the British banks got into trouble in 2008 the government bailed them out by taking large equity stakes –effectively nationalising them. One bank in particular, Bank of Scotland, ran a structured capital markets division effectively helping British companies to avoid British taxes through tax arrangements using offshore tax havens. When the government took a 70 per cent stake in the bank, this division was closed down. However, it appeared that Barclays Bank, which has been seeking government support, ran a much larger capital markets division that contributed $1 billion to group profits in 2007. The move by governments to shut down tax havens is really an exercise in shooting the messenger not the culprit. The culprits are in their own back yards.
The last area of structured finance activities that I am aware of is the selling of derivative products to company directors that help them lock in the value of the shares they hold in the company or enable them to sell options on shares in their companies which are “not in the money” but still have a market value. Such activities have occurred without any disclosure to the stock markets by directors of these profit-generating activities which are market sensitive data.
The development of such structured products and the promotion of them to help companies and their management (a) avoid disclosure laws, using SIVs to manipulate financial statements so that they would be opaque to investors and analysts alike; (b) avoid taxes that were legitimately imposed on corporate operations helping to inflate reported profits; and (c) help directors and executives profit from shares or options owned without disclosure to other investors, has meant that information which investors, lenders and governments needed to know to assess what has actually happened inside too many listed companies, has been effectively hidden from them.
If we take the Caux Round Table ethical foundations of responsible stewardship, living and working for mutual advantage and respect and protection of human dignity, many banks appear to have failed on all counts. The CRT principles emphasise that good ethics is good risk management, something that many banks did not take to heart. Many of the owners of these banks have suffered enormous wealth losses, yet the executives appear to have escaped with their loot intact.
Note that none of these activities was strictly-speaking illegal. Then again nor were bankers alone to blame for structured finance initiatives. They have been ably abetted by accounting firms and law firms, but the bankers ran with the concept and should have suffered most as a consequence. The accounting firms and law firms supposedly operated within their own ethical codes to protect the public interest yet I feel that the ethical codes of these professions could be in need of enhancement through a set of principles for responsible practice similar to the CRT principles.
That most of those involved in establishing the structured finance arrangements outlined above have to date suffered little, because of government intervention, leaves me worried that without proper analysis, investigation and changes to regulations we could see a repeat of these forms of financial subterfuge when the recession ends.