9 Bank Failures Cause Crisis: How Absent Management in Banks Can Cause a Crisis

It is a characteristic of many producer managers that they never seem to have enough time. The enormity and variety of tasks facing producer managers can be overwhelming. They have their position because they are very good at their job, certainly at the production side. So they are much in demand, internally and externally. They never have enough time. And if they do not have enough time, they have to prioritise, consciously or unconsciously. And production gets priority because that is where the money is, for the bank and the banker. The bankers leading the large deals are generally producer managers, responsible for managing anything from their own small teams to large divisions and even country operations.

The time conflict within each producer manager strongly favours the production, and it is common that management is done last, if at all. Any requirements from clients have an immediacy that management requirements often lack. The short-term timing requirements can be so overwhelming that even the toughest investment banker finds it hard to also carry out the medium-term, significantly less time-sensitive management tasks. If a banker does not win a deal, the bank’s top executives will hear about it and react. If the annual assessment of the banker’s team is late, human resources is likely to chase. There is no comparison in the seriousness of these two reactions for the producer manager.

The internal conflicts on how to prioritise time become particularly acute in times of crisis, when clients’ needs are likely to be at their most intense. This is also when the management requirements are at their most demanding, such as leadership and setting an example for younger, less experienced people, let alone taking strategic decisions for the bank. So while a producer manager is the only type of manager that is credible to other professionals, this is of little value if the production responsibilities prevent the very best management in times of crises. This is where the producer manager approach can cause absent management at the most critical moment.

The need to pay attention to short-term client and market production issues also means that medium- and long-term strategy may not get the attention required. The discussion within Salomon, for close to a decade, to improve the incentive plans to take account of risk, had never been implemented. The low priority for this complicated management task was probably a reason for this lack of implementation.

Another reason production tends to win the most attention from the producer manager is client focus. The importance of client focus is often paramount in all types of professional management service firms, and

banks are no exception. The client is the source of revenue and profit, of rewards in terms of both bonuses and promotion. Banks compete fiercely for clients. In some cases the relationship a banker has with a particular client is considered the most important value the banker brings to the bank. Some clients are so loyal to a particular banker that they will move their business with her, should she move to another bank. If such a valuable client needs attention, the producer is likely to abandon all other tasks to ensure the client has her full attention. Management responsibilities are likely to come a poor second.

Client focus has become a mantra for many banks. The promulgation of client focus as a key value of the bank further emphasises its importance and the outranking of management responsibilities in the producer manager’s agenda.

Conversely management is seen as diluting production. At the very least the management responsibilities are likely to be a distraction for the producer manager. With production on its own often being demanding enough, the outstanding management responsibilities can easily become an irritant. This development is unlikely to add to the motivation to complete these management responsibilities when the producer manager does get around to them, perhaps at the end of the day or at the weekend.

Another problem with the producer manager approach is that these people are very rarely equally skilled at both functions. Nearly all producer managers learn production first, from the day they join the bank. Once they have proven themselves successful as producers, they typically become leaders of small teams, the first step on the producer manager ladder.

In non-financial corporate organisations, where technical skills are highly rated, somebody who is given management responsibilities often stops producing. But even where this is not the case they are often then trained as managers. Management is after all just another technical skill that can be learnt. The idea that someone is a natural leader may have had application in simple organisations but is outdated given the complexities of the management responsibilities of a modern bank.

In banks the new manager keeps producing. Even in a retail branch, the newly promoted manager is likely to still see clients, although at some stage she may become a full-time specialist manager with an approach more like a retailer than a professional services firm.

In commercial and investment banks the newly promoted manager will continue to produce. But management training is rarely offered. In one case when three valuable producers were promoted to team leaders and

producer managers, human resources were requested to provide them with management training. No internal training for managers, or a list of external providers of such training, was available in the bank, which employed 3600 people in 2006.

As for the corporate approach of sending a newly appointed manager back to school, perhaps for an advanced management programme at a business school, this almost never happens in investment banks. The newly promoted producer manager is supposed to get on with the additional management responsibilities, while at no stage reducing her production.

Finally, there has been a significant change in complexity of production and management. For a bank in a single line of business, operating in a single state or country, neither producing nor managing is particularly complex. The senior person in such an entity can successfully carry out both production and manager responsibilities.

Both functions have grown significantly in complexity as evidenced by corresponding growth in complexity of banks. However, many bankers welcome a growth in complexity of their production. New products with complex features provide opportunities to serve clients better and beat the competition.

However, complexity of banks has grown so much that they have arguably become unmanageable. Consider the Morgan Stanley example with 30 times the number of employees in 20 years. That can be unmanageable by the best specialist managers available, doing nothing else than managing highly complex entities.

But most of those managing such banks are producer managers, with production priorities that are often greater than the management priorities. These production priorities provide greater achievements for the managers and, in the shorter term, probably account for a larger proportion of any bonus, and fit the skills of the producer managers much better than their management priorities.

Management of banks developed much later than in industry. It developed during a period of rapidly increasing complexity, both in terms of types of activities and geographically, with the additional pressure of significant growth of many banks both organically and by mergers and acquisition. The Baring example of the 1990s shows that this increased complexity developed ahead of management’s capabilities to understand and control the associated risks. The attitude to management changed in banks from the 1970s to the 1990s and, positively, became seen as a competitive advantage in retail banks. However the attitude to management as

a discipline remained negative in spite of the evident requirements for management of large, fast growing and complex organisations. This attitude, which was particularly evidenced in investment banks, is likely to have hindered management control and therefore made banking crises more likely. Not only the attitude to but also the capability for management had not developed adequately by the 1990s. There is little evidence that professional management had developed the ability and status within banks comparable to that in industry decades earlier.

Historically, the management approach of producer managers has remained unchanged while the complexity of many banks has increased enormously. This lack of development of management in banks is a major contribution to absent management.

RefeRences Auger, Philip, and Joy Palmer. 2003. The Rise of the Player Manager.

London: Penguin. Burton, Diane, Katherine Lawrence, and Thomas J. DeLong. 1999. Morgan

Stanley: Becoming a “One-Firm Firm”. Boston: Harvard Business School. Chandler, Alfred D., Jr. 1962. Strategy and Structure: Chapters in the History of the

Industrial Enterprise. Washington, DC: Beard Books. DeLong, Thomas J., John J. Gabarro, and Robert J. Lees. 2007. When Professionals

Have to Lead. Boston: Harvard Business School Press. Lorsch, Jay W., and Peter F. Mathias. 1987. When Professionals Have to Manage.

Harvard Business Review (July–August). Meiksins Wood, Ellen. 1998. The Agrarian Origins of Capitalism. Monthly Review 50, July 1998. Nanda, Ashish, Malcolm Salter, Boris Groysberg, and Sarah Matthews. 2006. The

Goldman Sachs. Boston: Harvard Business School. Phillips, Peter L., and Stephen A. Greyser. 2001. Bank One: “The Uncommon

Partnership”. Boston: The Design Management Institute/Harvard

Business School. Seeger, John A., Jay W. Lorsch, and Cyrus F. Gibson. 1974. First National City

Bank Operating Group (A). Boston: Harvard Business School. ———. 1975. First National City Bank Operating Group (B). Boston: Harvard

Business School. Thomas, David A., and Ayesha Kanji. 2005. Stanley O’Neal at Merrill Lynch.

Boston: Harvard Business School. Weber, Alex. 2018. J.P.Morgan – Defying Attempts to End Too Big to Fail.

Financial Times, 18 September 2018.

CHAPTER 9

Bank Failures Cause Crisis: How Absent Management in Banks Can Cause a Crisis

Absent management is particularly dangerous in times of financial crises. It is then even more likely to be the cause of the failure of a bank. The reason absent management rather than the financial crisis is the cause of the failure of the bank is that it is very rare for all banks to fail in a crisis. Management makes a difference, and absent management is likely to cause the failure of a bank when a financial crisis hits.

The possible reverse causation is even more serious. Absent management in banks can cause a financial crisis. Absent management in banks was a cause of the 2008 financial crisis.

A modern, systemic banking crisis can be defined as an episode where there are bank runs, a significant share of non-performing assets such as loans that are not repaid, bank liquidations and large-scale policy intervention to support banks (Calomiris and Gorton 1991). The 2008 financial crisis saw all of these. A banking crisis has the potential to cause a wider financial, national and international economic crisis. A key link in this causation is when sovereigns have to support banks. This can in turn lead to sovereign currency, debt or a combined currency and debt crisis. Another link is where a banking crisis causes a wider credit crisis that negatively affects sovereign debt. The further cause of an economic downturn, such as when the 2008 financial crisis caused the Great Recession, will be considered later. In this chapter the focus is on the link between absent management, bank failure and a wider banking crisis.

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Just like all banks do not fail in a crisis, so do all bank failures not result in a crisis. The two Barings crises are historical examples of this. In the second Barings crisis in 1995, caused by a rogue trader in Singapore and absent management above him, the bank was allowed to fail by its prime regulator, the Bank of England. It was assumed, correctly as it turned out, that the failure of Barings would not cause a wider banking and financial crisis. Barings and its problems were so unique that they were not considered to apply to other banks. Additionally while other banks were involved with Barings in 1995 and its failure caused these banks losses, their survival was not threatened. As such the failure of Barings was not judged likely to cause a wider, sometimes called systemic banking crisis, let alone a wider financial and possibly sovereign crisis.

The first Barings crisis was completely different. A failure of Barings in 1890 was considered a threat to the standing of the London banking system with negative implications for the United Kingdom economy. A rescue was arranged by the other London banks, not for the love of Barings, but as a matter of self-preservation and to protect London and the United Kingdom.

Banks cause crises in several ways. Most importantly any bank that fails will raise questions about the security of other banks. This is because many banks do similar kinds of business and many banks work closely with other banks.

Firstly, because banks do similar kinds of business, should there be a run on one bank, caused by depositors concern about the safety of their money, other depositors will question if their money is safe in their respective banks. So the loss of trust in one bank may cause the loss of trust in other banks, and the run of one bank is contagious and causes runs on other banks. This was seen in the banking crisis in the United States and many other countries during the Great Depression in 1929–1931.

Secondly, the interaction of banks has become increasingly deep and complex, for example through the use of financial instruments such as hedges and derivatives. If one bank is trading a hedge or other financial instrument on an established exchange, the main exposure is price volatility. The financial security of the exchange is unlikely to be a major concern and is often backed by all the exchange members. But not all financial instruments are traded on exchanges. A credit default swap is a financial instrument that pays out upon the default of a bond. It is used to protect against credit exposure of the bond issuer but has also become an asset class of its own. A credit default swap is an example of a financial instrument

that is not traded on an exchange but between individual banks. This type of trading is described as over the counter or OTC. In addition to the risk of price volatility, a financial instrument such as a credit default swap therefore also carries a credit or counterparty risk. If the bank that has sold the credit default swap for a premium is financially insecure, the credit default swap may not be honoured.

Banks also borrow from each other. The repurchase or Repo market works with banks borrowing short-term cash from each other, and also from investment funds, for one day and up to several weeks, but short term. The borrowing bank pledges high-quality securities as collateral. The riskier the borrower, the more collateral is required by the lending bank. This is very short-term finance, and it became extensively used in the 2000s, particularly by investment banks that had no regulatory restrictions on their leverage.

So all banks are dangerous, like bulls. But unlike bulls, the banks that are more dangerous are not the strongest banks but the weakest, the banks that fail. When a bank fails, it can cause suspicions about the security of other banks.

Alternatively and sometimes as well, a failure can cause losses to other banks, which, in turn, can cause losses to their counterparties and so on. The spread of suspicion of financial insecurity of more banks, or a spread of losses, is one example of what is called a systemic risk. And that is why a weak bank can cause a wider crisis, one weak bull causing a destructive stampede.

There are particularly complex, large and therefore dangerous banks, the universal banks. These are the banks that do all kinds of business, everywhere. They appear strong, but their strength is uncertain as it is masked by their complexity. They deal with retail and commercial customers as well as with investment banking clients including other banks. They act as asset managers investing on behalf of their private and institutional clients and as participants in the capital markets. Universal banks that own investment banks trade many types of instruments for clients and for the banks’ own account. They trade both on exchanges and over the counter, directly as sellers and buyers of financial instruments with other banks. In universal banks, the failure of one part of the bank, or just the suspicion of financial weakness in one part of the bank, can be enough to cause concern about all the bank’s activities. This concern may or may not be well founded, but if you believe your deposited money is in danger, some people may prefer to withdraw it. Maybe not to put it under a mattress, but

to put it somewhere not exposed to the intricacies of a universal bank. This was the reason the Swiss universal banks UBS and Credit Suisse suffered outflows from their asset management business when concerns were raised about their investment banking exposure to subprime lending during the 2008 financial crisis.

So all banks can cause a crisis, but some banks are more likely to do so than others. The bigger the bank and the more complex, the more difficult it is to manage. The more complex a bank is to manage, the more likely it is to experience absent management. And the more likely absent management, the more likely it is to fail. The more likely it is to fail, or just to be suspected of possible failure, the more likely it is to cause a crisis.

So when banks fail because of absent management and this failure is a cause of a wider financial crisis, absent management becomes a cause of a crisis.

However, banks are not here for the common good. I know because I was told this specific truth many times on the trading floor of the investment bank where I worked. Perhaps they should be. Or perhaps they should have a social responsibility. But many do not. They are primarily responsible to their owners, be they shareholders, partners or mutual deposit holders. They also have responsibilities to their customers, counterparties, employees, the environment and so on. But whether they have a social responsibility or not, they have a responsibility not to fail. This responsibility should be closely aligned to their other responsibilities, but it has an additional requirement. If a bank fails, it may cause a crisis. This makes it different from other nearly all corporate organisations, which can generally fail without a systemic, let alone wider financial and sovereign, crisis ensuing.

This book is not about whether banks should be managed to avoid causing a crisis. Of course they should. It is about absent management causing a crisis. Everyone makes mistakes. There will be mistakes in this book. Producer managers in banks are no different. The problem is that mistakes are expected and therefore have safety measures in place to prevent or at least mitigate them. This is generally what is termed risk management in banks. However, when there is absent management in banks, that is unexpected. Then there is nothing in place to prevent or mitigate failure because absent management is not expected. And when there is absent management in a bank, it can cause a lot of harm to other banks, their customers, employees, shareholders, countries, the countries’ taxpayers and those dependent on the country and its social security system.

The United States home prices that peaked in July 2006 had doubled since 2000 (Schiller Home Price index). The subsequent fall in housing prices was one of the early triggers of the 2008 financial crisis. House prices in the United States fell over 2 per cent in 2006, 6 per cent in 2007 and almost 11 per cent in just the month of January 2008 alone. The proportion of subprime loans that were delinquent reached one-fifth in the second quarter of 2007 and a quarter in the third quarter of 2007. Close to 7 per cent of properties with subprime mortgages were being foreclosed (Harris 2014). This meant that millions of people were losing their homes. And absent management in the banks’ lending was one reason behind it. A little later the consideration of Washington Mutual will show how some of its absent management, and absent management of other banks, was a cause of the 2008 financial crisis. The uncontrolled lending growth, unmanaged exactly because it was uncontrolled, encapsulated by Washington Mutual’s ‘The Power of Yes’ to lend more campaign, contributed to the increase in housing prices.

A particular part of this growth was subprime lending. Subprime mortgage was lending to people with weaker capability to pay back the mortgage loans. This had become possible due to a loosening of regulation, with the Depository Institutions Deregulatory and Monetary Control Act in 1980 under President Carter. Since the Glass-Steagall Act of 1933, there had been a regulatory ceiling on the interest rates that could be charged on mortgages. Under the 1980 Act the level of interest charged became a matter of private discretion, meaning the banks could decide (FDIC 1997). The previous limit on what interest rates were charged had the effect of limiting mortgages to those who were likely to be able to pay them back. Those with lower credit capabilities were not able to take out a mortgage because the interest they would be charged would be above the legal limit. In the following two decades, increasing competition in the mortgage market for more creditworthy borrowers, the prime market and the development of securitisation, which will be described later, contributed to the rapid growth of subprime lending (Ho and Guan 2008).

Mortgage brokers, intermediaries between borrower and lender, were paid a commission often linked to the level of interest rate paid. This incentivised mortgage brokers to focus on subprime mortgages, where the interest rates and corresponding commissions were higher. So the higher the risk of no repayment, the higher the incentive for the broker. And the lower the capability of the borrower to pay back the loan.

The mortgages could be structured so that the payments were low in the first two years. Thereafter, payments rose dramatically for the remaining 28 years of the mortgage. In a market with rising house prices, those with weaker loan repayment capability could sell the property within two years and gain equity for the next property. As long as the housing market kept rising.

Household International, owned by HSBC since 2002, and Washington Mutual, or WaMu, were active participants in subprime lending, as were many others such as Countrywide. By 2003 loans with adjustable rates made up a quarter of WaMu’s new house loans. In addition to lending to those less able to repay the loan, there was also an increased willingness to accept less rigid information in the loan application. This was all in the name of growth for the lender.

Subprime was not new. It had made up between one-twentieth and one-sixth of home loans since the 1990s. In 2005, it reached almost a quarter of all home loans, only to disappear almost completely by 2008 (Stowell and Meagher 2008).

In the past banks made a profit on the difference between what interest they paid depositors and what interest they charged the borrowers. This difference was called the spread. In addition to covering the interest paid to depositors, the spread was also intended to make a contribution to pay for those borrowers unable to repay the loans. The Medici did business like this in the fifteenth century. In good years banks could pay a dividend to their owners. In addition they could retain some of the profit to increase their capital. This capital would increase the bank’s buffer and enable them to lend more going forward, because they now had a greater security to do so in terms of increased capital.

The growth in lending was enabled by the growth in the packaging of loans and selling these securities on to investors. This was new. In the past banks had been restricted in their lending by the amount of deposits they had received and the amount of capital they had. Commercial banks in the United States and many other countries were also restricted by the amount of leverage they could raise, although this restriction did not apply to investment banks that did not accept deposits.

Once a lender has accumulated a portion of mortgage loans, an investment bank was engaged to package these loans and sell them to investors. The lender received as commission and achieved a reduction in its loan book. This meant that the lender could lend more without the need for increasing its capital. The lender would no longer make profit on loans

that were profitable, that is loans that were paid back with interest on time. Importantly the lender would not suffer any losses from loans that borrowers were unable to repay. The profit and risk of mortgage lending could be passed to investors in the capital market, insurers, pension funds, mutual funds and so on. These investors were now providing some of the capital required for mortgage lending that had been provided by lenders before mortgage-backed securities became established. Deposits and the capital of the lenders still backed some mortgage lending, but mortgagebacked securities and the vast global investment market grew rapidly in importance as the source of financing for mortgage lending.

Importantly the mortgage-backed securities were rated by the credit rating agencies. Depending on how the securities were structured, the rating achieved could be high indicating a low risk of default. This was due to the perceived diversification in the securities based on the high number of mortgages involved in the packaged securities and the belief that they would not all default simultaneously. The high ratings made the securities attractive to many investors who would normally only invest in secure assets typically rated at an ‘A’ level or investment grade. This was higher rated and therefore believed to be more secure than lower rated, noninvestment grade or ‘junk’ assets.

Banks selling securities backed by mortgage loans in the United States to institutional investors exploded, increasing almost eight times from 2000 to 2006, from $100 billion to close to $800 billion. In 2008, it collapsed to less than $50 billion (SIFMA 2009). The growth in securitising of subprime also increased rapidly from about half of all subprime loans in 2001 to three-quarters in 2006 (Demyanyk and van Hemert 2008).

With large proportions of the loans being bundled together, structured in different tranches and sold on to investors, the lenders were now incentivised to lend as much as possible. It was less important if the borrowers were able to repay because that risk had to a large extent been passed on to investors. So the banks were lending as much as possible. The investment banks were assisting the lending banks by underwriting the packaged mortgage loans and laying of the risks to investors and earning substantial fees on these transactions.

This is where we have to stop. Later, we will consider how investors behaved and why the music eventually stopped. But to avoid being caught up in the increasingly complex process of excessive lending, increasingly sophisticated packaging and selling of these packaged loans, the different instances of absent management have to be considered.

WaMu and the other aggressively growing lenders had abandoned management in the name of growth. Some of them had taken over so many other banks that additional takeovers would not make a sufficient difference in achieving further growth. So they grew their lending. What caused absent management was, again, complexity. Just like complexity had caused absent management when banks became involved in many different lines of business or in many countries or both, the increasing complexity of aggressive growth defeated management and the producer managers supposedly doing the management. The complexity arose from a combination of two highly interconnected developments.

It became possible for the lenders to sell on the loans to investors. This was the new development because traditional lending growth had been around since the Medici. Selling the loans meant that it became less necessary to manage the lending. It was no longer necessary to secure deposits within the lender to finance the lending. There were investment banks ready to structure the loans and investors keen to invest in these structures. So the historical combination of incentives to lend and to manage the lending shifted towards just growing the lending. It became more and more about production and less and less about management.

What the lenders did not understand, and might not have been expected to understand, was that the new market for packaged loans might end. This is not because they were not experienced bankers, but because this was a new market that no one had seen before and no one understood. If some did understand this they did not behave accordingly. The unsustainability of the market for packed loans or mortgage-backed securities was a complexity that defeated the management in the lending banks, some of whom had become utterly dependent on it. But while the lenders might not be expected to understand that the market for mortgage-backed securities could end, they should have understood their complete dependence on it. And to be completely dependent on something you do not understand is absent management.

However, the first big bank failure happened at the end, not at the beginning of the process. When original house prices stopped rising in 2006, this was the first link of the complex chain to change. Wherever in the chain there was significant retention of risk, including at the end, the effect would be significant.

One of the first indications of subprime affecting larger banks, and banks outside the United States, came as early as February 2007 when HSBC issued the first profit warning in its 142 years of history. A profit

warning is where a commercial operation issues a statement saying that profits will be lower than anticipated. HSBC was to make provisions for subprime loans of $11 billion, about a quarter higher than expected by equity analysts. HSBC announced that more provisions might be necessary and that it might take two to three years to resolve its subprime exposure.

In 2007 HSBC was one of the top five banks in the world, but its investment banking had not reached top ten. Originally established as a commercial bank in Hong Kong in 1865, the Hong Kong and Shanghai Bank had been a pioneer in the economic development of Asia. It survived the Second World War and the Communist Revolution in China to become the largest foreign-owned bank operating in this and many other Asian countries. It was listed on both the London and Hong Kong stock exchanges after Hong Kong reverted to Chinese rule in 1997. It had 10,000 offices in 82 countries across the globe, where it operated as a universal bank offering retail, commercial and increasingly investment banking and asset management services (O’Connor et al. 2013). The growth had been a combination of starting from scratch by establishing new banks and branches, particularly in Asian countries, to buying stakes in other banks, especially in China where foreign majority ownership was not allowed. It also included full takeovers such as Midland Bank in the United Kingdom in 1992, then one of the largest banking acquisitions in history. Midland Bank had been the largest bank in London early in the twentieth century, taking over that position from the Rothschilds. In 2002 HSBC bought Household International, a United States consumer finance company, for $15 billion. Household expanded rapidly in subprime mortgages and by 2006 HSBC was the largest subprime lender in the United States with $53 billion of subprime loans or just under a tenth of the market (Reuters 2008).

HSBC failed to achieve its investment banking growth targets but did not fail. The failure to reach the investment banking targets was partly due to the complexities of different cultures in a very large commercial bank aiming to grow its investment banking activities. Having hired a senior investment banker from Morgan Stanley, one of the leading pure investment banks, in 2003 this was followed by the hiring of an additional 2000 investment banking staff in just one year. The senior investment banker left three years later. During these three years $1 billion had been spent on building an investment bank, of which about four-fifths were staff remuneration. The bank had not made the list of top ten investment banks in

the world nor achieved its various league table targets. In particular it was not a top ten mortgage-backed securities underwriter. It remained strong in its traditional activities such as international asset management. HSBC was perceived as conservative by equity analysts, achieving lower returns on equity than many of its large competitors. This had been one of the motivators for the strategy to grow in the higher margins available in investment banking.

Not achieving its investment banking ambitions was a management failure but not absent management. There was no uncontrolled, unmanaged growth into investment banking, for example through acquisition of a pure, major investment bank, which HSBC’s very large balance sheet would have made possible.

The subprime crises had cost HSBC over $32 billion in losses by 2009. But this was due to poor management not absent management. It was a strategic and a very costly mistake to become a large subprime lender. HSBC owned up quickly to the initial losses, as early as February 2007, when it announced the subprime-related losses of $11 billion. It announced that the subprime crises might last until 2009. The losses were to grow substantially, but HSBC addressed this early, being one of the first major banks to announce a large subprime loss.

The losses were due to primary subprime lending, not complex mortgage-backed securities. Had HSBC succeeded in becoming a much larger investment bank, the losses from subprime could well have been much higher. But it had not been willing to sacrifice everything, including management, to achieve this growth.

Although a very large loss was caused by subprime lending in the United States, HSBC was so diversified that it remained profitable throughout 2007, 2008 and 2009 with $20 billion, $6 billion and $7 billion of profits, respectively. HSBC did not receive and was not made to receive any other government assistance. In April 2009 HSBC raised additional equity capital to strengthen its balance sheet with a rights issue of £12 billion (Mikes and Hamel 2014). In spite of the very large move into subprime lending and the resulting very large losses, HSBC did not fail, partly because it remained managed. It was large and complex but not so complex that it was unmanageable in terms of subprime lending.

Bear Stearns was an investment bank that made it through the Great Depression, the savings and loan crisis in 1980s and the dotcom stock market crash of the late 1990s. It had been founded in 1923 to take advantage of the early 1920s’ strong equity markets. It survived the Great

Depression by trading in the safest, most liquid asset, United States government bonds (Stowell and Meagher 2008). It was to become the first well-known casualty of the 2008 crisis. The failure of Bear Stearns would start with its investments in subprime.

Bear Stearns was primarily focused on bond trading until it went public in 1985. It then diversified into a broad range of investment banking activities including equities, individual investor services and mortgagerelated products (Stowell and Meagher 2008). Bear Stearns had unique traits including being somewhat of an outsider on Wall Street due to its strong trading culture and recruitment from diverse backgrounds. When the hedge fund Long-Term Capital Management was threatened with insolvency in 1998, the United States regulator, the Federal Reserve, arranged a market rescue of $4 billion. Bear Sterns was the only investment bank out of 14 to decline to participate. Bear Stearns continued to grow rapidly and successfully (Stowell and Meagher 2008).

The absent management in Bear Stearns was unusual. One aspect it did not manage was the relationships with its competitors, the other investment banks. The outsider status combined with the strong trading culture had been important contributors to Bear Stearns’ success. These features would now contribute to its downfall.

The significant new development was that mortgage loans were being packaged and sold to investors. Bear Stearns’ fund management business included clients’ funds invested in such mortgage exposures and invested through sophisticated credit derivatives. A lot of other funds were doing the same thing so there was nothing unusual about this. What was unusual was Bear Stearns’ decision to double the risk related to the United States housing market when house prices started to fall in 2006. Bear Stearns’ strong trading culture appears to have won and there was little apparent management. However it is easy to judge with hindsight. Bear Stearns had previously traded out of bad positions by increasing its position.

The funds were highly leveraged. This means that the funds had borrowed to make larger investments. The security for these loans was $1.2 billion. The original leverage was very high, at 35 times the funds held. As the housing market deteriorated the value of the funds fell. The Bear Stearns fund manager’s response was to raise a new fund with 100 times leverage. As the United States housing market continued to deteriorate the funds were left holding unprofitable mortgage exposure that no one wanted to buy. Many other funds were holding similar unattractive assets. Because the funds were so highly leveraged the lenders asked for the

security for the loans to be increased when the value of the security fell. Following intense discussions, Merrill Lynch, one of the lenders to the Bear Stearns fund, seized $400 million of the funds’ security. The funds defaulted in late July 2007, unable to repay clients’ money in full, with significant damage to Bear Stearns’ reputation.

There was also a literal but unusual example of actual absent management. The chief executive officer of Bear Stearns since 1993, during which its share price had multiplied six times over fourteen years, had been absent on a ten-day holiday and had not been contactable during the intense discussions with the lenders to the fund.

Not all of those foreign banks affected by United States subprime loans and the development of the complex mortgage-backed securities had the diversification of HSBC to handle the losses emanating therefrom.

The United States subprime crises had its first terminal, global effect in August 2007 when the German bank IKB was rescued by the German government. Established in 1924 to assist German corporate development after the First World War, IndustrieKreditBank was listed on the stock exchange in 1945 and merged with Deutsche Industriebank in 1974 to become IKB Deutsche Industriebank with a majority government ownership (Wikipedia “IKB”). IKB’s specific mandate was to finance small- and medium-sized business and long-term real estate in Germany. In spite of this specific mandate, the bank built up a mortgage-backed securities investment of €20 billion ($28 billion) in a Delaware investment vehicle called Rhineland Funding. IKB’s equity capital was only €1.4 billion (Spiegel Online 2007). IKB’s only motivation could have been a search for extra yield completely outside its technical and geographical areas of expertise. It was a complete abandonment of the management of its mandate.

When Deutsche Bank withdrew funding for the Rhineland Funding vehicle on 3 August 2007, IKB had incurred a loss of €1 billion and required rescuing. Initially, a €8 billion guarantee was provided by the government, followed by a further €2 billion in February 2008. The German Government bank KfW was the majority owner of IKB and provided the majority of the funds, with contributions from German commercial banks, including Deutsche Bank, Commerzbank and German cooperative banks. IKB was eventually acquired by the private equity firm Lone Star in August 2008. The government support became the subject of an investigation by the European Union regarding German contravention of state aid regulation. By August 2009, IKB had received Government guarantees of €7 billion

which was accepted by the European Union. Another German bank, Sachsen LB, had also invested in subprime-related assets and was provided with liquidity support of €17 billion (European Commission 2009).

The rapid growth in United States subprime lending, the packaging and selling of these loans in the form of mortgage-backed securities and the complexities of these risks were central to absent management in some United States banks. Involvement in these developments from outside the United States added an additional layer of complexities for management of foreign banks. The development of mortgage-backed securities for loans in other countries and the dependency of some banks on this development for growth were to prove complex beyond their management, resulting in absent management and failure.

Within a week of IKB’s failure, on 9 August 2007, the largest bank in France, BNP Paribas, halted the return of money to investors from three of its investment funds that had been holding mortgage-backed securities. The reason given was that the bank was not able to value the assets in the funds because there was no longer anyone willing to buy the assets. The bank said that the assets had experienced a “complete evaporation of liquidity” (Guillén 2012).

There were two important consequences of the action of halting the payment of money from the funds. Firstly, it was a trigger for the European Central Bank, supporting the European banking market, to make €95 billion of lending or liquidity available to banks, increased by a further €109 billion in the next few days. This resulted in the European Central Bank offering unlimited liquidity to banks at an interest rate of 4 per cent (Guillén 2012). The United States Federal Reserve, the Bank of Canada and the Bank of Japan also started to support their banks. As such BNP Paribas’ announcement has been seen as one of the triggers of the financial crises.

A second aspect was that BNP Paribas’ announcement was admitting absent management. The ability to value assets is a key function of any asset manager. The evaporation of liquidity had made traditional asset valuation, what price a buyer might pay for the assets, unworkable. A frequently used alternative, modelling or simulating the valuation, also appears to have been unworkable, although many investment banks were using this approach to value their own exposure at this time. The complexity of mortgage-backed securities and the absence of buyers had led to absent management in BNP Paribas.

The United States economy had overtaken the British economy by the end of the nineteenth century, and several other economies including German, France and Japan would do so by the end of the twentieth century. However London had remained one of the major banking centres in the world and the leading centre by some measures. One of these measures was that it was the most important location for all international investment banks from whichever country. This leading role ensured that the new developments from other centres, and particularly New York, were exported to London. The London operations of international investment banks were central to exporting these new, complex developments. One of these developments was mortgage-backed securities.

Excessive investing in mortgage-backed securities and being unable to value these investments were two types of absent management in Europe that caused the crises to spread beyond the United States. A third type of absent management was to cause the largest run on a bank in the United Kingdom for more than a century.

On Friday 14 September 2007, investors withdrew more than £1 billion from Northern Rock in a bank run. This followed a report on the BBC the day before that the Bank of England had granted Northern Rock financial support (Guillén 2012). To stop the bank run, the Government guaranteed the total deposits in Northern Rock. This action was a significant increase from the government guarantee for all deposits in British banks of up to £31,000 per account.

A building society is a mutual organisation, owned by its members, that takes deposits and lends money, particularly for buying residential properties. Building societies are similar to saving & loans and credit unions in the United States. The Northern Counties Permanent Building Society, founded in 1850, and the Rock Building Society, founded in 1865, merged in 1965 to form Northern Rock Building Society. They would both, just, have experienced the last major bank run in the United Kingdom, when Overend, Gurney and Company suspended payments in 1866 and the Bank of England refused to support it (Wikipedia “Northern Rock”).

Northern Rock grew rapidly through acquisition, taking over 53 smaller building societies over the next 30 years. It demutualised in 1997, becoming Northern Rock Bank, with distribution of the newly issued shares to its members who had savings accounts or mortgage loans.

While Northern Rock had grown rapidly through acquisition of other building societies, it was the financial innovation of mortgage-backed securities that enabled its further rapid growth. Northern Rock’s bank run

and failure was due to absent management in turn caused by uncontrolled growth and complexity.

Retail depositors can contribute to financing a bank and its lending by their deposits. Withdrawing such deposits rapidly can cause a run on the bank. A bank financed by depositors who causes these depositors to withdraw their deposits is either badly managed or not managed at all. A wellmanaged bank will either not be the target of a bank run or will be able to sustain it as WaMu did during the Great Depression in the United States.

Banks can also be financed by the capital market, that is other banks and institutional investors, also called the wholesale market. Wholesale markets can cause a bank run too. That is sometimes called a liquidity run. A bank needs funds to finance its lending. Some of this financing is longer term, perhaps several years, some is very short term, such as Repo mentioned previously, all the way down to overnight financing.

It has been a central part of banking through history to lend for longer terms than it borrows to finance loans. This is because the interest on longer loans is generally higher than shorter loans, allowing banks to make a profit on the difference between lending long term and borrowing short term. Managing the required liquidity to pay back its shorter-term borrowing from its longer-term lending has always been one of the central requirements of bank management.

The complexity that resulted in absent management in Northern Rock was the uncertainty related to the future availability of mortgage-backed security investors. One of the most important aspects of the new development of mortgage-backed securities was the addition of the world investment markets to finance bank lending in addition to traditional deposit financing. The ability to sell mortgages on to investors, securitisation, created a dependence on these investors that was either not considered, not understood or, if understood, ignored. As seen earlier, mortgage-backed securities had been used extensively by those originating mortgages in the United States including for subprime mortgages. It worked just as well for mortgages in the United Kingdom and many other countries. It became known as the ‘originate to distribute’ business model, originating mortgages by issuing loans, which were then packaged and distributed, or sold, to investors. The old building society model of accepting deposits to finance lending was partly replaced with the ‘originate to distribute’ model. In 1997, at the time Northern Rock was listed on the stock exchange, retail deposits made up nearly two thirds of Northern Rock’s financing. Within a decade, retail deposits made up less than a third (Milne and Wood 2009).

Abandoning management and focusing purely on production, this uncontrolled growth was largely dependent on additional securitisation. Importance of securitisation to finance mortgage lending multiplied from 3 per cent in 1999 to close to half in 2006. Northern Rock issued less than £1 billion of securitisation in 1999. By 2006 the amount issued was £46 billion. In that year alone Northern Rock’s balance sheet grew by onefifth. Only just over one-tenth of the growth came from an increase in deposits, while the other three-tenths were due to securitisation and other forms of finance (Milne and Wood 2009).

Although many other banks used mortgage-backed securities, no other bank in the United Kingdom or Europe became as dependent on this source of financing as Northern Rock. In 2006 one other bank in the United Kingdom, HBOS, which will be described later, had deposits to cover half its loans while all the other large banks had deposits closer to two thirds or higher, just like Northern Rock had back in 1997 (Milne and Wood 2009).

The mortgage loans made by Northern Rock were of longer maturity than the mortgage-backed securitisation used to finance the loans. This meant that new mortgage-backed securities needed to be issued to replace those that expired, to maintain financing of the outstanding loans. This created a significantly increased dependency on Northern Rock to be able to refinance.

Additionally, early repayment of mortgages meant that investors in the mortgage-backed securities would be repaid earlier than expected. If early repayment increased, investors would face a risk of not being able to invest their money at the same terms. This is called the reinvestment risk. Northern Rock unusually retained this risk by issuing mortgage-backed securities of different maturities to suit investors. The shorter the maturities of the mortgage-backed securities, the higher the dependency of being able to issue additional securities to finance the outstanding mortgages. This retention of reinvestment risk significantly increased the complexity of Northern Rock’s financing.

If Northern Rock sounds too complicated to manage it is because it was. Furthermore, it was too complicated to regulate. When it failed in 2007 the Financial Services Authority, the British bank regulator since 1997, was as surprised as everyone else. Not only had Northern Rock been too complicated to manage, it had importantly been too complicated to regulate. Little had changed in respect of the dangers of regulatory complexity since Barings’ failure in 1995.

And then the music stopped. Bear Sterns, IBK and BNP Paribas had all contributed to closing the market for mortgage-backed securities. The reason was that investors became reluctant to invest more. Northern Rock’s dependency on this market to refinance its aggressive lending growth was so great that the only avenue left was to ask the Bank of England for support. News that government support had been granted was enough for depositors to ask for their money back, forming queues outside Northern Rock branches.

The dependency on the securitisation was so extreme, in size and shorttermism, that Northern Rock lost over a quarter of its financing in the remaining four months of 2007. In February 2008, Northern Rock was nationalised. The bank was then split with the branch and retail operations eventually sold to the Virgin Group in 2012 and the high-risk mortgage assets finally sold to an investment fund, Cerberus Capital Management, in 2016. All depositors’ money was safe as they had been fully guaranteed by the government. The many former members of the building society who had received shares in the demutualisation, employees who had participated in the shareholder savings scheme and all other shareholders lost their investments.

In addition to absent management of Northern Rock, its failure is also important in that not all banks fail. Management, and particularly absent management, is the determining factor in bank failure. Other banks did not allow themselves to become so dependent on a market, mortgagebacked securities, which they did not understand. Other banks did not grow as aggressively based on this dependency. And Northern Rock was the first bank run in the United Kingdom in over 140 years.

While the government’s guaranteeing of the deposits of retail customers in Northern Rock set a precedent and prevented any further queues outside British banking branches, other spectacular failures of British banks were to follow.

In the meantime, subprime losses were affecting investment banks in the United States. Following a write-down of $1.9 billion of subprimerelated losses in November 2007, Bear Stearns started looking for someone to buy the firm. This was happening at a time when mortgage-related and particularly subprime losses were big and consistent news headlines. In March 2008, the Federal Reserve announced a $200 billion lending programme to support financial institutions through the crisis. Some interpreted this as particularly aimed at Bear Stearns. The firm then experienced a very modern bank run.

Other banks and investors tried to sell the positions they had with Bears Stearns. There were rumours that Bear Stearns was facing a liquidity crisis, related to subprime assets that could not be sold. Hedge funds that had been important clients of Bear Stearns stopped trading with the firm.

But stopping trading with the firm was not the only negative impact hedge funds had on Bear Stearns. Hedge funds were also selling the Bear Stearns share short. Selling short was originally a hedging tool. If an investor owns a lot of stock, he/she can sell the stock short to have some protection against a fall in the price of the stock. This hedging mechanism works by the investor taking out a contract with another party for a certain number of shares at a certain price. If the price falls the investor can close the contract with a profit by delivering the number of shares. The number of shares now cost less as their price has fallen providing the investor with a profit under the contract. This profit can be set against the fall in the price of the remaining stock. The short selling contract therefore protects, or hedges, the whole shareholding against a fall in price. Short selling without owning any stock, naked short selling, is a highly speculative type of investment because of the risk that the share price increases sharply. In addition, if the investor does not own any shares, he/she needs to borrow the shares to settle the trade. There is a risk that there may not always be a willing lender of shares that rise sharply.

Short selling puts pressure on a share price, particularly if the positions are large. From 2001 until June 2007, Bear Stearns shares sold short had amounted to around 6 million shares. Between June and November, the number of shares sold short tripled to around 18 million shares (Brewster and Gangahar 2008).

Later research has disputed the impact of short selling and in particular the pressure on the share price from naked short sellers seeking to borrow shares to settle a short trade (Fotak et al. 2014). Whether short selling was a contributory factor is not easy to establish. It certainly added to the complexities of managing a bank deeply involved in a deteriorating asset class, such as the financing of United States housing in general and subprime lending in particular. Short sellers probably did not identify absent management, but they were certainly looking for its effects.

The Securities and Exchange Commission, the regulator of the United States stock exchange, did eventually ban naked short selling on 19 September 2008, in coordination with the United Kingdom Financial Services Authority. The United States action applied to 799 financial companies including Bear Stearns. The aim was to temporarily ban aggressive

short selling of financial stocks to restore equilibrium to the markets (SEC 2008). However this was much too late to have any effect on Bear Stearns. By early March 2008 the Bear Stearns share price was in free fall from its once lofty $90 per share at the end of 2007 to $32 by Friday 14 March.

By the weekend of 15–16 March 2008 Bear Stearns had run out of options except for an offer from J.P.Morgan, initially at $4 per share. J.P.Morgan had been under significant pressure from the Federal Reserve to buy Bear Stearns. The Federal Reserve was now being led by a former chief executive officer of Goldman Sachs. He had deep and recent understanding of how intertwined investment banks were and what the possible effect of the failure of one of them could have on the other investment banks and possibly on other banks and wider financial markets.

The Federal Reserve had serious concerns that a default by Bear Stearns would significantly worsen an already very difficult financial market situation. J.P.Morgan reduced the offer to $2 per share. This maximised the burden on Bear Stearns shareholders. This was in the interest of the Federal Reserve, which was determined not to be seen to be bailing out failing investment banks while many citizens were being foreclosed on their mortgages and losing their homes. Bear Stearns was sold at this price on Sunday 16 March 2008, nine months after the mortgage funds had defaulted. It had traded at $32 per share on Friday afternoon and above $90 at the end of 2007 with an all time high of $173 during 2007.

Eventually, the price was finalised at $10 per share or $1.2 billion. Because of an initial agreed condition that J.P.Morgan would cover Bear Stearns trades for up to a year even if the takeover was not approved, Bear Stearns had a little room for negotiation and achieved the higher price. But $10 per share was still not much compared to the previous year’s $173.

J.P.Morgan would take the first $1 billion of losses. The Federal Reserve Bank of New York lent J.P.Morgan $30 billion, taking Bear Stearns’ mortgage holdings as collateral. This left the United States taxpayer with a $29 billion exposure to Bear Stearns’ liabilities (Meagher et al. 2008).

By buying Bear Stearns, J.P.Morgan, with the pressure and also the support of the Federal Reserve, prevented the crises spreading in March 2008. Triggering a full blown banking crises would be left to another investment bank.

The reason J.P.Morgan was able to support Bears Stearns was that it had managed its exposures. During the dotcom equity market boom and bust, J.P.Morgan had incurred significant losses including on the energy trading giant Enron. J.P.Morgan and Citi had provided finance to Enron

that allowed it to present misleading financial results. J.P.Morgan and Citi were fined $135 million and $101 million, respectively (Reynolds 2004). The total loss from Enron for J.P.Morgan was $3 billion including $2 billion from a class action from former Enron investors. These recent losses may have made J.P.Morgan more cautious. By 2007 J.P.Morgan was top three in many investment banking activities but outside the top ten in the more complex debt including mortgage-backed packages. J.P.Morgan had also limited reliance on short-term funding.

In addition to supporting the rescue of Bear Sterns, the Federal Reserve also reduced the discount rate, the interest rates it charged banks, by onequarter of 1 per cent on 16 March 2008 and a further three-quarters of 1 per cent two days later. Lowering the cost of borrowing was intended to make anybody in debt and with their interest payments linked to the Federal Reserve interest rate pay less. This was meant to be helpful to banks.

Importantly and for the first time the Federal Reserve also allowed investment banks access to the discount window. This was a lending facility for banks financing themselves with deposits. The discount window had previously been reserved exclusively for commercial deposit-taking banks to ensure they had access to adequate liquidity in times of stress. Banks using the discount window had to post high-quality security as collateral, rated investment grade by the credit rating agencies.

This blurring of regulation between deposit-taking commercial banks and investment banks relying on non-deposit financing was a historic step, indicating the severity of the financial situation in the United States. It had not happened since the Glass-Steagall Act in 1933. It also indicated the concerns of the Federal Reserve about the potential wider impact of a failure of a major investment bank on the wider economy. This latter risk had been the reason for supporting the rescue of Bear Stearns with a $29 billion loan.

Following the failure and rescue of Bear Stearns, two very large participants in the United States housing market had to be rescued. Founded in 1938 after the Great Depression, the purpose of the Federal National Mortgage Association, known as Fannie Mae, was to increase the level of home ownership and to make housing more affordable. This was done through the use of federal funds with the creation of a secondary market in residential mortgages by Fannie Mae buying mortgage loans issued by banks. Banks were able to sell the mortgages they had issued and were therefore able to issue more mortgages without the need for additional capital.

For the first 30 years Fannie Mae primarily bought mortgages insured by the Federal Housing Administration that provided security for the mortgages. So the mortgages purchased by Fannie Mae had a government guarantee. After 30 years of federal ownership Fannie Mae was listed on the stock exchange in 1968. This was quickly followed by ending Fannie Mae’s monopoly of the secondary mortgage market, through the establishment of the Federal Home Loan Mortgage Corporation, known as Freddie Mac, in 1970. This was done to compete with Fannie Mae and to further enhance the solidity and competitiveness of the secondary market for buying residential mortgages. Freddie Mac was listed on the stock exchange in 1989.

Importantly the mortgages banks could sell to Fannie Mae and Freddie Mac had to be conforming in order to have a government guarantee. To conform the loan had to be limited by the size of the mortgage depending on the location of the property. In addition for a loan to conform it had to meet guidelines regarding how much could be lent as a proportion of the total value of the property, the borrower’s income, credit score and history as well as documentation requirements. During the 1990s the government remit of both organisations was widened to meet affordable housing goals for those with lower earnings. An example of how these goals were progressively increased between 1996 and 2007 was that the target for increased buying of low and moderate households mortgages went from two fifths to over half.

The second activity of the two organisations was investments in mortgages, their own mortgage-backed securities, other mortgage-backed securities and other debt instruments. This activity was financed by the agencies’ capital and the issuing of bonds, known as agency debt. The two agencies owned $300 billion of mortgage-backed securities issued by others including $186 billion of subprime by the end of 2007 (Frame et al. 2005).

Although both agencies were listed on the stock exchange, there was a widespread belief that they had an implicit guarantee from the government for the funds they borrowed. Their position was so important to the United States housing market and its economy that their default was hard to imagine. Their growth was phenomenal. Mortgage-backed securities issued and guaranteed by the two agencies went from $20 billion in 1981 to $3.4 trillion by 2007 (Frame et al. 2005). They owned close to half the mortgages in the United States before the subprime crisis, amounting to over $5 trillion.

This belief in an implicit government guarantee became particularly important when the organisations started packaging mortgages and issuing mortgage-backed securities. For a fee, Fannie Mae and Freddie Mac guaranteed that the premiums and principals on these instruments would be paid to investors even if the original loans defaulted. Many investors in these mortgage-backed guarantees saw an implicit government guarantee behind the guarantee provided by Fannie Mae and Freddie Mac. There was, however, no explicit government guarantee. So while the government guaranteed the conforming mortgages bought by the two organisations, there was no government guarantee for investors in Fannie Mae and Freddie Mac issued securities and shares. However the implied guarantee which the market generally believed in meant that the two organisations could obtain funds from investors at much lower rates than commercial organisations. This meant that little competition developed in the secondary market for conforming loans (Islam et al. 2013).

The two organisations were important in establishing the market for mortgage-backed securities for conforming mortgages. Fannie Mae issued its first mortgage-backed security in 1970, followed by Freddie Mac the next year. This meant that Fannie Mae and Freddie Mac could finance the purchase of mortgages through investors rather than their own funds. However they did not lead the development of mortgage-backed securities of non-conforming and subprime loans more than 20 years later. That was left to investment banks.

The two organisations’ market share was close to two thirds of originated, conforming mortgages in 2003. This fell drastically to under half by 2006 as subprime origination exploded. The two organisations did compensate for this fall in conforming mortgages by purchasing significant amounts of lesser quality mortgages, including $168 billion of subprime exposure in the form of mortgage-backed securities originated by investment banks. This loosening of standards for buying mortgages was done to stem the loss of market share and to continue to service the two organisations’ shareholders.

There has been an extensive debate on the role of Fannie Mae and Freddie Mac in the financial crisis. Because of their dual objectives of working for shareholders and providing a liquid secondary market for mortgages, theirs was a complex business. The two organisations dominated the secondary market for conforming mortgages. But this does not mean that they caused the development of the subprime mortgage market. This was left to banks. And the subprime market caused a fall in United States housing prices which, in turn, caused Fannie Mae and