Banking collapse a possibility

In banking, systemic risk is a label for ultimate disaster. So, when Douglas Flint, FD of the world’s third biggest bank by market capitalisation, dared mention it at a recent international banking conference, bankers noticed.

Flint said HSBC was increasingly worried about the surge in bad debts at a number of international financial institutions (presumably not at HSBC). “It is something we are concerned about because of the systemic implications,” he said, drawing a gasp from the audience. “We do worry about systemic risk.”

Flint made it clear that the unbridled investment spree by US pension funds and the dotcom collapse of the late 1990s could yet bring some nasty surprises for the banks. Clearly, there is a danger of collapse.

“The fact that Germany’s third largest financial institution, Commerzbank, is now worth less than Britain’s smallest bank, Northern Rock, says the market doesn’t fancy the bank’s chances of survival if German bad debts come home to roost,” says Norman Bernard, director of First Consulting.

“German and Japanese banks in particular have sufficient bad debt problems to make them look vulnerable.” The German and Japanese banks aren’t the only ones that may have problems.

Switzerland’s two global players, UBS and Credit Suisse, are so heavily into capital markets business that one can’t help speculating on their health. And US investment banks’ trading floors and corporate finance offices are covered in blood.

Only UK banks have so far eluded the doom and gloom scenarios being painted by analysts and economists around the world. The robust UK economy plays in their favour, and one mustn’t overlook the active role taken by regulators and management itself, particularly after the corporate bad debts debacle of the 1990s, in ensuring that risk is properly managed.

Also, Britain’s banks are overwhelmingly domestic players, with little investment banking exposure. They are essentially risk-adverse institutions, and when they become risk-prone the result is often disastrous. Witness the Abbey National saga. Its exposure to Enron and its corporate bonds are key factors behind the City’s reasoning that it will, in all likelihood, soon end up in the arms of Bank of Ireland.

Although UK banks are faring better than others, from an asset performance point of view their situation is not so dissimilar to that of European or US banks. “The UK banks’ core operating profitability is superior, and this has a big impact on a bank’s ability to handle bad debts,” says Ian Linnell, banking analyst at Fitch Ratings. “Britain’s banks have re-structured, put in a lower cost base and achieve higher margins, which positions them to confront corporate bad debts. This said, their credit experience is not all that different to their peers’. Problem credits from the likes of WorldCom turn up on everybody’s books – the UK banks can just address them and write them off faster.”

The worry is that, if German or Japanese banks have problems with these kinds of credits that stop them meeting payments, there could be a knock-on effect. Banking supervisors around the world are looking closely at the threat to solvency posed by the amount of international trade in foreign exchange and bank deposits. This business runs into trillions of dollars a day and is hence only within reach of those in the Merrill Lynch or Goldman Sachs league. “If things went seriously wrong at a Citibank or a Deutsche Bank, governments would be inclined to step in to rescue the domestic portion of the bank and let the foreign business go down the plug hole,” says one analyst. Now there is a systemic risk scenario for you.

For the moment, the market remains sanguine about the risk of a domino effect even though the German banking system is struggling with weak profits.

“For now, bank ratings are a lot less volatile than those in the corporate sector,” says Linnell. “There has been a lot of stress in the market, particularly in the life assurance sector where we have seen a number of rights issues to shore up a weak financial base as a result of the collapse of equity prices. We are confident that ratings are at the right level for banks. Some have come down and undoubtedly more will be cut in the future. Saying there is a systemic crisis now is going a step too far. But in this credit environment, never say never.”