Citi’s eternal moral hazard

A massive problem of NPAs bedevils India's public sector banks currently. One of its major causes is the time-honoured practice of government-owned banks sanctioning loans to favoured corporate houses at the behest of their political masters. One would think that the banking sector of a developed economy like the United States would be better-run. The reader is quickly disabused of any such notion a few pages into this wellresearched — and well-timed — history of Citi.

The US banking sector has been very prone to the issue of moral hazard, as the Lehman crisis of a decade ago this month, showed. Leading the pack that indulged in reckless practices, got into trouble, and then had to be rescued by taxpayer-funded bailouts, not once but repeatedly, was Citi.

During the 2008 crisis, Citi received the largest rescue package of all, a humongous $517.3 billion. The argument by the leading lights of the government, like Hank Paulson and Timothy Geithner, was that it was too big to be allowed to fail. Its failure, they argued, would create a systemic crisis. Not everyone in government was convinced; nonetheless, the government went ahead with the bailout. Citi's shareholders, who in the normal course would have paid the price for the bank's excessive risktaking, escaped relatively unscathed.

In the 1980s, Citi, along with a few other banks, got into trouble lending to the governments of Latin American countries. The combined exposure of America's nine largest banks to Mexico, Argentina and Brazil was so high that if even half these loans were not repaid, all of them would have gone under. The US government arranged for loans from the International Monetary Fund (IMF) to prevent defaults by these nations.

America's banking regulators had two options then. They could have forced the banks to recognise the bad loans and reduce their reported capital levels. But this, they feared, could cause a run on these banks. The other option was not to enforce capital standards. The regulators chose to kick the can down the road. A little earlier in the same decade, such regulatory slack had not been granted to hundreds of smaller banks, which were allowed to fail. But different rules were applied to bigger banks. Once again, Citi had erred but escaped insolvency because it was deemed systemically too important to be allowed to fail.

Another highlight of this book is Citi's role during the Great Depression. The US stock markets witnessed a massive bull run during the 1920s. Citi had earlier been only in commercial banking, but in July 1911 its management set up an affiliate called National City Company (NCC), which entered the business of distributing stocks and bonds. At that point, regulators frowned on commercial banks getting into investment banking or selling of securities, but they did not force Citi to close down its affiliate.

NCC gave call loans, a type of loan that involves investors buying securities from their broker with a small down-payment, borrowing the balance, and putting the stocks up as collateral. As long as the bull run lasted, NCC's profits soared. Then the crash began in March 1929. Although the popular narrative of the time was that Citi, and its funding of stock market activities had caused the stock market crash and consequently led to the Great Depression, the authors disagree. According to them, it was the Federal Reserve's relentless raising of interest rates and choking of the money supply that killed off the possibility of an early recovery.

NCC collapsed in tandem with the markets. But Citi, the commercial bank, survived. Its bad loans did grow during the Depression years. Its books also suffered on account of loans to the governments of Chile and Germany that soured. One fallout of Citi's aggressive foray into the stock markets was the enactment of the Glass-Steagall Act of 1933, which enforced the separation of commercial and investment banking. Around this time, too, Citi accepted a bailout of $ 50 million from the government, and was able to tide over another crisis.

One issue the book focuses on is regulatory capture. Government officials, far more modestly paid than their private-sector counterparts, are often awed by the latter. Some even sell out. The payoffs are not immediate but come in the form of highly-paid sinecures after retirement. The revolving door between government and private-sector giants often results in laxity on regulators' part in enforcing laws strictly at critical junctures.

Anyone interested in banking will find this book engrossing. The saga of excessive risk-taking in pursuit of profits, the failure of regulators to rein in such risktaking while it is happening, then stepping in to rescue these giants with taxpayer money citing systemic risk, has been witnessed many times in the past, and will no doubt be repeated in the future. This pattern may not last. Giant banks like Citi may have got away with their reckless ways in the past. But if they don’t mend their ways, their Lehman moment could arrive in the not-too-distant future.

BORROWED TIME

Two Centuries of Booms, Busts, and Bailouts at Citi

James Freeman and Vern Mckinley HarperCollins

384 pages; ~599