How Europe’s banks got into a precarious position
IF you wanted to choose a single word to sum up how European banks got themselves into such a frightful pickle it would have to be "optionality". To understand what it means or, more precisely, what bankers think it means, we have to rewind to the 1990s when banks started to consolidate. The Federal Reserve has a brilliant chart to illustrate what happened next in the US (see main image above). On the left it is 1995 and there are 37 banks; on the right, it's 2009 and they had become four: Wells Fargo, Citigroup (a serial consolidator), Bank of America (which had just swallowed Merrill Lynch) and JP Morgan (which had recently become the proud owner of Bear Stearns).
The consolidation of European banks was by no means as prolific. But many lenders on this side of the pond had beefed up in order to compete with the American behemoths. Barclays had recently bought Lehman Brothers assets and the Royal Bank of Scotland had just made its ill-fated purchase of ABN Amro. All of these different banks were essentially pursuing the same business model: they all wanted to be global universal banks. What this meant was that they wanted to be all things, to all people in all parts of the world.
There was just one small snag. They couldn't all succeed. Many business lines were so competitive that only the top two or three best firms made any money. Indeed, it was an open secret that there were some areas in which no banks made any money. For a long time, firms would essentially issue interest- free loans to big companies as a way of getting their foot in the door and, hopefully but not always, winning other, more lucrative work.
The misnomer for all this was "cross-selling". But that implies that banks were selling different services to the same client. Too often, many services were given away for free. And if none of those services was making any money, well, that was OK too because the guys on the trading floor were coining it in and making enough to cover for the whole firm. Then came the credit crunch. And then came the regulations that were supposed to stop anything similar happening again. Once implemented, these started slowly but inexorably altering the economics of the whole banking industry.
The people running the big, global, universal banks were confronted with quite a predicament. They were all left sitting on business models that were finely calibrated to an extinct reality. But how could they transform? What business lines were they going to get out of? The obvious answer would be the ones that didn't make any money. But their entire business model was predicated on being all things to all people. It was like a giant game of Jenga - pull out the wrong brick and the whole precarious edifice could come crashing down.
That's not to say that banks hadn't cut business lines in the past. The history of the industry is littered with firms that tried and failed and then tried again. Many investment banks were famous for firing whole swathes of bankers and trader at the first whiff of a downturn only to get caught out when things picked up again and having to offer even bigger bonuses to staff up again. One American firm got caught out so often that these chop- and-change tactics became known as "doing a Merrills". But that was then and this is now. The difference is the amount of leverage - the proportion of bank equity to assets - that firms are allowed to deploy.
In past cycles banks would be happy to get out of business, in the knowledge that they could deploy leverage to bulk up again when the weather turned. But tougher leverage ratios make it harder to turn on a strategic dime. Banks knew that if they got out of business, they'd be out for a long time. So instead, they waited. They knew that other banks faced the same predicament and would, eventually, have to call it quits. The pie might have shrunk, but banks hoped that, simply by hanging in there, they'd get to enjoy a larger slice.
But what made a certain sense to individual banks amounted to collective madness. Because no one blinked. In 2012, some four years after the financial crisis, McKinsey's annual review on the global banking industry found that only 6pc of banks had cut their costs over the previous year - which, adjusting for currency variations and rounding errors, essentially means the industry had done the square root of nothing. They were, in the charming industry jargon that is so grating on the ear, "hoarding optionality", or, in non-bank speak, keeping their options open. They clung on to unprofitable business lines, hoping that something, anything, would turn up. And they were right, it did. It was called quantitative easing.