Banks Enter New World of High Risk : Huge Commitments Are Hidden From Their Balance Sheets
They call themselves the rocket scientists of American banking, leading the commercial banks into the strange new worlds of Euromarket investments, currency arbitrage, and interest-rate swaps.
They bear little resemblance to traditional commercial bankers, who tend to push loans to business customers and sedately book interest payments as revenues. The rocket scientists take their lead from investment bankers: proud, well-paid, engaged in creating contracts and transactions so complex that even the needs to which they are the solutions can seem impossibly arcane to the general public.
Consider the words of Robert M. Lichten, 45, president of Chase Manhattan Capital Market Corp. Having been an engineer with the propulsion set at Edwards Air Force Base 20 years ago, Lichten may be the only genuine rocket scientist in the business. Gesturing with his cigar over breakfast one recent morning, he observes, “When you run the interior ballistics on an engine, it’s sort of like doing corporate finance work.”
Dealing With Accountants
Lichten’s point has something to do with the necessity in both enterprises of crunching the numbers and dealing with accountants and bureaucrats. Yet among regulators, economists and even some bankers, the notion persists that, like the original rocket scientists of the 1940s and 1950s, this new breed is busily shooting products into the stratosphere with less than total concentration on where they might come down.
In their favor is the reality that the interrelation of global money markets and the deregulated financial environment in the United States has rendered obsolescent the traditional business of making loans and collecting interest. In dealing with the best corporate and international borrowers, the spread between the cost of a bank’s funds--that is, what it pays for deposits--and the interest rate on its loans is too thin to turn a profit, commercial bankers complain, particularly when investment banks, savings institutions and other new players are stealing away their best customers by offering corporations money at lower rates.
But critics argue that the wholesale plunge into new and unfamiliar markets will test the abilities of bank managements and government authorities to maintain the banking system’s stability. At worst, the proliferation of what are essentially new ways of lending money to less-than-sterling borrowers could topple weak institutions, undermine the ability of central banks to influence their national economies, and produce a worldwide glut of debt.
Record Failures
Concerns for the stability of the U.S. banking system have been heightened by record failures of banks since last year--95 so far this year--and the recent troubles at such major institutions as Continental Illinois, Crocker and Bank of America, largely in the traditional businesses of lending to farmers, real estate developers and foreign countries.
“We get so enchanted with new types of transactions and facilities that we forget that all lending commitments are extensions of credit,” Wells Fargo Bank Chairman Carl Reichardt warned a gathering of bank finance and accounting officers last May. “Terminology and accounting don’t change that fact.”
The battlefield between these two arguments is what are generally known as “off-balance-sheet” obligations, so called because their resemblance to outright loans, which must appear on bank books as assets, is sufficiently ambiguous to circumvent regulators’ definitions.
Take a standby letter of credit, perhaps the simplest and largest category. This is a pledge by a bank to a third party that it will lend money to a given customer under certain conditions. The bank commits itself to making the loan, but does not actually do so--in most cases, actually, it hopes it will not have to. In return for this temporary enhancement of the customer’s credit stature in the eyes of the third party, the bank gets a hefty fee. Although the bank is theoretically bound to fund the loan, if asked, over the term of the letter, neither the size of this commitment nor its risk appears on the bank’s balance sheet.
Such commitments dwarf the actual assets of most of the 15 largest U.S. banks, according to a recent study by the consulting firm of Multinational Strategies. Citibank, the nation’s largest commercial bank, had $122.5 billion in assets at the end of March. But it listed $246.17 billion, or more than twice that, in commitments and contingencies in its quarterly report to the Federal Reserve Board. Similarly, Bank of America reported $104.4 billion in assets and $204 billion in off-balance-sheet commitments.
Altogether, the consultants found, the 15 largest banks had more than $1.25 trillion outstanding in these potentially risky commitments. That figure did not even include some of the newest, riskiest and fastest-growing obligations, including interest-rate swaps and security-like instruments traded on European credit markets. Add those and the obligations of the top U.S. banks alone far outstripped the $900 billion at risk, worldwide, in the Latin American debt crisis.
Could Be Significant
“The off-balance-sheet amount is much bigger than the debt crisis,” says Paul Sacks, director of Multinational Strategies. “So if there’s a problem with them, is it significant? You bet.”
Such proliferation has led recently to some rhetorical sallies by banking authorities here and abroad. Just last month Bank of England Governor Robin Leigh-Pemberton, in a letter to the British Bankers Assn., cautioned its members against the accumulation of innovative risks without adequate capital or managerial backing:
“Managements of banks undertaking such business should ensure they possess the necessary skills and understanding to manage the often complex operations involved, to assess the risks, and to establish appropriate internal control,” he wrote.
U.S. authorities have been threatening to increase minimum capital requirements and to force banks to establish the equivalent of loan-loss reserves for some of the new instruments. They now require banks to disclose their positions in some off-balance-sheet obligations, particularly letters of credit, in greater detail. But regulators say they may be receiving less access to adequate information about the activities of the nation’s largest banks rather than more.
“You can’t tell very much about the real risk exposure of (an) institution from the balance sheets which are published today,” Charles Lucas, a vice president of the Federal Reserve Bank of New York, told a gathering of international bankers here on Sept. 25.
Diminishing Returns
Moreover, regulators are faced with the prospect that some tougher rules will provoke the law of diminishing returns. Applying conventional capital standards to letters of credit would require the nation’s 35 biggest banks to raise an extra $5.3 billion in capital, according to some estimates. The expense of doing so could force banks to simply submerge a greater portion of their obligations below the balance sheet, undermining the strengthened standard.
“We recognize that high capital standards force banks to take risks to produce higher returns to pay for all this capital,” says Jonathan Fiechter, director of economic and policy analysis for the U.S. Comptroller of the Currency, the regulator of most national banks.
Accordingly, regulators are trying to move toward a risk-based capital requirement--one that will force banks to recognize on their balance sheets the varying degrees of peril in the new instruments without giving them an incentive to hide their activities from regulators. Some off-balance sheet transactions, Fiechter also notes, are legitimate hedging maneuvers that may enhance a bank’s safety rather than diminish it.
For their part, commercial bankers maintain that they apply the same careful standards of credit analysis and prudent management to the new products that they have in the past to standard loans. Of its thriving business in interest-rate swaps, which are agreements in which two borrowers with different credit ratings and access to different lenders transfer those properties to one another, Chase’s Lichten says his bank runs exhaustive credit checks on the principals at both ends of the transactions.
“Our swaps look like loan agreements,” he says. “Every transaction has an independent credit analysis.”
Component of Mystery
Yet some of the transactions being touted by the big banks are so novel that they carry an inevitable component of mystery. Says one official of the Federal Reserve Bank of New York: “I’m convinced that no one at the top levels of these institutions has a thorough understanding of the risk properties of these instruments.”
The metamorphosis of U.S. banking from a credit-extension business to one of risk-transference is reflected in the growing importance to major banks of fee income over interest income, the money a bank makes from borrowers’ payments on their loans.
Fee revenues at six banks studied by the investment firm of Donaldson, Lufkin & Jenrette rose to 38.2% of total revenue in the middle of this year from 25% in 1979. (The six banks were Citicorp, Chase Manhattan, Manufacturers Hanover, Morgan Guaranty, Chemical and Bankers Trust.)
Fees are more profitable than interest revenues for several reasons. To earn interest, a bank must keep a loan on its balance sheet, where it appears as an asset. But federal regulators require banks to maintain a certain level of net capital--that is, the difference between its assets and such liabilities as deposits--that is currently set at 5.5% of assets. That means, in essence, that a bank can only lend out about 18 times as much money as it has in capital. To put it another way, if a bank has $1 million in net capital, it can collect interest on about $18 million in loans.
If some of those loans go bad, as billions of dollars in loans to oil and gas developers and to Latin American countries have in the last few years, the bank must set aside a portion or all of their value to cover the prospect of loss, further limiting the amount it has available for lending.
Has Two Choices
Since these rules can seriously hamper a bank’s ability to grow, an aggressive institution has two choices: It can raise more capital, which is a very costly proposition today, or it can hustle loans off its books as swiftly as possible, either by selling them outright or packaging them in new ways so that they do not appear on their balance sheets. Hence the explosion in off-balance sheet transactions.
One other factor has inspired the banks’ passion for finding new ways of committing their money: the unprecedented surfeit of it. In part because of the inflow of cash from oil-producing nations in the 1970s and the disappearance of what had earlier looked like productive lending markets--the oil business, the Third World, farming, and so on--bankers have watched their cash inventories build up, like auto makers who can’t sell cars but can’t turn off the assembly line.
Consider the sharp decline in international lending. This principal business of major U.S. banks peaked in 1982 with $98.2 billion in new international credits before falling in 1984 to $60.3 billion. Those figures include a decline in loans to members of the Organization for Economic Cooperation and Development, the Paris-based “club” of advanced industrialized nations, to $32.5 billion from $54.8 billion and a decline in lending to developing countries to $19.6 billion from $32.5 billion in 1982.
Meanwhile, top-drawer international borrowers such as corporations discovered that they could raise money more cheaply by skipping the banks and dipping directly into the European credit markets with the help of investment bankers.
Produced Price War
The resulting competition to make loans to a diminishing number of credit-worthy borrowers has produced a price war akin to Detroit’s recent frenzy of rebates and financing bargains.
“Lending in today’s environment doesn’t make a hell of a lot of sense at the fine, fine spreads that some of these top credits demand,” says George V. Zengo, senior vice president of the merchant banking group of Manufacturers Hanover.
Enter the rocket scientists, charged with responsibility for customizing the banks’ new transactions to customers’ increasingly catchpenny specifications.
“Some of the projects and transactions these days have so many bells and whistles on them that are mind-bendingly complex,” says Richard P. Urfer, director of corporate finance for Chase Manhattan Capital Markets Corp.
The most sophisticated products can mutate in form faster than a flu virus, which means that the innovators can stay at least one step ahead of the regulators charged with maintaining a sound banking system. This is an inevitable feature of regulation in a changing, largely deregulated industry, says Fiechter of the Comptroller’s office.
“If you believe in a free-market system, you’ll always have regulators catching up with the market, which is preferable to regulators leading the market,” he says. “We’re not going to ban innovation in the banking industry, which is what you’d have to do to have 4,000 examiners keep up with what 15,000 banks are doing.”
Gets Profitable Fee
People on all sides of the issue acknowledge that the mother of much of this invention is not necessity, but cash. Only for the custom-designed product--as odd or bizarre a creature as it may be--can a bank charge a profitable fee.
Some say the pace of innovation itself carries risks, one being that the products are too new to have been tested in a full business cycle or by the courts in any country. Thus, no one really knows how a given interest-rate swap will be valued at a time of sharply falling real interest rates, for example.
Also causing concern are a new breed of instruments know as “note issuance facilities” or NIFs, in which a handful of banks agree to market a borrower’s short or medium-term notes to other investors, while agreeing to buy themselves whatever notes they fail to sell.
Indeed, NIFs have spawned a school of variations, including RUFs (revolving underwriting facilities), TRUFs (transferable RUFs), and SNIFs (short-term issuance facilities).
The banks’ legal and financial obligations are unclear if a NIF or TRUFissuer fails in the next recession. At that point, presumably, the issuer’s notes would be held by dozens if not hundreds of investors in the secondary markets, none of whom may have a direct relationship with any of the banks that arranged the original loan.
“If there are wholesale defaults by the borrowers, there’s very little structure in place for organizing the note-holders,” observes Rupert Beaumont, a London lawyer who has examined the contract documentation of several NIFs. “It’s a free-for-all.”
Independent investors in the note market also lack the creditors’ flexibility that is characteristic of banks that make loans and continue to monitor and service the debtor.
Holders May Panic
“If I’m selling loans to non-traditional risk-takers and they go bad, the holders may panic,” says John G. Heimann, a former U.S. Comptroller of the Currency now at Merrill Lynch & Co. By undermining the customary “work-out” practices of banks faced with faltering borrowers, those debt holders could force otherwise salvageable debtors to fail.
If the regulators believe that the banks are cavorting on terra incognita, even many bankers agree that the skills needed to manage some of the new instruments are new to the traditional commercial banking culture. As it happens, commercial banks that are serious about playing in the Euromarkets tend to hire a lot of staff from investment banks.
“I’ve heard a lot of talk about our ability to develop the culture,” says David Lovejoy, head of the merchant banking group at Security Pacific National Bank. “It’s difficult but not impossible.” Among those whom Security Pacific has hired are a debt strategist from Merrill Lynch & Co. and a merchant banking specialist from S. G. Warburg. It has also agreed to buy the British investment firm of Hoare Govett, a primary dealer in British government securities, or “gilts.”
The importance of trading skills to success in the Euromarkets raises another risk, regulators say, that the traders gaining new authority at commercial banks can commit their institutions to huge positions before management has a chance to appraise their risk.
Says one New York Fed official: “In some of these deals it takes five days to place the paper and three weeks to figure out what motivates the transaction. Is there any real hope of handling these things the way we have in the past?”
Glaring Inexperience
Investment bankers familiar with the Euromarkets say the commercial banks showed glaring inexperience when they plunged wholesale into the business of marketing NIFs last year. Since with NIFs, it is presumed that only the least creditable paper will remain unsold and thus end up in the banks’ hands, some authorities question whether the banks are simply committing themselves to funding the least worthy loans.
This would not be so bad if the banks were sure of making those loans at prices that reflected their risk. But the commercial bankers, anxious to reclaim international customers they had lost to the investment banks, began offering NIFs at what observers considered loss-leader prices.
“The prices were driven down by competition,” acknowledges Lichten of Chase Manhattan.
Manufacturers Hanover and some other commercial banks say they have turned away business from good customers when the spreads were too thin.
“We saw a couple of institutions that effectively bought the business,” says Manufacturer’s Zengo. “We and most of the majors didn’t want to do that.”
But investment bankers in London say the newcomers characteristically underpriced their underwriting commitments, apparently believing that once they had the business they could boost their profits by making money in trading the paper.
As it happens, “the experience of the commercial banks in dealing paper has been abysmal,” in the words of one London-based trader for a U.S. investment bank. “Their understanding of buying and selling securities and their intimate contact with investors has been inadequate.”
Difficult to Compete
In short, the commercial banks have discovered that they could not easily compete with the Merrill Lynch, First Boston, or Salomon Bros. traders who had built up contacts in the Euromarkets over years.
London traders still complain about one bellwether deal led by Manufacturers involving a $1-billion NIF for the Kingdom of Denmark. The bank’s fee for the deal was set at five basis points, or 0.05% of the deal’s value. It was an extremely attractive price for the borrower but one that meant a participating commercial bank making a $100-million commitment would get a fee of only $50,000 a year. In the event, traders say, Manufacturers had problems lining up participants, although it eventually completed the deal with a group of foreign banks. No other U.S. commercial bank was in the final syndicate.
U.S. bankers also acknowledge that they paid too little attention to the true nature of their underwriting commitments in some of these complicated deals. Lovejoy says he advises potential clients to avoid some of his rivals by arguing their inexperience. “We urge clients to be discriminating about their underwriting group,” he says. “What’s easy is to get your front-end fee and not understand what your commitment is.”
Many bankers justify remaining in a market that features such cutthroat pricing and uncertain risks by arguing that they use it to attract corporate business in other areas, a process known as creating relationships.
“We approach investment banking as a relationship activity, not a transaction activity,” says Lichten of Chase. “What you’re looking for is repeat business.”
And most bankers say they expect competition to ease as less serious or able participants drop out of the market. “A lot of people will come into the business, and a lot will be crowded out,” says Lovejoy of Security Pacific.
OFF-BALANCE-SHEET COMMITMENTS OF MAJOR U.S. BANKS In billions of dollars; as of March 31, 1985
Contingencies and Total BANK commitments* assets Citibank 246.17 122.49 Bank of America 204.03 104.44 Chase Manhattan 144.04 79.81 Morgan Guaranty 103.51 63.36 Manufacturers Hanover 82.39 57.74 Chemical 104.20 55.10 Bankers Trust 113.75 45.29 Security Pacific 42.57 39.15 First Chicago 74.54 35.90 Continental Illinois 26.06 28.48 Marine Midland 36.15 21.53 Mellon 28.10 25.38 Wells Fargo 19.83 23.41 First Interstate 16.36 20.34 Crocker National 14.35 22.30 Total 1,256.05 744.72
*Contingent liabilities and commitments include standby letters of credit, foreign exchange commitments, futures and forward contracts, and participations in bankers acceptances. Not included are swaps or underwriting facilities such as NIFs. Source: Multinational Strategies Inc.
