The legendary Baron Münchhausen fell into a swamp and gloriously pulled himself out by his own bootstraps. Similarly, some banking markets appear attractive only because banks make them so. But bankers have as little faith in their capacity to engineer a positive macroeconomic situation as they would have in Münchhausen’s feat; so they believe that the positive fundamentals must have been there before them. No more is needed to start a self-reinforcing cycle that goes through boom and bust.
Two sectors that have played a major part in most banking crises are real estate lending and emerging markets banking. Unlike the first five deadly sins they are not wrong in themselves: there are prudent, stable ways of banking with both areas, some of which we will discuss for Handelsbanken specifically. Yet, more often than not, real estate lending and emerging markets banking lead to a crisis: it is surprising that banks quickly forget how often these areas have brought them into severe
trouble. The basic problem is that they are cyclical because they are for some time self-reinforcing. In real estate, credit expansion leads to increased demand for a fixed supply of real estate so asset price increases. With rising asset prices even problem cases rarely lead to a loss because selling the collateral at a higher price more than covers the loan. Lending standards are relaxed since risks appear negligible, further fuelling credit expansion and taking care of problem cases since it is easy to refinance. This is the narrative gleaned from senior loan officer surveys in the US and Europe.19
Similar mechanisms are often at work in emerging markets. As long as there is enough risk appetite to transfer funds on a large scale to emerging markets, these funds lead to strong economic growth. How can a country such as Ukraine not grow its economy very strongly during a period where lending increases by more than 50% per year from 2004 to 2008? In these years when banks are happy to lend to emerging markets everything looks benign: banks make large profits, asset quality is good, the country is growing strongly. This means more demand for banking products, even more growth and profits etc, so shareholders or regulators looking at numbers will find absolutely nothing to be unhappy about.20It takes a fool not to make money for a consecutive number of years in the real estate and emerging markets upswing.21
19 Also see Taylor (2008) for empirical data on the relationship of house prices and defaults.
20As Minsky puts it: ‘good times induce balance-sheet adventuring. The process by which speculative finance increases, as a proportion of the total financing of business, leads to higher asset prices and to increased investment. This leads to an improvement in employment, output, and business profits, which in turn proves to businessmen and bankers that experimenting with speculative finance was correct.’ (Minsky 1986, p. 42).
21A fate that Handelsbanken in its early days did not avoid. Via a closely related company, Svenska Emissionsaktiebolaget, Handelsbanken started speculating on international trade connections with Russia, Latin America and others around WWI. ‘A notable lightheartedness was evident in the handling of some of these affairs. The profits were dazzling at first, but when they dried up the ensuing loss was a very heavy one’ (Hildebrand 1971, p. 29).
Unsurprisingly, this whole self-reinforcing cycle can just as easily go into reverse. The moment international banks pull back there is a high likelihood that economic growth will come to an abrupt halt and asset quality will deteriorate sharply.
Barings’ first brush with bankruptcy in 1890 came from its dealing in loans to Argentina. Citi’s last encounter with insolvency is only a quarter of a century old: the emerging markets debt crisis meant that Citicorp faced large burdens of bad debt from lending to developing countries that later defaulted.22
The IMF database of banking crises (Laeven/Valencia 2008) is full of systemic bank failures in emerging markets. Some of them caused significant losses also for the banking system in the developed world (the already mentioned Latin American debt crisis in the 1980s, the Asian crisis 1997, the Russian crisis 1998, and the Argentina crisis 2001).
Today there are real concerns about the implications that banking in Eastern Europe would have on Western European banks.
Handelsbanken’s credit risk officer once quipped that lending in some Eastern European countries was ‘the closest in Europe to subprime lending’; banks were offering loans to inexperienced borrowers in foreign currencies.
Markets that everyone else finds unattractive can bizarrely be safer
environments because they lack the self-reinforcing boom and bust cycle.
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22Citicorp’s chairman Walter Wriston is still famous for his quote, ‘countries don’t go bust’. Well, until they did, partly because they had borrowed in foreign currencies which they could not print – see deadly sin number two.
Real estate or emerging markets banking becomes problematic only because the activity of banks creates what everybody believes to be the underlying fundamentals. The reason is that credit and credit growth are a more important driver for the development of housing and emerging markets than for many others. More lending leads to growth and asset price increases while risks remain low. Attributing these
“fundamentals” to secular trends attracts more bankers keen to participate, so the cycle gets reinforced. But emerging markets and real estate are relatively safe only where just a few banks operate and the resulting credit expansion is moderate.
Markets that everyone else finds unattractive or too risky can thus bizarrely be safer environments because they lack the self-reinforcing boom and bust cycle.