There is old style banking and there is new style banking. Old style is probably what most of us think that the banks still do, that is to lend out a prudent portion of their resources to customers, wait to be repaid according to the terms of their loan, and then repeat the process.
New style banking arranges loans as before but then, to use an ugly word, securitises them. This means pooling them with other similar loans and then selling the whole package to professional investors looking for a better rate of interest than they had previously been able to secure. This process of "selling on" has allowed the banks to do much more business and earn much higher profits than ever before. It was what Northern Rock learnt to do.
The great banking crisis now gripping the New York and London financial markets is about this new way of doing things. Unfortunately, this business model created over the past 20 years is beginning to break down so dramatically that it is unseating the leaders of even the big global institutions. Northern Rock's troubles were, it turns out, an early warning.
The head of Merrill Lynch, for instance, Stan O'Neal, fell from his saddle last week. The board of Citigroup, one of the largest financial services companies in the world, operating in more than 100 countries, met in New York yesterday and decided to dispense with the services of Charles Prince, its chairman and chief executive.
I'll say this about these titans of finance, they don't panic. Mr O'Neal spent much of August, when the crisis began, playing golf. Unkind observers have established that he turned in 19 scorecards during the month. James Cayne, the boss of Bear Stearns, two of whose hedge funds went belly up in July, was found as often on the golf course or at bridge tournaments during this period – without a phone – as he was in the office.
Mr Prince was similarly breezy. While Mr Cayne was wondering which card to lead at the bridge table, Mr Prince was asked what he thought of the deteriorating situation. He replied: "As long as the music is playing, you've got to get up and dance." And he added: "We're still dancing."
When Citigroup's Mr Prince was expressing his invincible optimism, others were scaling back and had been doing for over a year. But at Merrill Lynch, in spite of warnings from the older hands, executives kept buying and packaging loans long after investor appetite had dried up. They were addicted to the fees. In other words, and this is the first difficulty with the new style banking, one of the safeguards that is taken for granted when giving business to financial institutions and entrusting savings to them, that they will act prudently, had gone. It has been obliterated by salary packages tied to the sheer amount of business transacted.
A further safeguard, which keeps financial institutions straight, is that when you buy securities from them, you will always be able to value your purchases by referring to prices established between willing buyers and willing sellers. But to some extent that is old style. Now you are expected to get along without referring to a market price. So complicated are some of the investment products that the financial institutions have devised recently, that it is almost as if they didn't wish the purchasers to be able to understand them and thus establish their value.
Yet another relationship of trust has also been weakened. Look at the specialised companies called rating agencies which are widely used to do two things. The first is an old style task, that is to give an independent assessment of the credit worthiness of individual businesses including banks. The new style task is to estimate the probability of default on the packages of loans which the banks are selling.
It is the second that is going wrong. For now, these rating agencies are feverishly downgrading loans that only a few months ago they had certified as safe as houses. Why have they recognised reality so late in the day? Notice that the rating agencies draw their fees from the originators of the loans.
This business had become large, the fees enormous. So there has sprung up the lively suspicion that the rating agencies have been more interested in their relationships with their clients, the banks, than they should have been. Again a hunger for fee income had blinded people who occupied positions of trust.
The nemesis of new style banking is the American subprime loan. Old style bankers would have recognised them for what they are, mortgages granted to home buyers with poor credit histories. They have permeated everywhere. Every other British financial institution has got some exposure to them, at least indirectly. Their value is deteriorating fast as American house prices continue to tumble.
Which means that on both sides of the Atlantic more banking losses are going to be declared, more bank capital is going to be lost, more chief executives are going to be sacked and more bank employees are going to lose their jobs. Playing golf through a crisis is going to lose its allure. It won't look so cool any longer. And banking will be driven back to basics, after having caused a lot of misery to a lot of people.Reuse content