labels: banks & institutions
We have all become lenders of last resort news
16 August 2007

There are many examples where banks have thrown good money after bad in order to save their clients in the hope that they can save the money already lost. By Shahin Shojai, director of strategic research, Capco

Shahin ShojaiIn the old days they used to say that you should be very careful about how you treat your bank manager if you have borrowed a small amount from your bank but that it is your bank manager who should be worried about how he deals with you if you have a huge debt with the bank.

This has certainly be proven to be the case in many relationships with bank managers and there are many examples of situations where banks have thrown good money after bad in order to save their clients in the hope that they can save the money already lost.

Of course, the same relationship holds when a public company is in financial difficulties. Its own shareholders and lenders might provide it with additional capital in order to help it through a rough patch, even though given the information available at the time it is not clear whether the shareholders have any idea how helpful the extra funding would be in rescuing previous investments.

However, many make the additional investment in order to prevent the management from approaching a point where they are willing to take too much risk with investor and lender funds. This is because as a company approaches the likelihood of bankruptcy, especially in jurisdictions where there is bankruptcy protection, the management are more likely to take on greater risks with their shareholders' and bondholders' funds.

This is due to the fact that they realize they have a call option on the firm; they have all to gain and not much to lose if they take a huge risk with the funds available. If the risk pays off everyone, including them, gains. If it fails then the management have lost very little personally, since they rarely have large holdings in public companies. It is the shareholder's money that has been lost. In reality it is very difficult to stop firms from taking risks with shareholders' funds, though debt covenants do try their best.

As the importance of the firm to the economy grows so does the number of participants willing to help it through the crisis; and it is no longer just the shareholders that act lenders of last resort but even the government might step in. If the corporation is in fact a banking institution the central bank is required to step in and protect the banking sector, and the capital reserves held by the central bank do behave like insurance premiums.

Very few banking institutions have taken huge risks with their shareholders' and depositors' investments and abused the lender of last resort role of the central bank. However, many national governments have not been so generous. There are many examples of governments abusing the funds placed at their disposal because they feel that the world's lender of last resort, the IMF, would bail them out. The IMF does in its own way try to find ways to mitigate these risks.

It is not only the management of corporations or banks that investors / lenders / depositors try to prevent from taking on too much risk with their assets. Asset management companies are given very specific guidelines on how they can invest in order to mitigate such moral hazards. However, unlike the situation with corporations and their shareholders, asset management firms are in fact prevented from diverting too much from their permitted course by their investors. They are given very strict guidelines and will be penalised if they divert from them.

There are, of course, certain asset management companies that are not bound by strict investment guidelines, such as hedge funds; and they are certainly becoming a serious dilemma for the world of finance. It is now the hedge funds that seem to view their relationship with their clients or owners as one where the larger the investment the more likely they are to bail them out in times of trouble.

We are now seeing that the best of Wall Street are forced to bail out their own internal hedge funds, or those they have strong relationships with, in order to prevent a potential catastrophe for the bank, and even potentially the financial system. The world's major central banks have pumped huge amounts of liquidity into the system in order to prevent a meltdown caused by those who had invested in complex certificates that invested in different risk components of CDOs.

The experience of the 'long-term capital management' demonstrated to hedge fund managers that so long as their size, or the size of their bets, is large enough that their failure could be a major cause for concern in the financial markets they are free to take on huge risks.

If the risk pays off they could be paid astronomical fees and if it fails it is someone else's problem. Similarly, if they invest in hugely risky assets in which many peers have invested they can relax in the knowledge that a failure would have significant consequences for the global economy and everyone will have to step in and rescue them.

It is astonishing that despite the fact that a failure of one bank can no longer cause a financial meltdown, banking institutions are required to keep more than adequate reserves as insurance with the central bank. However, many large hedge funds that can leverage bets as large as the economies of major developed countries can go about taking huge risks on the market with little or no monitoring.

In the past few weeks we have seen everyone become a lender of last resort. Goldman Sachs and Bear Stearns in the US have been joined by the Federal Reserve and BNP Paribas and KfW have been accompanied by the ECB to save funds that were in serious trouble in order to avoid a major crisis of confidence in the markets.

There is very little doubt that the situation could get a lot worse, since as time goes by more people will realize that even those who structured some of these complex instruments had no idea how they would behave when the market got too sour for their pricing models.

The only question remaining is are the hedge fund managers now required to use some of the huge compensations they had received in the past to compensate their investors who have lost most of their investments or is that simply the job of the rest of us who act as their lenders of last resort.


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We have all become lenders of last resort