What's the Rational Thing to Do in a Bank Run?

Something significant happened last week in Europe that I’m guessing most of my readers overlooked. Ever since the debt crisis hit Europe three years ago, Europe has fallen into very predictable cycle. The cycle goes like this:

• Phase 1 – A financial crisis emerges.

• Phase 2 – After dire public warnings that the world as we know it will come to an end if something isn’t done immediately a meeting of European leaders is held.

• Phase 3 – The meeting is met with hope and trepidation, followed by great relief that an agreement has been reached.

• Phase 4 – Within a few days of the meeting, possibly as long as month, the apparent solution is exposed for what it is: “a band aid for a gaping wound” and the solution unravels.

Last week this cycle was broken. O yes it began exactly the same way. A crisis loomed: What was to be done with Greece? And Phase 2 kicked in, European leaders met. But this is where the cycle stopped. No alternative was found to solve the crisis. And maybe this is a good thing. Maybe, finally, European leaders are realizing that there is no solution to Greece. It’s kind of like an alcoholic who finally admits to himself he has a drinking problem. Until that happens he has no chance whatsoever of living a life of sobriety.

And now that the European leaders admit that there is no solution to the Greek’s financial problems they can now move onto the next phase which is, “How do we allow Greece to leave the eurozone that will minimize the damage?” It is no longer a question of if the Greeks will leave the eurozone it is only a matter of how to do it so that it minimizes the negative consequences from such an event.

And negative consequences there will be. Even now there is a run on the Greek banks. It reminds me of what happened to Washington Mutual a couple of years ago. One moment it was a healthy going concern and within a couple of weeks depositors had electronically pulled out all their deposits from the bank. What is the rational thing to do in a bank run? The rational thing to do is to participate. And that is what’s happening right now with the Greek banks and there is nothing anyone can do about it. The Greek people aren’t stupid. They’re transferring their money into other currencies that have less risk. It’s way too late for the Greek banks to recover.

The really important question is, “Are U.S. financial institutions prepared for what is happening in Greece?” The answer is “It depends on which banks you’re talking about.”

The vast majority of the American banks have no exposure whatsoever to the Greek financial crisis with the exception of our very largest banks – Bank of America, Citigroup, J.P. Morgan Chase, Morgan Stanley, Goldman Sachs and Wells Fargo. These six banks have definite exposure to what’s happening in Greece. All reports say that their exposure to Greek insolvency is manageable. If you want to believe what the banks are telling you then we have nothing to be concerned about. Call me a cynic, call me a “glass half-empty” type of guy if you like, but I don’t believe it.

Months ago I reported that American financial institutions had only modest amounts of European sovereign debt but they had significantly more risk with credit default swap exposure. A CDS is just a fancy way of saying that they are insuring those who own sovereign debt that it will not default. For a nice fee they are exposed to enormous risk if they are wrong. I believe this is what happened to J.P. Morgan Chase a couple of weeks ago. They bet wrong and voila, they lost $3 billion. Until Congress outlaws these risky forms of investments all bets are off that these six banks will come out of this crisis unscathed.

Sources: Greece and Banks by David Knox, Cumberland Advisors, May 23, 2012; The Rational Thing To Do In A Bank Run, GK Research, May 17, 2012; A Cycle of European Crisis Management, STRATFOR, May 25, 2012.

What the heck happened at JP Morgan Chase?

As you know by now JP Morgan Chase lost $2 billion last week by taking big bets on European bonds. Interesting to note (and telling) I found no article that explained what caused the loss. I scanned the internet and there are plenty of articles talking about whose heads would fly, articles supporting more regulation of the banks, articles about the political ramifications of the presidential race but no article that tried to explain what actually happened.  

Why not? I believe it’s because it’s too complicated for the lay person to understand. The investment that caused the loss is called a “synthetic credit portfolio.” Wow! What does that mean? I would guess that the average investment banker doesn’t fully understand the complexity of the investment vehicle either!  

Should we be concerned about this loss? Absolutely! As long as the American taxpayer has to bail out the banks when things go wrong we have every reason to be concerned. This $2 billion loss last week, although significant, is manageable. In comparison, last year JP Morgan Chase made a profit of $18 billion so a $2 billion loss is not the issue.  

The importance of last week’s loss shows us that we are just as vulnerable to a catastrophic event as we were four years ago when Lehman Brothers started the ball rolling. That’s the lesson we learned from this latest blunder by JP Morgan Chase. No legislation has been enacted, no common sense has been gained, that will prevent us from doing it all over again. How ominous is that.  

So if I were suddenly in charge how would I fix the problem? I would do the following:

1. As I stated in January in this blog I am in favor of the Dodd-Frank bill. Now I’m no expert on the bill but it has a number of common sense ideas that should be fully implemented. I know this is unpopular with many of my readers who believe in free markets but I believe that some regulation is necessary to save us from ourselves.

2. The deeper more penetrating question is, “Should banks in general be doing these types of trades?” I strongly believe the answer is a resounding “no” and agree with the Volker Rule (a section in the Dodd-Frank bill) which bans speculative trading on a bank’s own accounts.

3. I believe there needs to be a change in how investment bankers are compensated. Greed drives risky behavior. If they are on the right side of the bet they’re handsomely compensated. But what happens if they make poor choices? Do they give back some of their previous commissions and bonuses? Hardly! Instead reward employees for making sound investment decisions over time (perhaps over 2 or 3 years) and not on any one particular transaction.

4. The ultimate goal should be that banks should be allowed to fail if and when they make egregious errors in judgment. The federal government should not be in the business of bailing out the banks when things go wrong (though I do believe it was the right thing to do in 2008 to avoid a more catastrophic upheaval). This may mean that banks should be forced to downsize into several smaller financial institutions so that we can avoid the problem we had last time around when many of our bank were “too big to fail.”

Make me king for a day and I’ll solve all the world’s problems. But seriously, what occurred last week should be viewed as a wake-up call to everyone who is in charge of our financial institutions. How vulnerable are the American banks to the European debt crisis? What happens if a sovereign default does occur? Therein lies the great unknown.