Welcome Mark Helmantel, could you please introduce yourself?
My name is Mark Helmantel and I am 44 years old. I have two kids and I am living in Groningen. I studied Finance here in Groningen, from 1989 until 1995. Then I became an Assistant Professor at our Faculty of Economics. Currently I work here part-time mainly focused on teaching, e.g. Corporate Finance, Corporate Governance, and Derivative Instruments.
The other part of my time I work at PwC in Amsterdam. I joined the Valuations group in Advisory in January 2007. Initially I was hired to train junior consultants on Corporate Valuation and extend their academic thinking. Since my specialty and interests lie in derivatives, I also took on specific projects dealing with option-like structures. Later I transferred to the Financial Instruments team where I now work as a Senior Manager.
I have done jobs for several clients related to the topic of your conference such as Vestia and DSB, as well as a very big project for Lehman Brothers Treasury. This Dutch entity financed the U.S.-based headquarters in New York for over $35 billion through roughly 4000 highly structured notes. When Lehman Brothers collapsed, the amount of money expected to return to the Netherlands was much less than the outstanding notional. We were given the task to somehow value all those complicated notes so this money could be distributed in the right way to the creditors.
What made you suggest the current theme of the Risk Conference: ‘Too Big to Fail’?
First of all there was this constant debate about the Euro and European Union, and then Greece specifically. What implications might it have if Greece would no longer be part of the European Monetary Union? And how severe should the problems become before the European Union itself were to be threatened? Second was the ongoing debate on the potential failure of large banks. Were the bail-outs justified? Were the cash injections necessary and are banks indeed ‘too big to fail’? This debate was also fueled by the Asset Quality Review that was conducted by the ECB and of course the continuous stress tests the banks have to pass. Third was the issue of a limited number of audit firms. This is partly illustrated by specific mishaps discussed in the media, but also because of the quality reviews in general conducted by the AFM. Given the mandatory rotation of audit firms, there may be a concentration of power at the Big Four right now. Since they audit the vast majority of listed firms, there are not many real alternatives for publicly traded companies. What are the implications of such a market concentration and will that gap ever close? And what would happen if one of the Big Four were to fail? These three issues combined made me think that ‘Too Big to Fail’ is a good, interesting, and comprehensive theme for the Risk Conference.
Talking about ‘too big to fail’, do some companies deserve this tag?
The way I see this there are two aspects: when is a firm actually ‘failing’ and why would it be ‘too big to fail'? Put very simple, a firm will fail ‘economically’ when it cannot pay its liabilities and is not able to make a profit in the long run. However, what if a bank could only survive and really be profitable when it would just focus on shareholder value? Alternatively though, if such an institution is acting in the interest of its clients and society at large, then why should it fail? So the definition of ‘failure’ will depend on the perspective one has. Typically, in economics we assume that in case of wrongdoing by a company, this firm must fail because customers can walk away. Similarly, in finance we believe that no person would accept risks without proper reward. Yet, the financial system is not very transparent and essentially based on long-term trust. As such, any wrongdoing is not easy to detect and may thus only be discovered until it is too late.
Typically, in economics we assume that in case of wrongdoing by a company, this firm must fail because customers can walk away. Similarly, in finance we believe that no person would accept risks without proper reward.
Why a financial institution may be too big to fail mainly stems from the negative repercussions in terms of trust. When such a company would collapse the consequences might be catastrophic. As said, trust is highly important in the financial sector since every transaction is basically an exchange in risks: be it making a payment, financing a company or trading securities. Derivative transactions are essentially trading risks without ever owning the underlying assets, and with credit default swaps trusting that the counterparty will not default itself becomes even more important. When such trust in the financial sector receives a blow, this can have major implications for every financial institution. Furthermore, the impact of failure on society should be taken into consideration.
For instance, it is claimed that Bear Stearns was saved in March 2008 because it played a central role in over-the-counter derivative markets. Its sudden collapse was not well anticipated and would have had severe consequences for counterparties, and a potential reach much further than that. Another example is the bail-out of AIG, the American insurance giant, which was huge in selling credit default swaps. Such contracts are meant to offer protection against the default of certain reference entities and were heavily traded at that time. If AIG would have been allowed to collapse, other firms with massive exposure to these instruments (including investment banks speculating on a downturn in the credit markets) would not have received any payments on their insurance, which would have had led to the potential collapse of more financial institutions. A further example, which is not in the financial sector, comes from General Motors: bailed out in December 2008. The collapse of such an industrial giant would have had a huge impact on the whole economy of the U.S., so one could surely label the firm as ‘too big to fail’. This only leaves us with one question: who should pick up the bill?
Continuing on the bail-outs and cash injections you mentioned, were these justified in your opinion?
With hindsight and thus ex post: Yes, in the economic reality back then the institutions had to be saved. They were literally too big and too interconnected to other (financial) firms that the effects on the global economy would have been too severe. If Bear Stearns and especially AIG had not been saved, then others banks would have collapsed as well, which would have led to a domino effect of even more institutions falling over. In all openness, I think that had the authorities realized what the impact of that collapse would ultimately be, I believe the decision not to save Lehman Brothers might not have been made.
From an ex ante point of view, however, we should not be in a position that such companies need to be saved. They should have had sufficient buffers to protect themselves. The leverage of banks has increased significantly over the past decades, meaning that any movement in the underlying assets has a much larger effect on the equity reserves of a bank. As such, the hidden risks have dramatically increased! If you know that, and if you see that, you need to force these institutions to issue more equity to maintain their buffers. Why do the tax payers have to put up that much money to save the investments of shareholders? The distribution of risk was disproportioned in the sense that investors who benefitted from the upside potential of increasing risk did not face the consequence in terms of its downside. Companies now expect, simply because of their size and because they know they are ‘too big to fail’, they can pull off such stunts. The government would essentially have to bail them out to save the economy. In my opinion we should move in the direction where the government may say that either financial institutions should become smaller in the sense that they are ‘allowed to fail’, or that retail banking should be separated from investment banking again. Let the (proprietary) traders gamble with their own money instead of somebody else’s.
From an ex ante point of view, however, we should not be in a position that such companies need to be saved. They should have had sufficient buffers to protect themselves.
What role did the derivative instruments play in the crisis?
The role was essentially twofold: first off all, the banks securitized large part of their assets since they wanted to reduce their balance sheets. There was a large amount of collateralized debt obligations and asset backed securities. That in itself may be a problem already, since the incentive for banks to monitor the credit worthiness of loan counterparties decreased drastically. They did not feel that this responsibility was with the initial lenders anymore. That combined with the commercial mindset of banks to sell loans also led to less screening of counterparties upfront.
Second, the over-the-counter trading of derivatives was highly unregulated and large concentration risks could built up at institutions selling credit default swaps. Where investors thought that they had protection against the default of bonds, they were not fully aware of the counterparty risk they took. Moreover, it was difficult, also for credit rating agencies, to monitor this additional risk. Since who was ultimately responsible?
With nothing happening to counter these developments, you saw that eventually there was so much liquidity in for instance the retail market for mortgages that housing prices just kept on inflating. Consequently, when that bubble did finally burst, serious problems arose. In my mind, there was too much unsupervised borrowing going on which eventually led to this credit crisis. Whilst another issue with the derivatives was that such instruments increased the overall interconnectedness of financial institutions and decreased their general level of transparency.
So has anything changed since the financial crisis?
No, I do not think that anything has changed essentially. What you see now is that governments and supervisors try to control the beast by regulation. They are trying to regulate behavior, an impossible task. In my opinion, banks should not be put on the spot to misbehave in the first place. As long as banks can gamble with other people’s money, they will continue to have the wrong incentive since the payoffs of their gambles are really huge and actually may work most of the time. Such an uneven distribution of risks is still too much present in current policies I think.
The next big concern that I foresee to become problematic is so-called flash trading or algorithmic trading, but we should not go into that much detail now. The financial sector is just so large at the moment, while the actual base in terms of real activities is not that big. It is holding derivatives based on assets that one does not even own, it is trading following data which is not even real information, but based on price movements analyzed by algorithms. The financial sector is too large for its base so of course something will happen in the future if we keep it this way.
No, I do not think that anything has changed essentially. What you see now is that governments and supervisors try to control the beast by regulation. They are trying to regulate behavior, an impossible task.
So how can we conclude? How should we cope with these institutions?
There are a few things that should be done in my opinion. First of all we need to separate certain activities again to limit the underlying risks which still remain hidden. Let the payment activities and savings business of banks be separated from investment banking again. Let people that are willing to invest in an investment bank do so, but do not let them gamble with other people’s money. This goes hand-in-hand with the reduction in size for certain companies where there is no clear reason for the firms to be so large. There is such a concentration of real power at the moment that the situation is just unstable. Supervisors should continue with stress testing banks and other institutions, but keep in mind that ultimately postponing to take an inevitable loss is leading to a decrease in trust. As such, conducting Asset Quality Reviews are a really good step. Although only a portion of potentially ‘toxic’ assets was found, it is better than doing no asset review at all. Essentially, I believe the best form of regulation is to clearly state what is allowed and what not, and not resort to all kinds of detailed rules that are meant to influence the overall incentives and management of certain activities.
As such I think a lot of companies nowadays may actually be ‘too big to succeed’ but then indeed the egos of the executives might be ‘too big to fail’!
In light of the theme of your conference, I would like to conclude with the observation that size is not everything. I actually believe that even though a lot of companies and also public organizations strive to grow in size (‘to become more efficient’), this is not necessarily the best strategy and they should focus on the primary processes while strengthening their core competences. As such I think a lot of companies nowadays may actually be ‘too big to succeed’ but then indeed the egos of the executives might be ‘too big to fail’!