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Don’t believe everything the big banks tell you about themselves

 (ES Composte)
(ES Composte)

The big banks have been displaying their financial muscle this week. They are making profits and, more to the point in these febrile days, are “beating analysts’ expectations” for the key numbers. On Tuesday HSBC led the way, posting pre-tax three-monthly profits of £5.8 billion against analysts’ guesses of £5.3 billion, and up from £4.8 billion this time last year.

Nevertheless, the shares took a dive. The immediate cause was the worsening prospects in China, now that all pretence of a market-driven economy has gone, following Xi Jinping’s elevation to absolute power for as long as he likes. This was sheer bad luck for the bank’s spinners, but in truth, getting a grip on what’s inside the bank is as hard as trying to analyse the six-man Politburo Standing Committee under Xi.

HSBC investors were offered a 46-page announcement, 33 pages of analysts’ presentations and a bumper 107-page PDF data pack. Surely, everything you could ever wish to know is in there somewhere?

Well, maybe. Or maybe not. Anat Admati of Stanford University is a thorn in the side of the world’s big banks. She argues that the sheer complexity of the business makes a proper assessment of the risks they really run nigh-on impossible.

Bankers are (well) paid to dream up clever ways to make money, and occasionally one of their schemes breaks cover, as we saw earlier this month with the derivatives bought by pension funds. It is still far from clear where the risk lies here, and there are hundreds of schemes, often tailor-made for a specific problem, which work fine as long as they do. In essence, the weird and wonderful instruments the bankers dream up are ways of turning a (possible) small gain into a bigger one. It works through the magic of gearing, familiar to any home-owner with a mortgage.

Just as you sleep better if your mortgage is much smaller than the value of the house, the simple answer for banks is to force them to hold more pure equity, which can be wiped out without triggering default — “loss absorbing” in the jargon. When Royal Bank of Scotland failed, its equity was just 3% of its balance sheet — so if the value of its assets were to fall by 3%, it would be bankrupt. It was. No amount of clever balance-sheet manipulation would change the arithmetic.

This week, the big banks have been telling us how well capitalised they are now, declaring profits that “beat expectations” and starting to pay significant dividends. Yet the shares remain mere shadows of their pre-crisis values, having collapsed and never recovered. They even stand at discounts to the theoretical break-up value of the businesses and remain distinctly unloved.It is probably too much to expect a bank to be loved, especially when it is telling its borrowers they must pay a lot more than they have become used to, but the basement rating for the shares reflects something else.

It’s odds-on that our cash-strapped Government will try and squeeze the banking lemon again, since it is both popular and raises a lot of money. The banks will complain that they will have less money to lend. hoping we don’t understand how bank lending works.

It is also likely that come the next crisis, we will discover that they have found all sorts of new ways to lose money that they hadn’t thought of before, as risks emerge in unexpected places.

The banking regulators, struggling to keep up with an ever-evolving business, will get the blame as usual. This is particularly unfair, since the brightest of them are routinely head-hunted by the banks for multiples of their regulator’s salaries.

The bankers themselves have continued to do well, or very well, as one crisis has followed another. The impoverished shareholders can only dream of the glory days before the Great Collapse of 2008. Their shares will never be rated highly again because the real risk is impossible for outsiders to grasp, and some of us suspect that it is beyond those inside the banks as well.