Banks are getting a lot of criticism at the moment and most of it is justified. What mistakes did the banks make?
Bonuses which encouraged Risky Short Termism.
If managers gained short term profit for the bank, they would be in line for large bonuses. If they lost money, they didn’t get a pay cut. It was a one way bet for bankers to take the riskiest profit / growth strategies.
- It is this culture of bonuses which is behind many bad decision from the trader Nik Lesson breaking Barings to explaining why RBS paid over the odds for a Dutch bank Amro.
Not Being Aware of Risk
Many US subprime mortgages were risky assets. But, they were bundled up into consolidated debt packages and these risky debts somehow got reclassified as triple A star safe debt. Many British banks bought these debt packages not realising or working out that they were buying very risky assets. When US householders started defaulting on their mortgages, British banks lost huge sums of money which is why they have become reluctant to lend.
Borrowing to Lend
Traditionally banks have lent money in relation to their deposits. Building societies lent mortgages by using saving deposits. However, banks found it more profitable to borrow money on money markets so they could lend more mortgages. Effectively they were borrowing to lend. The worst offender was Northern Rock. 75% of its loans were not backed by savings. At the start of the credit crunch they suddenly couldn’t finance their long term mortgages and so required government intervention.
Assuming Housing Bubble Would Continue
By assuming house prices would continue to rise, many banks continued to lend 100% mortgages even 125%. This means that now house prices are falling many households face negative equity (house worth less than outstanding mortgage).
Banks were unable to moderate a credit bubble and bust. By aggressive lending in the bubble they overreached themselves and now are relying on government bailouts.