Jeremy Warner's Outlook: The bank that took the first hit says the credit crunch is far from finished

Tuesday, 5 August 2008

We are coming up for the first anniversary of the credit crunch, which most people date as 9 August, the day last year when, with interbank lending freezing up, the European Central Bank started to flood the money markets with liquidity following a warning by BNP Paribas that it was closing two of its funds.

Yet the first sign of trouble to come came much earlier, as far back as February last year, when HSBC first warned of massive writedowns on its exposure to US sub-prime mortgage lending.

Few had properly focused on the United States' emerging housing crisis before this announcement. The initial response was to think of it as a largely contained problem that would have limited impact outside the lower echelons of American trailer-park society.

As late as June last year, Ben Bernanke, the chairman of the US Federal Reserve, said he thought sub-prime problems would have little impact on the wider economy. Not many were prepared to challenge this view, which was very much the prevailing wisdom of the time. How wrong can you be?

As for HSBC, the original harbinger of things to come, this great lumbering supertanker of a bank is now judged to be sailing through the credit crunch relatively unscathed. With bad debts for the first half at $10bn, profits are admittedly down by nearly a third, but against the near wipeout being reported by others, this is judged a solid performance. Balance sheet growth remains robust, capital ratios are still strong, and the bank is increasing its dividend by 6 per cent.

Outside the US, which is still a disaster zone for HSBC with continued heavy writedowns on the sub-prime portfolio, things are chugging along nicely. If it had its time again, HSBC would obviously never have bought Household International, the American consumer finance company whose loose lending practices have taken such a terrible toll on profits, but HSBC's global reach and depth have seen it through. A year and a half ago, Stephen Green, the chairman, was fighting for his job, with the losses suffered on sub-prime lending giving activist investors another stick to beat him with. Today, he's seen as one of banking's heroes, if that's not a contradiction in terms, having taken his punishment on direct sub-prime exposures early and apparently avoided the full force of the meltdown in mortgage backed securities.

He was pretty glum about the future yesterday, complaining of "the most difficult financial markets in decades". Emerging markets, which have so far remained strong through the credit crisis, are now facing growing inflationary problems, he warned.

As for banking, the growth models of the past based on high and increasing leverage are "no longer sustainable". Things are going to get worse before they get better in the real economy, he thinks, but it will eventually recover. However, "financial markets will not and should not return to the status quo ante", he says.

Mr Green is no doubt right in thinking banking is unlikely to return quickly to the way it was, but he's wrong in believing supervisors, bankers, underwriters and investors will learn the lessons. There's a serious banking crisis somewhere in the world approximately once every 10 years. Every 30 or 40 years there is a cataclysmic one. Like volcanic eruptions or earthquakes, nothing can be done to stop them and the lessons of each rarely help prevent the next. Each banking crisis is different in nature, but they all share one over-riding characteristic. As the good times roll, there is a collapse in lending standards.

The consequent misallocation of capital eventually results in a big debt overhang which must either be written off, as is now occurring with some vigour in the Western banking system, or as in Japan during its lost decade of growth, is left to fester, starving enterprise of the capital it needs to create renewed growth.

Things feel grim at the moment, but today's write-offs and recapitalisations are a necessary pre-cursor to the process of renewal. At which point, the whole merry-go-round begins again, as the next generation of bankers invents hitherto undreamt of ways of squandering our capital afresh.