A Measly Fine for RBS Shows Just How Little We’ve Learnt From the Financial Crisis

Today the Royal Bank of Scotland (RBS) agreed to pay a $5bn settlement to the US government over its activities in the run up to the financial crisis. The settlement covers the mis-selling of so-called residential mortgage-backed securities (RMBS) by the bank to US financial institutions. The fine is considered very lenient, and RBS shares have jumped after the announcement.

RMBSs, ABSs, and the GFC.

RMBSs are a special type of ‘asset-backed security’ (ABS) that were central to the financial crisis, as any of you who have seen the Big Short will know. ABSs are created by ‘securitising’ certain forms of debt: turning these debts into securities that can be traded, just like a normal bond or equity. A bank like RBS would issue a number of mortgages, bundle them up into RMBSs, and sell them to investors. The bundling process was particularly important because it involved the combination of very safe mortgages given to credit-worthy borrowers with so called ‘sub-prime’ mortgages given to borrowers who were at risk of default.

By pooling risk in this way, the sellers of ABSs could obscure their risky sub-prime loans, and turn illiquid (i.e. not easily turned into cash) mortgages into highly liquid assets, with fairly low levels of risk. This process made it seem as though banks were holding lots of safe, liquid assets that they could sell in the event of a default, which allowed them to issue even more mortgages. With ever greater amounts of money chasing after effectively the same number of homes, increasing levels of credit sent house prices skyrocketing and created a bubble in the housing market.

These activities happened in banks all over the world, particularly in the US and the UK, and was perfectly legal. What distinguishes this securitisation from the kind of securitisation performed by RBS is that RBS is alleged to have deceived the market about the quality of their RMBSs. RBS was accused by regulators of ‘deceptive practices’ in its underwriting and selling of RMBSs before the financial crisis: the US attorney general said the bank had been warned that many of the loans included in the securities were far below legal and regulatory requirements, but it ‘packaged them up and sold them anyway’.

In a system built on greed, RBS stands out as an extreme example of aggressive expansion and voracity in the run up to the financial crisis. RBS’ leverage – the ratio of risky debt to safe equity – increased from 25 times at the end of 2004 to 42 times at the end of 2007. But this is mirrored by a dramatic increase in leverage across the banking system more broadly. In fact, given the whole point of an RMBS is to obscure risk, it is very hard to draw a sharp line between legal obfuscation and illegal deception, especially given the role of the ratings agencies in failing to adequately monitor what was going into these RMBSs.

House of cards.

When the house of cards came crashing down, it became evident that no one had a clue what mortgages had been bundled up into what securities. There is a fascinating scene in the Big Short in which Mark Baum (Steve Carell) goes to a strip club to talk to the women about their mortgage debt. He finds they have taken out multiple mortgages on multiple homes, with tiny deposits and ‘teaser rates’ that will eventually spike if they aren’t re-mortgaged. Michael Burry (Christian Bale) figures out that when these teaser rates stop in 2007, people will start to default and won’t be able to re-mortgage. Just as Burry predicts, people start to default in 2007 and, without any way of knowing which mortgages are in which securities, the whole market in these RMBSs and other ABSs collapses.

Banks like RBS suddenly realised the ‘assets’ they held on their books were worthless. Central banks around the world stepped in and launched a coordinated campaign to convince markets that these banks were facing a classic liquidity crisis. But it was clear to most people in the know that many banks – RBS included – were effectively insolvent. Rather than letting these banks collapse, writing off the unpayable debt on their books, and calling in the state insurance of the banks’ deposits, the state stepped in to bail RBS out, costing the taxpayer £45.5bn. Total support to the banks peaked at £1trn at the peak of the financial crisis.

What next?

The taxpayer now part-owns RBS, so the announcement of the lenient fine could be seen as good news. It will allow the state to gain a better price for RBS and use the windfall to pay down some of the public debt incurred from bailing these banks out in the first place. But as was made clear during the previous sell-off of RBS shares, the shares will be deliberately under-priced. Many of these will end up accruing to middle class individuals who will sell them on and receive a capital gain. This will also mean lower revenues for the exchequer, leaving working people responsible for paying off what remains of the banks’ socialised debt.

The story of RBS is not the just story of a rogue bank, run by particularly greedy individuals, whose risk taking brought the system to its knees. It is also a story of the corruption of the financial system as a whole. Bankers, economists, regulators, politicians, ratings agencies all failed to call an end to what was effectively a Ponzi scheme. This was either due to wilful ignorance or, in some cases, outright corruption. Issuing a series of fines to the ‘bad’ banks won’t do anything to curb the voracious greed upon which our financial system is built – but then again, it isn’t supposed to.

In fact, very little has changed since the financial crisis. The Bank of England recently warned consumer credit is reaching dangerous levels. Mark Carney has declared the growth of shadow banking since the financial crisis to be the greatest threat to financial stability today. The IMF has warned that, instead of securitising mortgages, banks and other financial institutions are now securitising car loans and student debt. In fact, the UK government itself recently announced the securitisation and sale of the student loan book.

The economist Hyman Minsky had a theory of the financial cycle that he termed the financial instability hypothesis. He argued that, left to its own devices, the financial cycle tends towards a type of ‘Ponzi finance’ that renders the whole system unstable. 2007 has been pointed to by some the archetypal Minsky moment. Today, it is clear that we have failed to learn from Minsky, and so we are doomed to make the same mistakes over and over again. We may not be facing a 2007 2.0, but our debt-laden economy is facing many years of sluggish growth that will eventually be combined with another financial crisis of one kind or another. When it comes, regulators will pretend to be shocked, but the truth is that crisis is an inherent part of the system.