SCMP:Some sympathy for the devils

24 July 2009

It's deeply unfashionable to feel any sympathy for bankers these days.

In Hong Kong, they have been exposed as no better than back-alley thieves, cruelly mugging harmless old grannies, stealing their savings and leaving them with purses stuffed with nothing but worthless Lehman Brothers minibonds.

That's pretty much the narrative as it's been told to us. But you have to wonder how accurate that interpretation of the minibond story is. And you have to doubt whether Wednesday's settlement, in which 16 banks agreed to pay minibond investors back at least 60 cents in the dollar, is really as great a deal as it's been made out.

With minibonds sold to senile, illiterate and mentally handicapped savers, there were clear breaches of the regulations in some cases. Those investors should be paid back at 100 cents in the dollar, not 60, and the offending banks should be hammered with stiff penalties to boot, not allowed to escape additional punishment.

But those cases are in the minority. For the most part, minibonds were bought by people who went into their banks with eyes open and who knew exactly what they were after: higher returns.

As the first chart below shows, interest rates on bank time deposits have collapsed in recent years, falling from double-digit levels in the early 1980s to rates as low as zero in the early years of this decade.

As a result, depositors turned into eager buyers of complex structured instruments that promised a higher rate of return than plain vanilla time deposits.

Yet as anyone who isn't senile, illiterate or mentally handicapped can work out for themselves, a product that offers a yield of 5 per cent or more when interest rates are at zero must come with considerably more risk of loss than a simple time deposit. You don't need to understand one-touch options or credit default swaps to work that one out. It's a clear case of caveat emptor: buyer beware.

There is a strong argument to be made that savers who bought minibonds because they demanded higher returns should have to bear their losses. They invested in risky securities and were unlucky enough to have them blow up in their faces. That's tough. But it is hard to see why one group of investors - the banks' shareholders - should be forced to bail out another - the minibond buyers - simply because the second group made a bad decision.

On the other hand, the banks were hardly blameless. Until the mid-1990s, profits were relatively easy to come by. Demand for loans was brisk, and Hong Kong's loan to deposit ratio rose as high as 180 per cent.

The 1997 Asian crisis changed all that. As the second chart below shows, loan demand dried up even as deposits kept mounting. The loan to deposit ratio tumbled, falling to within a whisker of 50 per cent in recent years, brutally squeezing bank's interest income.

In response, Hong Kong banks ramped up their sales of securities, pushing structured products like minibonds to their depositors in order to capture lucrative commission income. Many went for the hard sell, sacrificing long-term customer relationships to boost short-term profits.

Yet although that's dumb and although many of the instruments sold were wildly unsuitable for ordinary retail investors, what the banks did - for the most part - was perfectly legal. It is unclear why they should be punished for it.

But the real problem with the minibond settlement is not so much its injustice, but the precedent it sets.

Securities and Futures Commission chief Martin Wheatley called Wednesday's deal "a watershed in the regulation of financial services in Hong Kong". He's not kidding. In pushing for a blanket bail-out of minibond investors, the regulators have served notice that from now on investors who lose money will be bailed out if only they make a loud enough noise about it.

So, expect a flood of compensation demands from investors who have taken losses on other structured products, on warrants or hedge funds. The list is endless.

Worse, Wednesday's agreement will only encourage investors to take excessive risks in the future, safe in the knowledge that if they end up out of pocket, they will be able to cry "mis-selling" and force the banks to refund their money. The minibond deal badly skews the balance of risk and reward for investors, introducing a hefty dose of moral hazard that stands to inflict severe damage on Hong Kong's financial services industry.

So although it's not fashionable to feel sorry for bankers, perhaps they do deserve some small sympathy in this case.