Big Banks Take Risks Expecting Taxpayers To Cover Losses

FRANKFURT, Germany — Governments, banks and households struggling with too much debt are dragging down the world's economy and more needs to be done to make the banking system safer, a global organization of central banks warned Sunday.

The Bank for International Settlements said in its annual report that the world economy remains out of balance, with advanced economies struggling with debt and emerging economies growing strongly but facing risks of their own version of boom and bust.

The BIS – an intergovernmental organization of central banks based in Basel, Switzerland – said it's key for governments to make banks take responsibility for their losses and force them to rebuild their finances. Meanwhile, the threat from risky bank behavior is growing again.

"The world is now five years on from the outbreak of the financial crisis, yet the global economy is still unbalanced and seemingly becoming more so as interacting weaknesses continue to amplify each other," the BIS said in its 82nd annual report.

"The goals of balanced growth, balanced economic policies and a safe financial system still elude us."

The financial crisis that began in 2007 with losses suffered by investment funds and banks on mortgage-backed securities in the United States led to a full-blown crisis and global recession after U.S. investment bank Lehman Brothers went bankrupt in 2008. Stock markets have plunged and then recovered, governments have put billions into rescuing banks to avoid a worse collapse, and central banks have slashed interest rates and in some cases expanded the supply of money to bolster their economies.

This has left an uneven and fragile recovery, with high unemployment and increased levels of government debt afflicting developed economies. Meanwhile, the 17-countries that use the euro have sunk into a crisis over excessive government debt.

The aftermath, says the BIS, is that governments, banks, and consumers are all trying to cut back on debt at the same time, magnifying each other's problem as they do so.

Stephen Cecchetti, the head of the BIS's monetary and economic department, said central banks should not be expected to carry the entire load of supporting growth and debt reduction. "In the middle of all this we find the overburdened central banks, pushed to use what power they have to contain the damage. But there are very clear limits to what central banks can do. "

In an attempt to help bolster the economy, the U.S. Federal Reserve has cut rates to near zero and created new money through purchasing financial assets. Meanwhile the European Central Bank has reduced interest rates to a record low 1.0 percent and made (EURO) 1 trillion in cheap loans to banks to steady the financial system.

But there is only so much a central bank can do, Cecchetti warned. It cannot make companies and governments reduce debt or improve the productivity of economies, he said.

The report also emphasized the need to increase the safety of the banking system by pushing banks to be responsible for their losses, add to their financial buffers and avoid risky practices. It added that big banks still have an interest in using high-risk debt – so-called "leveraging" – to magnify any trading gains because they can expect taxpayers to step in and cover their losses if things go bad.

"Big banks continue to have an interest in driving up their leverage without enough regard for the consequences of failure: because of their systemic weight, they expect the public sector to cover the downside, " said BIS. "Another worrying sign is that trading, after a brief crisis-induced squeeze, has again become a major source of income for large banks."

"These conditions are moving the financial sector towards the same high risk profile it had before the crisis."

Some of the concerns about banks reflected in the BIS report were highlighted last week by the downgrade of the credit ratings of 15 large banks by Moody's Investors Service. The credit rating agency cited the banks' "significant exposure to the volatility and risk of outsized losses inherent to capital markets activities."

News that J.P. Morgan last month suffered a $2 billion trading loss related to a hedging strategy raised similar concerns.

The BIS said fundamental progress would be secured when the "largest institutions can fail without the taxpayer having to respond" and when the size of the financial sector relative to the rest of the economy stays within tight limits.