Banks' losses and gains in sub-prime crisis

Goldman Sachs estimates that financial institutions will take a hit of $400 bn due to the turmoil in financial markets. But the impact varies widely across institutions. Goldman, Lehman and Morgan Stanley have come out relatively unscathed while Bear Stearns, Merrill, Citigroup and Bank of America have suffered big losses.

For some banks, there is a big offset coming from stakes in Chinese banks. The increase in market value of the stakes of top international banks in Chinese banks - FT's Lex column places this at $70 bn- exceeds the sub-prime write-offs that banks have announced so far.

The difficulty, as Lex points out, is that international banks will be able to augment their capital only if they actually sell their stakes in Chinese banks. So far, they have been reluctant because they view these as strategic investments that will help them gain access to the Chinese market. But, as capital is progressively impacted by sub-prime exposures, the case for selling these stakes will become strong.

Two pieces of good news from the above. One, the banking system as a whole is better placed to weather the impact on capital of sub-prime losses than many would suppose. Capital may shrink but it is not likely to turn negative- in other words, a generalised banking crisis appears a remote prospect. That augurs well for the world economy.

Two, because there are good performers among banks, the bonus pool for 2007 is estimated to be slightly higher than for 2006 even though shareholders have seen their value eroded. How to explain this?

Well, there is an asymmetry in rewards and penalties in banking. In all banks, including underperforming ones, the divisions that have done well need to be rewarded generously. Those that have done badly will be penalised through job losses but there will be no negative payments, so to speak, for employees. Heads you win, tails you don't lose- that's the story for employees.