‘Worst Bank Scenario’ a book that should spark a discussion on bank supervision

My review of a fascinating book on swaps, derivatives, and Dutch supervisory shenanigans by Hester Bais and Wink Sabée

The book by Hester Bais and Wink Sabée documents poor conduct by banks in the Netherlands during the first decades of the century. For the international edition: click here. Nevertheless, the points below are undoubtedly descriptive of how supervision is organized in other countries. For example, banks mis-selling swaps happened in my country of residence too, see this link. So, please read on.

Bais and Sabée focus on the way Dutch banks sold mortgages to small and medium-sized firms (SMEs). In the early years of the century, banks required SMEs to borrow using a variable rate. They also required them to enter into agreements to swap the variable rate for a fixed rate.

The swap agreements were sold by banks under false pretences. Interest rates were low at the time, and banks created expectations that rates would rise. SMEs were told that the swaps protected them from rising interest payments. SMEs did not know that banks actually expected interest rates to drop. Which, according to Bais and Sabeé, constitutes mis-selling.

Banks also failed to inform SME borrowers that swaps trigger a margin call once the value of the swap becomes negative. Instead, the Dutch banks serviced the margin call themselves. The reason: had banks informed their clients about the margin call requirement (which was legally required) then no sane person would enter into the swap agreement.

Both authors explain that banks misrepresented the swap arrangements to limit their own interest rate exposure. The swaps transferred interest rate risk to SMEs. Problems arose when interest rates dropped. Realizing that they had insufficient collateral to service their own margin accounts, banks forced SMEs to service the margin account. Obviously that did not heal well.

Bais, a lawyer, discovered that all big banks in the Netherlands engaged in these mis-selling practices.

A wicked business model

Why did banks bend over backwards to mis-sell swaps? To understand this, one should realize that there was a particular group of firms that benefited from the swap arrangements: institutional investors, such as pension funds and life insurance companies. With the banks, they shared their view on the future trajectory of interest rates: these were expected to drop. The problem with low interest rates is that the value of liabilities would increase and income would drop. To solve the last problem, pension funds and life insurance companies arranged swaps that converted their variable interest income into fixed interest income.

In other words, the swaps would allow SMEs to pay, albeit indirectly, a fixed interest rate to pension funds.

The banks benefited from the swap arrangements because they transferred interest rate risk to SMEs and pension funds. They also benefitted from the swap fees. And lastly, the banks acted as counterparties for the swaps arrangements, thereby absorbing all benefits. See this link for an explainer of the swapmagic tricks played by banks.

The only issue was that the banks would have to service margin accounts for the SMEs themselves, which required a lot of high quality collateral. Here is where Article 80 of the EU Capital Requirements Directive (CRD) comes into play. It allowed banks to apply a risk weight of zero for intra-group exposures, that is, if conditions are met. This carve-out opened the door for banks to freely use the funds of insurance companies and pension funds as collateral, that is, if these were part of the same group of financial firms.

Initially, the Netherlands did not implement the CRD carve out, but did so in 2008. Bank-insurance groups benefited greatly from the carve-out, including ING, SNS, and Rabobank. In these groups, the bank subsidiaries now had legitimate and low-cost access to collateral, allowing them to continue offloading interest rate risk onto SMEs.

Over time, regulators and accounting standard setters lost their tolerance for the netting of intra-group exposures. In response to post-CFC regulations (Basel 3, CRD IV), bank-insurance companies were forced to demerge, causing banks to undo their netting positions. This was a painful process, because banks could no longer rely on the collateral of insurance companies.


The Worst Bank Scenario is a fascinating book. Authors have taken the extra mile to demonstrate a corrupt part of the Dutch financial fabric. Since I was a bank supervision policymaker during the time the book is set, I recognize a lot of the details. But, the desperation of banks for collateral and the extraordinary lengths they took to mitigate liquidity shortages are now much clearer to me (!)

Margin call

The book demonstrates the importance of liquidity and collateral for sustaining today’s bank business model. It relies on lending long and borrowing short, which creates an exposure to interest rate risk. Derivatives, like swaps, enable banks to manage that exposure, move it entirely off balance. But derivatives require high quality collateral to serve or support margin accounts.

The authors argue that, today, banks obtain their high quality collateral from the ECB, which, for example, since 2016 accepts corporate bonds to be purchased under its corporate sector purchase programme.

He who is without sin cast the first stone

The other takeaway from the book is the way key decision makers are appointed to important roles at banks, audit firms, law firms, advisors, and supervisors. There are just too many examples of inbreeding, nepotism, conflicts of interests, social engineering, etc. Rupert Murdoch’s acolytes would have a field day writing about this.

Ignorance is bliss

Then there is the incompetence: supervisor AFM systematically ignored Bais’ emails about the problems with swaps. And these problems were real. They affected SMEs, local governments, schools, and universities. The AFM even decided that margin requirements were irrelevant for SMEs, local governments, and other victims of swapmagic tricks played by banks. In this context, it is interesting to note that some weeks ago, in an environment of interest rate increases, the ESMA postponed the clearing obligation for pension funds with another year. (As an aside, for many years former AFM director Steven Maijoor chaired ESMA. Today, Steven is an executive board member of DNB. No surprise.)

Prudential supervisor DNB did not timely recognize the relevance of collateral. In the years after Lehman, the focus was on capital, eliminating double gearing. But hardly any attention was paid to liquidity and collateral. Until SNS collapsed, which made it clear that netting and collateral have important downsides.

That law change

One point that the authors seem to over-egg is the illegal law change that allowed banks to apply a risk weight of zero to intra group exposures, announced in the State Herald of 2008. According to the authors, this law change was not subjected to parliamentary scrutiny. But it should be noted that banks nevertheless applied that carve-out for some time, under the watchful eyes of the supervisor. The change in the law would legalise the use of the carve-out and level the playing field, since other countries had done the same with Article 80 CRD. So, yes, this law change did not pass the smell test. But if enforcement of financial regulation was weak (or even non-existent at times) then what does it matter in practice?

Another point that authors make was that the same State Herald of 2008 changed the definition of capital to help banks. I am not so sure. The State Herald announced a small, but significant change to Article 89 of the Decree on prudential rules under the Law of Prudential Supervision. This change improved the loss absorbing capacity of regulatory capital. The rule change harmed the solvency ratios of banks. Which was a win for prudential supervision: it disallowed group subsidiaries from using bank capital instruments, such as shares in other banks within the same group, as collateral. Uh oh.

So, on the one hand the Dutch government allowed banks to assign a zero risk weight to intra-group holdings (Article 80 CRD and Article 61.7 of Decree on prudential rules under the Law of Prudential Supervision), but on the other hand it banned banks for using intra-group share holdings as collateral, Article 89. The end result is probably the same: banks applied the carve out even though it was formally illegal (which could cost a bank its banking licence). Then banks continued to use intra-group capital as collateral and did not inform the supervisor.

The authors place a lot of emphasis on the “illegal” law change announced in the State Herald of 2008, in order to feed the narrative that regulators, supervisors, banks, were all in cahoots. But it is not unlikely that

  • The regulators did not fully appreciate the potential harmful effects of levelling the playing field by way of introducing the carve-out of Article 80 of the CRD.
  • Supervisors did not realize that banks did not inform them correctly about the use of capital as collateral. In the end, it was a seemingly innocuous change that could easily be overlooked by any supervisor. It was 2008-2009 and I worked on the definition of capital at the supervisor. That definition was going to change anyway, and the change of Article 89 was something pre-Lehman. I don’t remember it being discussed. It is documented that at least one bank did not inform lied to the supervisor about the use of capital instruments as collateral: SNS, see here and here.

It should be noted that DNB, the Dutch supervisor, was aware of the complexities of large financial groups. It seconded staff to the EC in Brussels. In an attempt to manage the capital of bank-insurance groups, they would contribute to the directive on financial conglomerates. Then yours truly contributed to a delegated regulation that calculates the regulatory capital of bank-insurance groups. But these efforts were all very much focused on capital instead of on liquidity and collateral (partly my fault, perhaps).

Conclusion: Plus ça change

Apart from this different interpretation of the significance of the law change, the book offers a dim view on Dutch prudential supervision. The authors document conflicts of interest, nepotism, etc, etc. Just staggering. But Worst Bank Scenario is also kind of fun to read because of the gossipy stories. For me, it was a trip down memory lane as well as an eye-opener that showed how well-organized the Dutch banking sector is and how poorly resourced the Dutch supervisors DNB and AFM. That in itself should spark a discussion on trust in the financial sector. We are now about 15 years from the onset of the Global Financial crisis. It is depressing and sad to notice how much has remained the same.