The Bankwatch

Gillian Tett voices her concerns here, based on background discussions with bankers. We are not out of the woods yet, despite the equity markets.

Rally fuelled by cheap money brings a sense of foreboding | FT

Yet, if you talk at length to traders – or senior bankers – it seems that few truly believe that fundamentals alone explain this pattern. Instead, the real trigger is the amount of money that central bankers have poured into the system that is frantically seeking a home, because most banks simply do not want to use that cash to make loans. Hence, the fact that the prices of almost all risk assets are rallying – even as non-risky assets such as Treasuries bounce too.
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In the meantime, it is crystal clear that the longer that money remains ultra cheap, the more traders will have an incentive to gamble (particularly if they privately suspect that today’s boom will be short-lived and want to score big over the next year). Somehow all this feels horribly familiar; I just hope that my sense of foreboding turns out to be wrong.

Martin Wolf makes a persuasive argument that regulatory division between financial utilities and risk takers (casinos in his words) is impossible.

Why curbing finance is hard to do | FT Martin Wolf

First, the border between utility and casino banking is impossible to draw. For Mr Kay, the utility is the payment system and protection of deposits. This would leave all lending – including to households and businesses – inside the casino. For those in the US who hark back to the Glass-Steagall Act, the distinction is between commercial and riskier investment banking.

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Mr Kay’s distinction is clear, but problematic. If we followed him, all risk management would become unregulated. It is inconceivable that governments would, or could, leave them so. If we moved back to a Glass-Steagall distinction (itself never accepted in continental Europe), we would need to draw a line. But where? Why would lending to households and business be good, but securitising those loans bad? Why would hedging be good, but speculating bad and how might one draw the line between them?

I disagree. It is hard but not impossible. From inside a bank it is abundantly clear where the distinction lies, so there has to be a way to draw up the rules. Personal mortgages funded dollar for dollar directly against retail deposits for example with no securitization vehicle in between would be a good place to begin. The inevitable argument would be that without access to alternative securitization activities that consumer credit would be more expensive. Well recent experience would suggest stability over extreme discounts would be a good thing. There could be two types of mortgage offerred by utility and by risk banks. This would be a fascinating comparison.

At the other end of the division Mr Wolf draws we have clear investment banking activities funding large corporates with obscure investment vehicles.

The difficulty would lie in the middle range of products as to whether they are utility or casino. The rule would be best served to keep them in the casino until they can be shown as deserving to be in utility. No amount of debate will solve this – it would require draconian regulation driven by speaking to regular bankers, not investment bankers.

Finally the drive from consumers towards utility or riskier banking products would be the ultimate measure. Bearing in mind that the offerors of the risky products would have no government backing, this would be reflected in the price and the nature of collateral they would require. The final piece of this puzzle is the extent to which the utility offering banks have deposit insurance, and government assistance. They should in my view have deposit insurance to a limited dollar value, but should not be government owned.

It is a journey worth beginning, and should not be written off lightly as this Wolf piece does – the future stability of consumer economy depends on it.

In the regular Monetary Policy Report the Bank of Canada keeps their focus on a low interest rate environment right through 2010.

On inflation the view is mixed …

The main upside risks to inflation relate to the possibility of a stronger-than anticipated recovery in the global economy. A stronger global recovery would be transmitted to Canada via trade, financial, confidence, and commodity price channels. There is also the risk that Canadian domestic demand could be more robust and have a more sustained momentum than projected.

On the downside, a stronger-than-assumed Canadian dollar, driven by global portfolio movements out of U.S.-dollar assets, could act as a significant further drag on growth and put additional downward pressure on inflation. Another important downside risk is that the global recovery could be even more protracted than projected if self-sustaining growth in private demand, which will be required for a solid recovery, takes longer than expected to materialize.

Worldwide consumer demand rejuvenation is not assumed in the near term …

Vigorous and coordinated fiscal and monetary policy stimulus in the G-20 economies, including a wide range of measures to support the fl ow of credit, have been sustaining aggregate demand, but evidence of self-sustaining private demand remains modest. Necessary adjustments on both the real and financial sides of the global economy are under way, and will involve a significant and protracted rotation of global demand, as well as deleveraging by U.S. and European banks, households, and firms.

Canadian consumer confidence is very real estate focussed due to affordability.

On capacity …

After reviewing all the indicators of capacity pressures and taking into account the weakness in potential output associated with the ongoing restructuring in the Canadian economy, the Bank judges that the economy was operating about 3 1/2 per cent below its production capacity in the third quarter of 2009, in line with the July projection.

This chart is worrisome though, begins to sow seeds of doubt. Consumer credit is growing but business credit is lagging. Consumers are increasing mortgage debt but not purchasing ‘things’ – (sound familiar – 2007?)

On money supply enormous growth, but suggestions the money is being parked – i.e. low velocity of money suggesting low prospect of near term inflation.

The monetary aggregates have continued to grow strongly. In the three months to August, the narrow aggregate M1+ grew at an annual rate of 18.2 per cent, while M2++ grew by 7.0 per cent. It is diffi cult to assess the implications of monetary expansion for economic activity, since the demand for money is likely to be abnormally high in an environment of very low interest rates and tight credit conditions. The continued robust growth in narrow money reflects the desire of both households and firms to keep money in liquid assets until it is clear that the economic recovery is taking hold. Consistent with our base-case projection, the growth in money balances is expected to gradually decline over time.

On GDP – this is a very clear depiction that consumer spending has been replaced by government spending, and that won’t change consequently until 2011. The other factor also noted here is that currency shifts and changes in imports/ exports will be the real next thing that determines each country’s economy

On consumer confidence 2 …

In the wake of a short, severe recession, and with residual economic uncertainty, the personal savings rate remains elevated over the projection horizon.

Monetary Policy Report Oct 2009 mpr221009.pdf

I thought this a particularly succinct view of the next 10 years view prospects for banks and their business planning.

The view from New York | Buttonwood/ Economist

The bearish view came from Josh Rosner of Graham-Fisher. Mr Rosner was one of the first analysts to spot the potential havoc caused by the interaction between subprime mortgages and structured products like CDOs. He thinks the economy will not rebound as it did in the 1980s. Demographic trends are not as favourable (the baby boomers were entering their prime earning period in the 1980s; now they are retiring); while credit card use was about to explode (now it is contracting). He argues that small businesses, a key source of job creation are still being denied credit; one problem is that small businessmen can no longer afford to use their houses as collateral.

It is with some relish I see Mervyn King agreeing with me from last February.

King calls for break-up of banks | FT – Oct 2009

Mervyn King, governor of the Bank of England, called on Tuesday night for banks to be split into separate utility companies and risky ventures, saying it was “a delusion” to think tougher regulation would prevent future financial crises.

The Great Unwinding | part 1 of 3: 2009 – 2012 | The Bankwatch – Feb 2009

This will effectively split the financial community into two distinct sets:

1. financial utilities – significant operating restrictions in light of implicit and explicit government guarantees underpinning the business
2. risk takers – not clearly defined as yet – will be dependent on regulation applicability

I expect my commission cheque is in the mail.

Full Text of King speech at in Edinburgh on 20 October 2009: speech406 pdf

Edit:  King provides attribution to John Kay here written Sept 09.

In this piece at the NY Times, Krugman points out the obvious that despite profits, Banks’ retail operations have not recovered. The large profits we are hearing about are all centred in the Investment Banking units.

I would add that it will take more than a turnaround in consumer confidence and reduction in unemployment. It will also take time to work through the de-leveraging impacts of consumer desire to reduce debts and save more for future crises while this one is firmly in peoples minds. For everyone who is still working they know of someone who is not, and that memory takes time to erase.

The Banks Are Not Alright

But there’s an even bigger problem: while the wheeler-dealer side of the financial industry, a k a trading operations, is highly profitable again, the part of banking that really matters — lending, which fuels investment and job creation — is not. Key banks remain financially weak, and their weakness is hurting the economy as a whole.

In the banking business I think we all understand the point and motivational benefit of bonuses, however this story from a Bank that is almost a Government Department (70% government owned) takes insanity to a new level, if you are a taxpayer.

The sheer size of the bonus pool of £4 billion is astounding. That represents just under 10% of the banks equity!

I mention the government ownership because while we are used to investment bankers paying out such bonuses, one would have thought that their government overseers would have insisted on that £4 billion being used to boost capital, or repay Government assistance.

Nice work if you can get it.

Royal Bank of Scotland to give huge bonuses The Times

The average employee in its high-risk investment banking arm is likely to take home £240,000, with the top 20 staff in line for payments of between £1m and £5m.

Relevance to Bankwatch:
On a slightly more serious note, when I predicted the arrival of financial utilities in financial services, I did not expect such a hands off approach from government. Surely it will be a matter of time only.

Michael Geist provides a gallant service following and analyzing the legal developments in the Canadian Parliament relative to internet, privacy, DRM. His current focus is the ECPA that is having its Commons review completed Monday.

Electronic Commerce Protection Act (C-27) (Posts on Michael Geist site re this topic)

The ECPA is basically intended to be an anti-spam bill. This should include opt-in only relative to advertising. It has become mired in the minutiae of cookies, tracking, email address collection and such things. The opposition Liberals appear to be taking the opportunity to side with the lobbyists from the advertising world to create exclusions.

I have little faith in such legislation. The future will be in self protection, and online tools that assist. The comments in the latest post on copyright lobbyists are well worth the read.

US deficit is now in Botswana and Russia territory in terms of record levels relative to GDP. The argument that this is not inflationary sounds to me like pushing water uphill.

$1.4 Trillion Deficit Complicates Stimulus Plans

WASHINGTON — The Obama administration said Friday that the federal budget deficit for the fiscal year that just ended was $1.4 trillion, nearly a trillion dollars greater than the year before and the largest shortfall relative to the size of the economy since 1945.

http://www.nytimes.com/2009/10/17/us/17deficit.html?_r=1&th&emc=th

Over at Econbrowser Menzie highlights this new paper from two Profs, and someone from the NY Fed (no title). It closes the loop for me on something thats been bothering me about economists and the financial crisis. The debate about the cause of the crisis vacillates between Greenspan and loose credit, versus, global imbalances and Chinese who save too much. Neither of these resonate much, appear as reactions to a situation, and are therefore more symptomatic than causal.

From the abstract to Why are we in a recession? The Financial Crisis is the Symptom not the Disease!, by Ravi Jagannathan, Mudit Kapoor, and Ernst Schaumburg:

This paper lays the cause of the crisis on the increased labour supply in developing countries. Now this sounds more like a root cause. Things are no longer manufactured in Pittsburgh, but now China. That labour supply in China is net new to the world. There could be a debate about whether that represents an increase in labour supply, or transfer of labour supply.

In what follows we argue that this huge and rapid increase in developed world’s labor supply, triggered by geo-political events and technological innovations, is the major underlying force that is affecting world events today.2 The inability of existing financial and legal institutions in the US and abroad to cope with the events set off by this force is the reason for the current great recession: The inability of emerging economies to absorb savings through domestic investment and consumption caused by inadequate national financial markets and difficulties in enforcing financial contracts through the legal system; the currency controls motivated by immediate national objectives; the inability of the US economy to adjust to the perverse incentives caused by huge moneys inflow leading to a break down of checks and balances at various financial institutions, set the stage for the great recession. The financial crisis was the first symptom.

In my simplistic interpretation of that, globalised labour supply got ahead of globalised finance. Yes there are international financial markets and products, but to what extent do they factor in the new value transfer from developed to developing countries.

Relevance to Bankwatch:
In any event, I will leave the economic analysis to experts. What matters is the extent that the labour supply shifts are indeed the root cause, because that cause remains in place, and is unresolved. It will not be solved by new bank regulation. Nor can we expect banks to solve it. The instability which results will continue, and that is the reality Banks must operate within.
why are we in a recession labour markets jagannathan090309 (3).pdf

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follow up – root cause of crisis – capital reserves, capital flows:

The end of financial globalization 3.0?

What followed was financial globalization 3.0. Emerging markets heeded Martin Feldstein’s advice and took out an insurance policy against the vagaries of financial globalization.[2] By running current account surpluses, intervening in foreign exchange markets and building up currency reserves Asian and other emerging economies were sustaining export led growth and buying insurance against future financial instability. These policies turned developing markets into net capital exporters to the developed world, mainly to the US. Between 1990 and 1998 – during what I have termed financial globalization 2.0 – emerging and developing economies (according to the IMF classification) were running an average current account deficit of about 1.7% of their GDP. Between 1999 and 2008 – during financial globalization 3.0 – this deficit turned into a surplus of 2.5% of GDP.[3]Just like its predecessor, financial globalization 3.0 seemed a success story for a while, generating financial stability and high rates of economic growth. Yet the accumulation of large war chests of foreign reserves through currency intervention carried negative externalities. The arrangement opened up a Pandora’s box of financial distortions that eventually came to haunt the global economy. The glut of savings from emerging markets has been a key factor in the decline in US and global real-long term interest rates – despite the parallel decline in US savings.[4] Lower interest rates in turn have enabled American households to increase consumption levels and worsened the imbalance between savings and investment. And because foreign savings were predominantly channeled through government (or central bank) hands into safe assets such as treasuries, private investors turned elsewhere to look for higher yields. This led to a more general re-pricing of financial risks and unleashed the ingenuity of financial engineers to develop new financial products for the low interest rate world – such as securitized debt instruments.[5]