The Bankwatch

With one speech Lagarde, the new head of the IMF makes it clear that she believes the state of economies and banks is running severe risks that are not being accepted by politicians both in Europe and US.  This follows the similar but softer theme from Bernanke.

Lagarde calls for urgent action on banks

European banks need “urgent recapitalisation” to stop the spread of the eurozone’s sovereign and financial crisis; the US must act to stop a downward spiral in house prices; and both need credible long-term fiscal policies that allow spending to continue to support growth in the short term.

update:

Trichet of the ECB takes a different and thoughtful approach at his Jackson Hole Speech.

Jackson Hole Speeches – links to Fed, IMF and ECB respectively:

Bernanke

Lagarde

Trichet

Much has been written on the Global Financial Crisis (GFC) and the focus has leant heavily on re-regulation, and higher bank capital.  However there remains a nagging sense that nothing really has changed and that it could happen again.

This piece from Wray at Levy is a refreshing look at some practical aspects of the GFC that resonate more clearly as potential foundational causes and that remain in place, and are not dealt with by regulation, at least not directly.

The first is financial leverage amongst banks.

Lessons we should have learned from the Global Financial Crisis : Wray – Levy

We can think of this as financial layering: financial institutions borrowing from each other to lend. This led to complex linkages, such that failure of one financial institution (Bear or Lehman) would topple all the others that held its liabilities. This explanation clearly highlights one of the greatest indicators of financial fragility, and I think it is the closest to Minsky’s explanation, and much closer to getting it right.

Why did the markets inexplicably freeze on the week of September 14th, 2008?  This tight reliance between each other because of interbank lending at record levels could be one legitimate reason for interbank trust literally falling off a cliff.  The graph shows growth in financial sector lending from negligible in the 60’s to 25% higher than consumer debt in 2008.

Another parallel explanation lies in the Shadow Banking system which is generally comprised of large funds able to compete with banks because of their size.  (emphasis mine)

pension funds, sovereign wealth funds, mutual funds, and insurance funds. Pension funds alone grew to about three-quarters the size of GDP.   Managed money was largely unregulated and was able to compete with the regulated banks.

The broader point lies in the inherent volatility that comes from such large numbers relative to the regular commercial economy.  The commercial economy is somewhat predictable unlike the shadow banking system.

By tapping managed money, they helped to bubble up stocks, then real estate, and finally commodities markets. To compete, banks created off-balance sheet entities (such as special purpose vehicles) that took huge risks without supervision. Those risks came back to banks when the crisis hit. It is difficult to imagine how we could have had the GFC without the rise of money managers and the shadow banks.

Wray goes on to make a few points on what he believes was the true cause of the GFC and with some colourful language leaves the cause firmly on the doorstep of the banks both then and still today as an mitigated risk.

1. The GFC was not a “Liquidity Crisis”

In my view, that is a gross misstatement. What actually happened is that default rates on risky mortgage loans rose sharply while home prices plateaued. Megabanks took a look at their balance sheets and realized they were not only holding trashy mortgage products, but also lots of liabilities of other mega financial institutions. It suddenly dawned on them that all the others probably had balance sheets as bad as theirs, so they refused to roll-over those short-term liabilities. And since the Leviathans were highly interconnected, when they stopped lending to one another the whole Ponzi pyramid scheme collapsed.

2. We Should Have Learned That Underwriting Matters.

All the big institutions involved in home finance reduced or eliminated underwriting over the past decade. The “efficient markets” hypothesis said you really do not need underwriting because markets will discover the proper prices for securitized loans; and lending was so much easier and cheaper to do if you did not bother to check the financial capacity of the borrower.

3. Unregulated and Unsupervised Financial Institutions Naturally Evolve into Control
Frauds.

But policy makers still do not want to recognize that there is fraud everywhere. We know that the banks committed lender fraud on an unprecedented scale (the best estimate is that 80% of all mortgage fraud was committed by lenders); we know they continue to commit foreclosure fraud (and that their creation, MERS—Mortgage Electronic Registry System—has irretrievably damaged the nation’s property records; this will take a decade to sort out); and we know they duped investors into buying toxic waste securities (using bait and switch—substituting the worst mortgages into the pools) and then bet against them using credit default swaps. Every time an investigator finally musters the courage to go after one of these banks, fraud is uncovered and a settlement is recovered.

Relevance to Bankwatch:

There is an uneasy feeling about banks and their stability, particularly US and Euro banks.  The $5Bn investment by Buffet into BofA was an extraordinary example of this.

I am watching “’Inside Job’ tonight.  Its a documentary on the financial crisis narrated by Matt Damon.  The thing that is fascinating me is the dates.  Many of the senior people interviewed including bankers and government are noting 2009 as the time they saw a problem.

I searched my own blog, and the first indications of a problem were are least two years earlier.

All I do is read the press.  I am not involved directly in investment banking, but am directly involved in retail financial services.  Yet this blog had indications of the eventual problem as early as 2007, one and a half years before the September 2008 freeze.

This was a predictable crisis.

This has to be the most predictable problem that ever could have arisen.  When the lenders were happily throwing money at New Century, the markets have been mixing obligations within Collateralised Debt Obligations which go into the derivatives market.  The collaterised nature, and higher rates would have been attractive in those markets.  Now that the alarm is raised as a results of default on payments (not on the principal, yet, just the monthly payments), the derivatives market stands to drop next.

Relevance to Bankwatch:

This is not a problem that will be solved with regulation.   There is a peculiar numbness that takes over understanding of crises that must be better understood.  The financial media have a responsibility here.  I can write away with my little blog and a few people see it.  Yet where were the media in 2007 ?

A real engineer builds bridges.  A financial engineer builds dreams.  [quote from the documentary]

The piece quotes Rajan, <speech rajan2005> who in 2005 at the Jackson Hole Fed conference famously predicted the 2008 banking crisis from sub prime and derivatives.

There is a lot of downsizing going in with banks.  My speculation is that this will broaden into a more sweeping breakup of universal banks.  As a prelude, I will start a scorecard of employee shifts amongst the large banks.  Here is the first installment.

These words from Merkel in reference to the markets forcing the politicians to in effect shore up the markets is exactly the kind of unintended consequence that I expected to happen when I wrote the Great Unwinding posts.

Merkel defies pressure on debt crisis | ft.com

“Politics cannot and will not simply follow the markets,” Germany’s chancellor said, repeating her refusal to countenance funding indebted nations with a bond guaranteed by all members of the single currency bloc.

“The markets want to force us into doing certain things, and that we won’t do,” Ms Merkel said, shrugging off last week’s gyrations in equity and bond markets.

And no its not a question of being far-sighted. It is simple mathematics and accounting and it is all about the banks of the world who have most to lose when it comes to sovereign risk as significant bond holders especially in Europe. 

The core issue is de-leveraging by consumers in weak economies.  They have too much debt, and worse their job prospects in the developed countries are not strong. 

With that backdrop, Banks are beginning the process that will see them fork into one of two models in my view:

banks and financial services will be offerred through two broad service models:

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

It is a well known fact that corporations worldwide are sitting on trillions of spare cash ready to invest it.  This is not the case with banks who are cutting workforces in unprecedented numbers.  Those cuts are not even the beginning.  Banks are too big and spread out across diverse and unreliably profitable ventures.  They made it through the 2007/8 financial markets freeze but now realise that their paternal support from their home governments in the future is in jeopardy. 

Banks with large investments in people and developed countries can see the future growth prospects are moderate at best and the wildly successful profits of the early 2000’s are not on the horizon.

The smart ones will seek to optimise customer and product acquisition using modern technology not building more old style branches.  Bank of America which came through the crisis the worse for wear is insisting it will not go to the market for additional capital, but rather is focussed on Project New BAC.  I will be surprised if that project is not something significant and some new thinking along these lines I proposed here.

Relevance to Bankwatch:

We are likely seeing that shift to ‘Back to Basics’ banking.  This infers a close look at all the patchwork of business models that universal global banks have taken on and reassessing their value particularly in view of the capital allocated to those models. 

This capital allocation assessment takes on unprecedented importance when the attraction of high value growth in the developing countries is held up as an alternative.

The Globe notes a recent post at Zero Hedge that blows open a little known fact of Canadian bank accounting.

Canada’s banks: Next dominos to fall? | Globe and Mail

Now wait, say those of you who have been paying attention to Canadian bank disclosure. Canadian banks routinely disclose TCE ratios north of 10 per cent. Well, yes, but it’s a case of apples and oranges. The banks talk about tangible common equity to risk weighted assets, while Mr. Durden (am I the only one who feels strange calling him that?) is looking at TCE to total assets. Risk weighted assets adjust for the chance that the assets will go bad, and that’s hardly a science. Total assets doesn’t allow for such judgement calls.

On that basis, Canadian banks are just as leveraged as European banks, and far more so than American banks. Is the legend of Canadian bank invincibility starting to shake for you just yet?

I like to think I understand Balance Sheets quite well, but modern accounting trickery makes it hard for the average person to pick out those simple things that used to be so important – Total Assets and Total Capital (as in Total Assets, minus current and long term liabilities), and the banks reference to “Risk Weighted Assets” is just one of those accounting sleights of hand.

Well the jig is up.  As reported here many times when writing about bank leverage (Total Liabilities/ Capital) or here specifically to Canada in March 2010, the Canadian banks are as much or more vulnerable to balance sheet risk.

A useless piece of trivia from the markets.

Apple is worth as much as all EU banks | Financial Post

Technology company Apple is now worth as much as the 32 biggest euro zone banks.

That’s the stark result from a steep fall in the share price of banks including Spain’s Santander, France’s BNP Paribas, Germany’s Deutsche Bank and Italy’s Unicredit, compared to a steady rise in Apple’s valuation, according to Thomson Reuters data.

Step by step this cynical blogger is becoming a convert.  Raising $10M is a big deal.  It seems the model is to provide a quality front end with a bank and FDIC guarantees behind.

I remember back in the 90’s when internet was new and one of the models we conjectured was banks becoming ‘manufacturers’ sitting the in the background offerring banking services wholesale.  Part of that model requires Banks to buy in.

BankSimple have absorbed that model it seems and found willing providers.  key will be the financial arrangement between the players.  It is easy to take on the costs for the front end (BankSimple) but the bank must accept a fee structure that accepts they are relatively dormant in the back end.

More power to BankSimple and lets see where this goes.

The latest round of financing was led by current investor IA Ventures and joined by existing investors and Shasta Ventures. It follows an initial round of $3.1 million raised in September last year.

In a blog post, BankSimple founder Joshua Reich, says: “This financing allows us to shift gears from building BankSimple to launching BankSimple. Our business has many moving parts and this capital allows us to scale our engineering, operations, and customer service organisations in preparation for launch.”

This is a must read for anyone interested in banks and banking.

The coming world of smaller banks | Frank Partnoy – ft.com

How many people does it take to operate a modern bank and how much should such a bank’s shares be worth?

With that simple question Frank kicks of the article by reciting the seemingly dramatic reductions in banking staff.  Yet he points out the markets reacted by driving down stock prices of banks.  Then comes the killer point (emphasis mine)

Bank analysts cite several reasons for share price declines, including litigation exposure, declining investor and consumer confidence and a faltering economy. But one overarching factor, which also explains the increase in lay-offs, is the declining importance of banks.

Banks are supposed to play only a limited function in the economy. Historically they just match lenders and borrowers. Most banking activity – lending, underwriting, mergers, sales, trading and wealth management – revolves around the allocation of capital. But over time, banks have expanded into riskier and more complex activities, including structured finance, derivatives trading and regulatory arbitrage, which can allocate capital in distorted ways. But even distorted capital allocation is still capital allocation; for better and worse, that is essentially what banks do.

He goes on to compare technology companies such as Google, and Apple, and even refers to hedge funds all of whom attack problems strategically and not by throwing people at the problem.

He concludes by noting that whereas companies are broadly in business for the benefit of shareholders, banks have lost that and are in business for the benefit of employees.  Ouch. 

… although banks are supposed to be exemplars of capitalism, during the previous two decades, bank employees have consistently won the labour-capital battle. As banks expanded, employees extracted most of the gains, like professional athletes demanding their teams’ profits and leaving owners with paltry returns, or even losses.

The year 2008 was a tipping point for banks, exemplified by the sight of those bank leaders paraded before Barney Frank and Congress like errant schoolboys.  There has not been a better time for banks to get radical and break out of the current mould which results in all banks looking identical. 

Potential examples:

Thought experiment:  As a top tier full service bank, do we need …

• a brokerage – typically the least loyal of banking groups, there is less correlation between banking customers and brokerage than one might expect
• a derivative trading desk – if you need to hedge then purchase from someone else.  Why carry the employee overhead and counterparty risk?
• technology system developers & project management – yes … eliminate all system development, and project management.  Retain only the staff that are needed to maintain the current systems (perhaps 25% of current technology team).  Concurrently hire some new developers all under age 30 and many under 25.  Begin with a small team and work out from there.  They will build new systems using modern languages because that is what they know.  They will be able to connect to the old systems but will treat them as the black boxes they are and  graduate functionality and smart decisioning algorithms to the new front end.  Remember you cannot get there (modern internet platforms) from here (legacy and disparate systems).  Time to cut the cord.
• branches – the largest use of employees.  Time to get serious about banking online and move certain functions online.  Why open any bank accounts in branches.  It is a 1 hour exercise and one of the most labour intensive activities.  There are ways to manage AML activities online and automate those functions.
• loans officers – eliminate loans in branches and route to credit card division?  Automate personal lending and manage online only?
• ABM machines – enormously expensive and labour intensive to run.  Could be outsourced.
• flagship head office branches – today you can fire a missile through most and be unlikely to hit anyone except the bored staff.

Relevance to Bankwatch:

The message here is that incremental reductions of 10% here and 15% there are patchwork solutions designed to reduce expense run rate, and assume the remaining staff will pick up any slack.  Once you get over the pride hurdle of managing a full service bank that must have all the same departments that the competition does, frees up thinking to dramatically reduce run rates and shift towards a leaner more agile institution. 

Coupled with that must be a resolve to shift to modern adaptable technology platforms. I am aware of one bank that is thankfully rolling out a new upgrade to its commercial banking online platform this month (buzzwords removed to protect the innocent).  The big news is that this is a shift from a DOS based platform to windows .. wow! 

Banks for too long have been locked into large platform providers that have had a business model of aggregating providers over the last 15 years rather than providing simple break out web based systems that just work … online.  Give me a few Ruby developers over a monolithic bank technology division any day.

About time is all I can say about this.  The country that sticks to miles and mag stripes truly needs to get with the programme and I hope Visa are serious about forcing this through.  MasterCard should be all over this too.

Visa cites m-payments as it pushes US to EMV | Finextra

Now card giant Visa has set out its programme to drive the adoption of dual-interface chip technology to "help prepare the US payment infrastructure for the arrival of NFC-based mobile payments" as well as improve security and international interoperability.