The Bankwatch

There is the usual talk that increased bank capital requirements will curtail bank lending.  I have been a fan of David Cameron, but he is wrong here.  His inexperience is showing through.   This from E&Y (pdf) who are as guilty.

The combination of regulatory change, lower leverage and an uncertain economic outlook means that banks  may struggle to lift return-on-equity toward their 12-15% targets. We forecast total assets of the UK banking sector to expand at a significantly reduced rate of just 3%pa during 2011-15. Given these considerable headwinds, there remains a risk that credit shortages could restrict the pace of economic recovery over the forecast horizon.

This analysis is one sided.  It fails to consider what would occur if the capital requirements are maintained at todays lower levels.  Would we not get what we already have? Current levels of banks lending which are considered low, and continuing trillions of corporate cash sitting on the sidelines due to lack of confidence and clear signs of consumers returning to purchase. 

It seems to me this is exactly the time to force the banks back into shape while banks remain relatively servile and before they hit the inevitable balance sheet pressures from sovereign default and other pressures sooner or later.  There is no easy and soft landing from The Great Unwinding.

When we dig into the E&Y report, this comment is important. (emphasis mine)

This estimate may also be overstating the effect as large businesses have access to alternative sources of funds from debt and equity issuance in the capital markets, as well as being able to borrow from foreign banks. We can therefore conclude from this analysis that the impact of ringfencing on the wider UK economy isn’t likely to be vast.

So the result of ringfencing, the separation and independent capitalisation of retail banking from investment banking is basically almost zero to retail banking.  The impact is on investment banking, and that is why banks are so up in arms.  They are losing the cheapest cost of funds available. 

Time for the Camerons and other politicians to see clearly here.  I know banks … I do not know investment banking so much, but I know enough to know this is true.  Back to basics banking.

John Kay is a smart author and columnist focussed on economics.  This piece is smart and incisive.  I particularly liked this quote and the reference to some of the financial products that contributed to the 2008 collapse [emphasis mine]

Economics fails to resolve exceptions to the rule | ft.com

The behaviour of great industrialists such as Henry Ford or Steve Jobs, or great investors such as Warren Buffett and George Soros, cannot be predicted by general rules. If such prediction were possible, their actions would have been anticipated and these individuals would not have been innovative or become rich. And similar unpredictability applies to the actions of great fools, such as those who believed that securitisation conjured immense wealth out of thin air. Like ingenuity, stupidity endures but constantly finds new ways to express itself.

Bank of America is now in the category “beleaguered“.

Bank of America has reshuffled its top ranks, ousting Sallie Krawcheck from its wealth management division in an effort to streamline the beleaguered financial group.

Probably prescient choice of words.

Deutsche Bank’s chief executive has said he may have to consider cutting costs in a stark warning

Banks also needed to ask themselves more questions about the usefulness of many of their services for the real economy.

A remarkable statistic from a small bank in Nebraska. 

Banking in a Time of Over-Regulation | WSJ

Consider a conversation I had recently with a banker in Nebraska. For the first time, he said, his bank now devotes more work hours to compliance than to lending. Specifically, he has 1.2 employees on compliance for every one employee focused on lending and bringing in business.

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.