Tuesday, 28 September 2010

Not Quite Convinced or Satisfied by Soft Contrition

Financial Times

Sir, In `Casino jibes do our banks no justice` (September 24), Barclays` outgoing chief executive, John Varley, makes a soft act of contrition and a misrepresentation that core investment banking activities of universal banks consist primarily of positions backing products and services with embedded derivatives providing clients with risk management tools. He says nothing about proprietary trading, which brought many banks to the brink of failure, often at great taxpayers` risk and expense.

Barclays avoided such a rescue mostly due to two strokes of luck rather than internal prudence or risk management skills. The acquisition of ABN Amro sunk RBS and Fortis rather than Barclays, who would have been lumped with it save for the bigger fools in the room. The blind acquisition of Lehman, which was vetoed at the 11th hour by the British authorities, saved Barclays from self-destruction.

Barclays owes the British public more than a soft contrition. It owes a big thank you rather than hints of temptation to relocate if regulators take measures to address its `too big to fail` systemic risk.

Sunday, 19 September 2010

Neglecting What Saved Us

The Malta Independent on Sunday 19.09.2010

Neglecting what saved us

Often we hear boasts from different quarters claiming credit for the fact that our banking sector has remained rock solid even during a financial crisis that shook the best and the rest.   Credit is certainly due.

What is questionable is to whom.

Primarily it is due to our forefathers who have imbued into us a strong culture of thrift.   Thrift ensured that funds necessary for macro and micro investments were found internally without resorting to foreign borrowing in any meaningful manner.   Thrift empowered our domestic banks to fund all their loan books through retail deposit with liquidity to spare.   When the 2008 liquidity crunch hit, our banks were not at the mercy of wholesale lenders withdrawing credit lines simultaneously.

Northern Rock, Bear Stearns, Lehman Brothers, Royal Bank of Scotland, Citibank, Lloyds Bank, Fortis, Hypo Real Estate and many others remain horror stories we read about but thankfully distant
from local realities.

Credit is due to local bankers who stuck to what modern finance whizz kids would consider boring utility banking of taking deposits and converting them into loans to other sectors of the economy, basically the traditional intermediation role of banks between savers and investors.
Prudent banking policies ensured that loan books remained in relatively good performing condition.
Loans were never hived off from our banks’ balance sheet through securitisation.   The need for banks to know their customer who was to remain an asset on their balance for a very long time, ensured that the credit approval process remained robust and capable of withstanding economic downturns.

As success has many fathers, credit has been claimed also by the political class and the regulators.
Probably a measure of credit is due to this class as well but recent events seem to suggest that this credit is mostly due by accident rather than by design.   Otherwise our regulators would not be allowing the stark erosion of competitive advantages that have saved us in times of troubles.

It is strange but true that this is happening whilst financial regulators worldwide are carefully designing stricter regulations and tightening supervision over financial markets to avoid a relapse similar to the 2007 -2009 crisis.

This by no means implies that regulators are allowing or condoning breach of the written rule book.
Effective regulation, however, goes well beyond the rule book.  Effective regulation depends on the wink and the nod much more than it depends on the rule book. It is this wink and the nod which seems to be disappearing from our system of financial regulation.

Let me be as specific as prudence permits me to be.    Local banks that operate across the whole service universe are a great asset to the economy.     HSBC and Bank of Valletta dominate but smaller banks like APS and Lombard offer competition relative to their size.    Recently these were joined by a Banif, a Portuguese owned bank that added spice to the competition much to the benefit of consumers, be they savers or borrowers.

Some competition also comes from foreign owned banks operating mostly to book international business, but once here, they adopt a rather laid back approach to attracting local deposits and do some local lending.

The spectrum was until recently complete with a specialised bank like FimBank, a niche bank with internationally recognised competence for specialised trade finance that competes prudently for fund raising whilst adding value to the local economy through offering trade finance to both local enterprises as well foreign units owned by local entrepreneurs.

All these banks are credit licensed institutions authorised to participate in the privilege to raise deposits in this liquid economy and benefit from the Deposit Protection Insurance set up by the regulator.

 In essence this insurance is a contingent liability that exposes the taxpayer to substantial liability if such liability were to change from contingent to real ( as happened in UK with the failure of
Icelandic banks operating under the home deposit protection scheme which was clearly insufficient and the burden spilled over to the UK taxpayer).

The system has a cloak of fairness around it, a sort of unwritten social contract among the banks, the depositors and the taxpayers represented by the government and the regulator.   The taxpayer offers the depositors an explicitly limited and implicitly unlimited guarantee on their deposits and the banks in return intermediate such deposit by transforming them into maturity mismatched loans to permit the economy to grow through private sector investments in factories, hotels, real estate, homes and to a limited extent consumption borrowing.

This unwritten social contract was breached when a foreign owned bank, using a name, corporate colours and logo which attempt to draw brand power from the former Mid-Med Bank, was licensed
to compete aggressively in the deposit market purely and explicitly to operate as a long only highly leveraged hedge fund investing in high rated foreign fixed income securities.
A thorough analysis of their financials, which show a bare gearing of some 27 times gross assets to equity and consequent unweighted  capital ratio of less than 4% which magically converts to a comfortable 37% through regulatory risk weighting of the assets, shows this is clearly a hedge fund licensed to raise deposits which are used to fund margin for borrowing huge sums on wholesale inter-bank  market to invest in high rated papers currently accepted for repo by the European Central Bank (ECB).

The promoters of the new bank are clever to exploit a rare opportunity created by the artificial scenario caused by the ECB’s rescue effort to stabilise the banking system, where banks can borrow
short term at near zero rate from the ECB, and consequently on interbank markets on a secured basis, and invest same in high rated paper generating a margin of 3% (300 basis points) or more.

 Nothing wrong in banks doing this to restore their balance sheets after the knock they received in 2008/2009, and so be able to start functioning properly again in their crucial intermediation function.

However there is something gravely wrong in allowing private equity investors to dress their hedge fund with a Maltese credit institution licence and ride free on the Maltese taxpayers’ explicit and implicit guarantee to raise deposits which are immediately leaked out of our economy and used to provide margin calls for huge wholesale funding.
Such margins funding is normally done by hedge fund investors with their own money without any taxpayer protection.

Hopefully we will not have another banking crisis in my lifetime and this lowering of our regulatory standards, especially the unwritten wink and nod type, will not send any bill to our taxpayers.  Hopefully I will sound like a Cassandra.    But this does not mean that we should take the risks we are taking.  No way can anyone be satisfied that we are really out of the woods in the financial crisis.

Barclays promoting Bob Diamond to the CEO role says it plainly that the big banks just don’t get it and insist on running casino banking alongside taxpayer protected utility banking. This is like lighting a bonfire next to a fireworks factory.    Barclays received two great strokes of luck that saved it from casino bets that Bob Diamond wanted it to make. It was saved from disaster of overpaying for ABN AMRO just before the crisis hit in 2007, purely because there was a bigger fool who over paid even more. The bigger fool was a tandem formed by RBS and Fortis who both had to be saved at great taxpayers’ expense.

Barclays was saved a second time by the British Government by refusing to authorise its blind purchase of Lehman Brothers which would have wiped out Barclays through the acquisition of overpriced toxic assets.   As it happened following Lehman bankruptcy, Barclays acquired the pieces of Lehman it really needed basically for free and without any risk. It was not Bob Diamond’s skill that kept Barclays on the straight and narrow; it was pure lady luck.

Yet Diamond gets promoted to CEO, secures atrocious remuneration deals and bullies the UK regulator that if they pursue with plans to break up Barclays to separate casino banking from utility banking he will move the bank to a new jurisdiction.

Secondly we should not assume blindly that the ECB will be there forever. The sustainability of the Euro system is being increasingly questioned. Whilst the political will to save the Euro remains strong, ultimately if the price of saving it gets too big, no one should assume a blank cheque from anyone.

And if the ECB is not there to offer repo’s to banks that need instant liquidity would the burden fall on our own Central Bank, and if so would it have the appetite and the capacity to offer such repo’s?

  Are we oblivion to such hidden risks or are we truly willing to neglect what saved us?  

Sunday, 5 September 2010

Caught Between Extremes

The Malta Independent on Sunday  - 05 09 2010

 I just finished reading a Research Note issued by a major global bank on ‘The Future of the Euro’ and it is clear that as the Euro area gets ever more divided into two extremes, Malta is sitting right in the middle. It is not a bad place to be.
If all other Euro members were sitting in close proximity the monetary union would be a much happier and peaceful place.

Reality is much different.

Essentially the EU has become divided into three groups giving a de facto three speed EU.

Motoring along at awesome speed, practically as if the global crisis never happened, are Germany Austria. Netherlands and Scandinavia ( Denmark, Sweden and Finland) who along with Luxembourg and Switzerland are by all measures out of the recession, seeing unemployment falling, growth returning at pre-crisis rates or better, improving fiscal structures and strong balance of payments position.

At the other extreme you have Ireland, Portugal, Spain and UK who are undergoing strong fiscal consolidation to address chronic fiscal imbalances, at a time of high unemployment and economic contraction while dealing with a broken banking system severely damaged by the bursting of the property bubble.

Greece has not been included in the extreme group at the wrong end of the spectrum because even within this group Greece would be an outlier.

Greece’s problems are not so much caused by the global crisis but by a long period of economic mismanagement, undue rigidities suppressing the spirit of innovation and competitiveness, and fiscal evasion on massive scale in an engrained culture of public sector corruption and social benefits fraud.

In the middle close to the point of general equilibrium are a group of countries led by France and Italy comprising Belgium, Slovakia, Slovenia, Cyprus and Malta.

This middle group shows general equilibrium with respectable balance of payments position, slow but positive growth, a healthy banking system underpinned by strong domestic thrift culture, and a fiscal position which although outside the normal Maastricht criteria remains acceptable in the context of a global recession and is expected to continue improving through a combination of increased fiscal revenues from normal growth and mild austerity measures. Where do we go from here? 

Two reflections first.

For all self-criticism about our state of things when examined from the outside looking in, we are quite in shape.   Of course we should be much better given that we are nursing a substantial accumulation of national debt over the last quarter century which is not reflected in the state and quality of our infrastructure.

But as a nation, rather than as a government, we have been prudent and hardworking, we have avoided leverage exposure to foreign lenders and we have kept this a fairly good place to live or visit, with a quality of life superior to what pure financial per capita income would tend to suggest.

With careful and well planned investment, avoiding the sort of tragicomedies we are experiencing in the Delimara power station extension contract, we can make this a much better place and can render our economy more competitive and stable.

Secondly we are living in times of extremes.

Half of the economic cadre, the likes of Paul Krugman in the US and Martin Wolf in UK, argue that governments need to continue stimulating the economy to create demand as otherwise the contraction in consumption could lead the economies of US and UK into a dangerous depression which it would be very painful to recover from.

At the other extreme we have the Chicago economic school of thought who firmly believe in the self healing powers of the free market, arguing that the last stimulus was a perfect waste of money and that further stimulus would be more so as the market needs to be given time to self correct and governments should as much as possible get out of the way by reducing taxes, rather than take a more central role in managing demand.

For those mindful of economic history it is the Keynesian school in a tussle with Ricardian School, but this time in extreme doses.

Experience shows that reality is somewhere in the middle.

I believe that the crisis of 2008 was so sudden and sharp that without massive government intervention we would have experienced a thirties style depression.   Now that the economy has been stabilised, even though growth is anaemic and well below potential, further benefits from any stimulus would be outweighed by the negative vibrations from increasing fiscal deficits.

With governments having limited economic and political capacity to increase deficits to stimulate demand, and with monetary policy having exhausted most of its tool box and at best capable of avoiding a depression but is as likely to stimulate demand as ‘pushing on a string’, growth will be organic, slow but sustainable.

In this context a major portion of the stress of the adjustment process will have to be carried by the foreign exchange markets.  Countries with chronic Balance of Payments surpluses will see pressure on their currency to appreciate.

We are witnessing the Japanese Yen and the Swiss Franc reaching record levels and the China facing increasing political pressure to let its currency float a bit more freely to reflect the country’s economic progress.

Countries with deficits will be forced to see their currencies depreciate as the only practical way to balance their economies by gaining competitiveness on the export front and fill their resource gap through  foreign demand as home consumers stay on the lean and meant while deleveraging and repairing their balance sheets.

Central among these is the US which desperately needs a weaker dollar.

In this context the Euro is an enigma.   The German core are having a free ride through being super competitive without finding appreciating pressure on their currency which is kept down by the woes of Greece and its companions in distress.

The problems of Greece, Ireland, Spain and Portugal are a big bonus for German competitiveness.
Unfortunately labour mobility within the EU is still very viscous.   Were it otherwise the Greeks and the Spanish would merely pack their bags and move to fill opportunities in German core countries.

This will not happen on any significant scale.

These imbalance and the pressure they build in a monetary union among members with very disparate economic realities will continue to stimulate tensions putting the future of the euro
in jeopardy. A small country like us has no choice but to watch out with vigilance while building a strong balanced economy to protect us in the turmoil that awaits.