Friday, 25 October 2013

Stress tests, AQRs and banana skins

AQR = Asset Quality Review.

It is the detailed analysis that The European Central Bank (ECB) has to do over the next 12 months concering the main Europen Banks ( including the three largest Maltese Banks) before it takes over direct responsibility for their supervison as part of the EU's plan for a banking union and a common deposit insurance scheme.  These are necessary to restore confidence and stability to the EU's banking system.  

The banking union and common deposit insurance scheme are indispensable pre-conditions for restoring economic growth which depends on a properly function credit system and a reliable transmission mechanism for the ECB's monetary policy.

The AQR can only be credible if the ECB sets tough standards which challenge the inflated asset values that still sit on European banks' balances sheets, not least German regional banks,  that have not been properly marked down to their real value.    Yet if the ECB is too tough it could uncover a capital deficiency gap so wide that causes the inverse effect of creating a confidence crisis.   This makes it compelling to have some ready mechanism to fill up the gap with new capital that restores bank equity resources to confidence building levels.

Unless the exercise is properly planned and perfectly executed it could either be ineffective if the markets judge that the stress tests used for the AQR as too soft (as has been the case with the two previous stress tests executed in 2010 and 2011) or worse it could trigger a crisis of confidence fire without have the back-stop fire engines at the ready.

The major two factors which will determine the capital deficiency is the valuation to be given to the banks' holding of sovereign debt portfolios and perhaps even more critical the haircuts to be applied to loans to private sector borrowers that are not servicing their commitments.

For sovereign debt holdings there is a ready market price and any stress tests that avoids marking such asset to their market price, given that there is now relative stability on capital markets, would probably be considered as not rigorous enough.

There is however no ready market price markers for the true value of the loan books, especially that part which is considered non-performing i.e. where interest and capital repayments are not being met.
There is much dead stuff to be uncovered in the valuation of such private sector loans sitting on bank balance sheets in Europe.   The EU average of 5% of non-performing loans as a percentage of total loans seems unquestionably weak.   Germany's rate of just 2% is highly suspicious especially knowing the problems with balance sheets of regional banks that are in repair mode denying access for credit to SME's who had to seek the bond capital markets to service their financing needs.

Malta has a very resilient banking system.   We have proven this during the crisis and the way we shrugged off contagion risks as the Cyprus banking system nearly collapsed and unfair international comparisons started being made between Malta's and Cyprus' banking systems.   Yet Maltese core banks had a non-performing loan ratio of 8.1% (2012) of total loans which has consistently crept up from a pre-crisis level of around 5%.

Using Malta's benchmarks may indicate the size of the haircuts which other European banks still have to do if the AQR discipline of the ECB is to have any teeth.

Which brings us to the question of how the capital deficiency resulting from a properly dosed AQR is to be financed.

Two school of thoughts still prevail.   The German school wants to use the Cyprus model where the capital deficiency is filled as much as possible by bailing-in bondholders and uninsured depositors in order to make the least possible reliance on recapitalisation by the sovereigns directly or through ESM ( European Stability Mechanism).     The ECB view is that recourse to the Cyprus bail-in model could destablise the markets and force bondholders to dump their investments reducing asset prices further and forcing banks into a loop which increases the capital deficiency.

It is crucial for this issue to be settled with prudence and wisdom.   Both sides have strong arguments to support their positions and there is no ideal solution to choose from.   I should think that the best of both system needs to be taken.    To the extent that there results negative equity in individual banks it would be unavoidable to use the German model to bail-in creditors in the order of their priority ranking to neutralise the negative equity after wiping out the existing shareholders.   However once the negative equity has been addressed, additional capital to the confidence level required should be contributed by the ESM.    Sovereigns already have too much on their plate and they should not be burdened with more bank recapitalisation commitments which would drain away fiscal funds needed to restore sovereign balance sheets back to health.

Obviously the question is:  does the EMS have enough resources to meet the recapitalisation requirements which could be very big, if the AQR is to gain market approval??

For me this is a moot point.   The ESM should have whatever resources are needed to address the additional capitalisation requirements.  And I argue that these have to be big enough to shock and awe the markets so that there is no question that at the end of this exercise the main European banks will be healthy and capable of acting as credit creators to service economic growth and give full effect to the ECB's monetary policy.

If the existent ESM resources prove insufficient the ECB should have no qualms to monetise in favour of the ESM whatever they need to fund such recapitalisation.

For those who think that such monetisation is dangerous or disingenious they should just realise that extraordinary situations require extraordinary measures.   They should read a brilliant Occassional Paper just published by the Group of Thirty based on Lord Adair Turner's speech to the Cass Business School in London last February 6th, 2013 titled:

 "Debt, Money, and Mephistopheles: How Do We Get Out of This Mess?"

A brilliant paper which should make Lord Adair Turner a clear favourite for a future Nobel Prize for Economics award.

Sunday, 20 October 2013

The big picture

This article was published in The Malta Independent on Sunday - 20th October 2013

It was all so predictable. Like Berlusconi in Italy, the Republicans in the US had to eat humble pie.
Taking their country to the brink, threatening to render the US a pariah in the eyes of the rest of the world, posturing that they were prepared to allow their country to default on its obligations unless they were allowed to impose their minority view on the majority and then, right on the stroke of midnight, the majority view was finally allowed to prevail.
This is not the way to do politics. As President Obama stated in an address after he signed the bill that permitted the US government to re-open and the debt ceiling to be raised, the way to change things is not by holding the whole country hostage to your minority views. In order to change things you have to win elections. You have to have your views endorsed by the majority to gain a democratic mandate for change.
A lot of harm has been done to the US economy through this unnecessary debacle. And a lot of harm is still being done, as the patched up agreement gives a very temporary solution and there is every likelihood that the same game will have to be played again early next year. This insecurity could dampen consumer and business optimism, force the postponement of capital investment plans, entice consumers to buy just what is necessary and generally deliver a very flat Thanksgiving and Christmas shopping period – the tempo of which normally decides the rate of growth of the US economy, dependant as it is on consumer demand.
But the damage done goes well beyond America’s shores. Against most predictions – which had not taken into account the silly extremes of the Tea Party element of the Republicans in the US Congress – the debacle has weakened the appeal to international investors of holding dollars and instead we have seen a shift into other currencies, including the euro, with all its defects.
The fall of the US dollar against the euro and predictions that, until the US political debacle is finally resolved, the dollar may well fall further, has rendered the euro uncomfortably strong on foreign exchange markets. This goes diametrically against the interests of the euro countries in distress, that are undergoing painful internal restructuring processes to regain competitiveness, as it makes their challenges more uphill.
While Germany, competitive as it already is, can well live with a rate of exchange of $1.40 for every €1, particularly as Germany exports machinery and big ticket items where quality is more important than price, countries such as Italy, Spain, Portugal, Greece, Cyprus and Ireland, whose exports are more price-sensitive consumer goods and services, will see a rate of $1.40 neutralising most of the efforts made internally to regain competiveness at great political and social cost.
If this situation is prolonged, Europe must defend its own. The social tensions in distressed countries have rendered political stability extremely fragile. People cannot give democracy a fair chance forever if it fails to meet their rightful expectations. If round after round of austerity and sacrifice do not deliver growth, people cannot be expected to continue pursuing a painful policy where the light at the end of the tunnel keeps moving further away, rather than bringing redemption closer.
If a few US Tea Party Congressmen can hold the US hostage and, through the impact of their actions on exchange rate mechanisms, nullify the hard work of workers in distressed EU countries, then sooner or later the latter will decide “to hell with globalisation”.
Although the central banks of all other large, industrialised countries have adopted an ultra loose, unconventional monetary policy to ease their countries towards economic growth after the financial crisis of 2008, the same cannot (yet) be said of the European Central Bank (ECB). The US Federal Reserve, the Bank of England and the Bank of Japan have all conducted various rounds of quantitative easing (QE: a polite term for creating money artificially by the central bank entering the market to buy long-term bonds with newly-printed/created money) when bringing the interest rate to zero proved to be not sufficiently stimulating.
The ECB has shied away from such interventions for two reasons. Firstly, because it is not clear whether it has the mandate to do so, given that its constitution gives it the sole objective of keeping inflation close to but under two per cent and does not specifically make it responsible for economic growth; and, secondly, because – being the only large central bank that is not supported by a single treasury but has to deal with the 18 treasuries of its constituent countries, all of whom operate their fiscal policy independently of each other – there would be practical problems with the ECB deciding whose bonds to buy, even if it wanted to pursue QE.
But this does not mean that the ECB should just sit on its hands, given the unfair events happening on foreign exchange (forex) markets. It may well have to see the big picture, rather the granularity of the legalities in its mandate, and rightly uphold that it is within its mandate to remove anything that blocks the transmission mechanism for its monetary policy, especially when the readings of inflation start to consistently underscore the two per cent target and hover dangerously around deflation levels. With inflation falling to around one per cent, the ECB may well be forced to intervene on forex markets, initially through verbal intervention by merely indicating that it is considering a choice between QE and negative interest rates in order to bring the euro forex value down to levels that remove unfair obstacles to countries undergoing painful economic restructuring.
Staying upright and sane alone, when all around you are going wild, may well be deadly when business is taken away from you through unfair practices. In such circumstances, sanity can kill you and you have to defend yourself in order to survive instead of merely preaching virtues.
Something along these lines applies to Malta when dealing with illegal immigration. It is all well and good that we have to honour international and social obligations by saving lives and giving shelter to immigrants who force their way on us through illegal channels. But that is the narrow picture. The big picture is that, in doing so, we are encouraging more and more immigrants – whether purely economic migrants or genuine refugees is not yet clear – to risk their lives taking to sea in rickety, overcrowded boats that are not fit for purpose.
And the more risks that are taken, the more tragedies will occur and the more exposed will be the dishonesty of north European countries who are pretending that southern European border countries, many of which are already grappling with nerve-wrenching economic restructuring programmes, can handle the burden of such illegal immigration without solidarity and determination to resolve the problem at its source: before these immigrants leave their countries and embark on boats of death.
And those who totally deny “pushback” policies, whatever the circumstances, should see that their conscience-pricking is playing into the hands of the merchants of death who remorselessly continue trafficking people and sending them to their death purely for financial gain.
It is time to see the big picture.

Monday, 14 October 2013

Konrad the magician

My DNA is structured so that when I hear something that is too good to be true than my face-value assumption is that it is not true and I demand from the proponent an additional dose of verification to prove their case.

Minister asks Police to investigate fuel procurement processThat was my first reaction when in a small focus group we were addressed by Konrad Mizzi with an outline of PL's proposal for a new energy policy which will deliver reduced tariffs, reduction in Enemalta's debt, operating efficiency and protection of jobs.   And all this without any investment on the part of government as the PPP project will be fully funded by the private partner who will put money up front to deliver in advance the goodies that consumers need to lighten up their utility consumption expenditure.

I remember grilling Konrad from different aspects of the proposal but impressively he always had all the answers, confidence and assurances to the point that in the end the energy proposal was adopted as the key deliverable in PL's electoral manifesto that was so overwhelmingly approved by the electorate last March.

I must admit too that a lingering doubt always remained, knowing that the project had substantial execution risks.  Improper execution could ruin the best of plans.

But here we are barely 7 months after he took over his Ministry, Konrad has delivered beyond my, and I would say anybody's expectations.   He has proven beyond doubt that his plan had been well conceived , thought of, sequenced and will no doubt be properly executed now that the risks are diminished once the choice of the winning consortium has been made and the execution passes over mainly to the private partner's side of the fence.

And for those who have nothing to criticise but the fact that the price at which the private partner will sell energy to Enemalta from the new gas plant has been fixed only for 5 years they should first familiarise themselves with the technologies being made in gas exploration, especially in the US through fracking methods.   It would be very risky to fix gas prices for the very long term given that these advances in technologies could in the long term deliver much cheaper gas prices.  Five years is as much as any serious risk manager would counsel to hedge gas prices in current circumstances.

Well done Konrad.

Wednesday, 9 October 2013

A Berlusconi moment

The consequences of a default by the US on its debt, even if temporary, are so profound that it is unthinkable that Congress would allow such a thing to happen purely because they think they can overrule the electorate who in electing President Obama for a 2nd term last November showed clearly what the people want.

Public opinion of Congress is rock bottom. If they let the country default they would be signing their suicide note.

Rational thinking would suggest that the House GOP will soon have a Berlusconi moment and back down even if Obama is gentle enough to offer a face saver by entering negotiations on further measures to cut the deficit which is in any case falling on its own momentum.

But can you expect rationality from the irrational?

Monday, 7 October 2013

Berlusconi, the GOP and Simon

This article was published in The Malta Independent on Sunday - 06 10  2013

Silvio Berlusconi performed the mother of all u-turns this week.   He grossly  over-estimated his hold on Italian politics and took too much for granted about where the loyalty of his troops lies.   ‘Berlusconi’ should find its place in the Oxford Dictionary to define unashamed hypocritical u-turns.
The elections of last February returned a result which made Italy only governable if the parties of the centre- right and centre-left formed a German style grand coalition.    With the Democratic Party (DP) leader Bersani committing himself not to join any coalition with Berlusconi’s party, the country seemed basically ungovernable.    The DP failed to secure a majority in the Senate even if the independent Senators and the moderate centre parties gave support.   Without Berlusconi party’s support no stable government could be formed.  Berlusconi, whom many had considered down and out when he was forced to resign and make space for Monti’s technical government, unexpectedly had a veto on the formation of government.

It had to be the skill and moral authority of outgoing President Napolitano to force the party leaders, Berlusconi and Bersani, to move aside and appoint Letta as Prime Minister.  Letta comes from the DP on the left but had family members well-known and commanding the confidence of Berlusconi.  This helped to secure a fragile coalition which needed Napolitano to offer himself for re-election as Italy’s President in spite of his age.  Napolitano was considered the only voice that could bring stability in a very volatile political environment where the only deterrence against chaos that would lead to fresh elections, was the fear that the electorates would chastise the traditional party and protest vote to elect comedians and extremists.
Prime Minister Letta was doing a good job against all odds. Last week he was in New York using his presence for the UN Meeting promoting  Italy’s credentials for foreign investments. But Berlusconi wanted to show who was really in charge.

Faced with a final judgement guilty of fraud and tax evasion, Berlusconi was facing the real prospect of being booted out of the Senate and being stripped of civil rights to vote and contest elections. In a clear demonstration that for Berlusconi private interest come before the sovereign safeguards, he pulled the plug on the Letta government and ordered ‘his ministers’ to resign from Cabinet and his delegates to resign from parliament.
It was a shocking move as no one ever thought that Berlusconi would be as daring as to create enough political chaos to render the country ungovernable merely to protect his own skin.   He further made several public outbursts accusing Napolitano and Letta as forming part of grand devious scheme to push him out of politics.

It would not be bad at all if there are controls to ensure that owners of capital and resources do not use their wealth and connections to gain political power to protect their patrimony rather than the general good of the country. But in Berlusconi’s case he was found guilty by several layers of the Italian court system after all possible appeals failed.   It is convenient for Berlusconi to protest the political partiality of the judiciary but arguing that the Italian court system is from top to bottom a front for left wing politics is an insult to intelligence.
From a gallant kamikaze on Sunday Berlusconi was tamed into an unashamed waverer by Wednesday when the Italians could not believe their eyes seeing Berlusconi voting confidence in a government that he brought down in the first place.

Numbers were the source of Berlusconi’s mega shift.   When a sizeable portion of his troops, including the five ministers that were forced to resign from cabinet, made it clear that they will put the country’s interest before Berlusconi’s and if necessary breakaway to form a new moderate centre-right party, Berlusconi was disarmed.  
A similar fate awaits the GOP ( Grand Old Part – Republican Party) in the US.  Their fundamentalism against Obama’s health care initiative to make it accessible to the lower strata of society, coupled with their dislike of Obama personally, is forcing the GOP to jeopardise the country’s interest and reputation to satisfy their obsessions.

Making continuing funding for government operations conditional on de-funding for Obama’s health care signature legislation has forced the US government on life support.   Threatening not to raise the debt ceiling, normally a pure administrative measure to make it possible to fund budgets already approved, could force total government shutdown, including essential services and possibly even defaulting on America’s debt, reducing the US  to the leagues of Argentina, Greece, Jamaica  and Bolivia.  
As public opinion turns against the GOP in disgust of their abuse of democratic power, moderate elements within the GOP will like Berlusconi read the numbers and force the leadership to side-line the Tea Party extreme elements to bring back America to normal civilisation.

And what has Simon got to do in all of this?  Dr Busuttil’s walk-out of parliament this week purely because a Speaker’s ruling did not go his way, is a small example of the my-way-or-the-highway attitude of Berlusconi and the GOP.
But in the PN’s case Simon Busuttil does not even have the political levers to force his points.   Making showdowns is not the way to advance in modern politics.    He can of course disagree with the Speaker’s ruling, he can protest and argue against it, but walking out of parliament is childish and counter-productive.

Dr Busuttil would do himself and his party a great favour if he is more concrete and factual in his criticism.   He is entitled to express suspicions,  but suspicions are no proof.   Assertions do not make facts.   He has all the right to disagree with decisions taken by appointed executives, including the Commissioner of Police, but extending this to assertions of  interference by the Prime Minister needs proof, not mere suspicions.
Busuttil should not imitate Berlusconi or the GOP’s style of leadership.   Rather than showdowns to assert his authority on the Party he would be well advised to work quietly to build and strengthen the Party’s weakened internal structures before starting to play gallery games.