Archives for October 2013

Banking Matters

Healthy banks are a critical ingredient in the economic infrastructure that underpins growth and equity market performance.  Today the healthiest banks are found in Japan and Asia and the weakest in the Eurozone.  Thus banks in Japan and Asia look best placed to support growth in their economies, whilst Eurozone banks appear worst-placed.  This analysis contributes to and supports our current positioning within equity markets, where we favour the Japanese and Asian markets and are cautious on the Eurozone markets.

Five years ago, Hank Paulson, the then US Treasury Secretary, decided that financial markets would be able to deal with the bankruptcy of Lehman Bros, and refused public money to rescue it.  His judgement was that Lehmans was not “Too Big to Fail” and it proved to be wrong, since the following six months led to an almost total shutdown in interbank lending and a collapse in economic activity all over the world.  Governments around the world were forced to provide capital for the weaker banks in their economies and central banks provided the liquidity for banks that the banking system had previously provided by itself.  In hindsight, Lehmans was “Too Big to Fail”, and by implication, so were many more banks all over the world.

Over the five years since then, policymakers have focussed much more on dealing with the macro-economic consequences of the crisis than on dealing with this key weakness that caused the crisis.  Some small steps have been made. Firstly, there is now an official list of systemically important financial institutions produced by the Financial Stability Board, a new global body that monitors the global financial system and makes recommendations for change.  These institutions have slightly higher capital requirements than other banks to reflect the fact that since they are agreed to be systemically important, they will be bailed out in the event of a future crisis.  Secondly, many countries have now brought in the concept of “living wills” for their largest banks, setting out how their activities can be wound down in a rapid and orderly fashion in the event of them falling into a financial crisis.  These steps effectively acknowledge that many banks remain “Too Big to Fail”, and merely attempt to make it easier to deal with any problems that may arise from that reality.

The crisis actually made the larger banks even bigger, since weaker institutions were pushed into mergers with what were thought to be stronger institutions – in the US, Merrill Lynch was absorbed by Bank of America and Bear Stearns was absorbed by J P Morgan, and in the UK, HBOS was forced into a merger with Lloyds.  The financial crisis in Japan over the last 20 years has seen the number of major banks there decline from ten to just three as the banks merged to maintain profitability.  Earlier this year the US Attorney General, Eric Holder, admitted publicly that as well as being “Too Big to Fail”, he believed that the largest banks had become “Too Big to Jail”, since prosecuting these banks for fraud or money-laundering offences might be so damaging to their reputations and their businesses that it might have significant economic consequences.

Within the more troubled Eurozone economies, where governments found it difficult to find buyers for the bonds issued to finance their burgeoning deficits, the local banks were “encouraged” to buy the bond issues, using the extra liquidity supplied by the ECB.  This has created a potential downward spiral, in which a government struggling to service its debts creates problems for its own banking system, which then requires bail-outs from the same government to keep it afloat.  Italy and Spain are most at risk of falling into this spiral.

Almost by definition, banks deemed “Too Big to Fail” have significant political influence, and will use it to fight attempts to make them smaller.  Tougher capital requirements are being imposed, but only to levels that would have been seen as hugely risky by the bank managements of thirty years ago.  Policymakers have a clear conflict here – they are desperate for banks to resume lending to stimulate and support economic growth, but demanding higher capital ratios of the banks only acts to restrain lending.  There has been little in the way of forcing the banks to become smaller entities, apart from the ending of proprietary trading within investment banks and, in the UK, the Lloyds spin-off of a number of its branches under the TSB brand name.

The health of a country’s banking system is generally seen as critical to its ability to support economic growth – though this is less true in America where the corporate bond market is extremely deep and wide, enabling smaller and riskier companies to raise bond finance as well as loan finance.  Some may be surprised that the major economy with the healthiest banking system is Japan – this follows two decades of the banks writing off bad debts and making little in the way of new loans over this period.  Loan-to-deposit ratios are now very low and the capacity to lend to the private sector of the Japanese economy is great, should the demand for those loans improve (which finally appears to be happening).  Asian banks underwent an existential crisis in the late 1990s, and continue to maintain prudent capital and loan-to-deposit ratios – they remain very well-placed to support the expected rapid growth in Asia.  The UK banks are still working their way through a large amount of bad debt related to UK commercial property, but are believed to have made provisions for the bulk, if not all, of their expected losses – they are now in a position to consider lending again, though are still scarred from the experience of the last few years.

It is the Eurozone that is the home of the greatest banking problems today.  Each country has a number of banks that are nationally systemically important, and so do not wish to see fail, but where there are substantial unrecognised bad debts.  These debts cannot be written off without imperilling the capital position of the banks, and so they remain on the banks’ balance sheets. The amount of new capital  that Eurozone banks would be required to find in order to be able to write off these debts and remain in business is believed to be very large, beyond the capacity of the financial markets to provide, and will thus require capital to be provided by governments, which are themselves short of funds.  Until this is resolved, Eurozone banks are in a very weak position to support growth through new lending.

Thus banks in Japan and Asia look best placed to support growth in their economies, whilst Eurozone banks appear worst-placed.  This analysis contributes to and supports our current positioning within equity markets, where we favour the Japanese and Asian markets and are cautious on the Eurozone markets.