The Financial Services Club's Blog

Stressed? Don't worry. The French and Germans will sort it out ...

I will not spend much more time on this, but was irritated by the CEBS stress tests last week and so one more quick note.

The reason CEBS, the European Commission and European Central Bank gave for not including the scenario of a sovereign default in the stress tests is that they just don’t think it’s going to happen.

“It is not possible”, they said.

“Why”, we asked.

“Because it is just incredibly unlikely and, even if anything did start to fragment in the fissures of finance in Greece or Spain, we have the European Financial Stability Fund (EFSF) to solve it”, they replied.

Now that’s an interesting statement ... because it is also a fuddle.

The EFSF is a €440 billion fund designed to cover any sovereign debt crisis in Europe in the future.

Therefore, the concept of a bank being exposed to huge losses from Greece and Spain is no longer an issue.

That is the logic.

And it’s quite good.

But it’s already been shot to pieces.

Ken Wattret, a market analyst with BNP Paribas, performed a really interesting analysis of the EFSF and issued a note in July that provides a clear Q&A overview. The analysis is available through their website (large pdf, see page 10) and a public version was summarised nicely by Financial News.

Here’s my summary of Ken’s research note:

The EFSF is a limited liability company based in Luxembourg announced in May as a measure to “preserve financial stability in Europe”. Its CEO is Klaus Regling, a former senior German Finance Ministry official who worked on the preparations for EMU and who has also worked at the IMF.

The purpose of the EFSF, according to its terms of reference, is “to collect funds and provide loans in conjunction with the IMF to cover the financing needs of Eurozone member states in difficulty, subject to strict conditionality”.

According to the Framework Agreement, the EFSF will finance the provision of loans via the issuance of “bonds, notes, commercial paper, debt securities or other financing arrangements” which will be backed by unconditional and irrevocable guarantees from those member states which participate.

Only the member states of the Eurozone participate in the scheme, providing guarantees up to a total of €440bn on a pro-rata basis.

If a Eurozone member state seeks assistance from the EFSF, they must initially agree a Memorandum of Understanding (MoU) with the European Commission, in liaison with the IMF and the ECB. This MoU will set out the budgetary and economic policy conditions which the Eurozone member state must comply with in order to receive financial assistance.

The detailed terms and conditions would then be set out in a Loan Facility Agreement which is subject to the agreement of all the guarantors (i.e. those countries in the EFSF).

The EFSF will enter into force when five or more member states, comprising at least two-thirds of the total guarantees, have confirmed that they have concluded the necessary procedures under their national legislation. It will last for almost three years, with the guarantees applying to loans made on or before 30 June 2013.

Now then, what Mr. Wattret did next is the most intriguing part. He produced this chart (double click to see larger image):

Column C3 is the one that interests me, for it shows that Germany and France contribute almost half of all of the ECB’s capital for this scheme, whilst the PIIGS – Portugal, Italy, Ireland, Greece and Spain – contribute almost 35% of the scheme, with Italy and Spain representing 30%.

Greece does not contribute anything to the scheme at this time for obvious reasons.

So what the ECB are saying is that the $1 trillion exposure of European banks to the sovereign debt of just Greece and Spain, as discussed yesterday, can be covered by the €440 billion available in an emergency through this scheme.

But let’s take this a step further.

Spain gets into distress and has to leave the scheme.

That removes a further 12% of the scheme’s funding.

In fact, if Ken had continued his percentages and logic across columns C6 and C7, then the new figures look like this:

In other words, should Spain have issues, the burden on France and Germany increases by a further 7% of the fund – or an additional €7.5 billion to bring their number to a total of €250 billion between them.

This is what prompted me to ask at the end of the CEBS press conference: “so what you’re really saying is that you didn’t use the scenario of a sovereign default because you believe French and German citizens will be happy to bailout Spain like they did with Greece?”

That didn’t go down well but it had to be asked and, no matter how unlikely it is for this to occur, it is the reality of the situation.

Stress tests useful or misleading?

Having spent much of the weekend absorbing the European bank stress test results, I’ve got to ask why they bothered.

OK, so it was to get bank share prices up, but the whole thing was just a typical European sham where every country does things in a different way, with the whole thing designed to cover up the real weaknesses in the European banking system.

Bearing in mind that the stress tests were called to shore up confidence in the system due to the concerns in the markets over a sovereign default in Greece or Spain, the fact that the tests left out that particular scenario is ridiculous.

In case you didn’t catch it, the tests looked at a double dip recession and a sovereign debt shock, but purely based upon debt that banks were trading, not debt that banks had in their vaults. 

Now I blogged a while back about the fact that Europe’s banks held over $1 trillion in debt to just Greece and Spain (double click picture to enlarge):

With sovereign debt trading on the bank's books worth about a tenth of their total exposure, that means that around $900 billion of potential sovereign debt has been ignored.  How this can be ignored is beyond me.

Secondly, the tests ignore any liquidity risk issues, and just looked at market and credit risks. Why?

This crisis started with liquidity risk when interbank lending dried up, and then exploded when sovereign debt became a major concern. The fact that CEBS left out these two clearly important dimensions just seems silly.

But then it is purely a politically motivated exercise to try to stop the haemorrhaging of confidence in the European system.

Now, I actually went to the press briefing on Friday night – a time chosen to ensure that markets could not react immediately to this sham – and saw the baying hounds of the media looking totally incredulous as the headlines were announced.

“We have seven bank failures that, between them, in the most adverse scenario would need €3.5 billion of new capital.”

I’m sorry, but that’s nuts.

When the Americans did their stress tests, half their banks failed and they needed $75 billion of new capital. So how come, in the worst of situations, our banks would only need €3.5 billion and fewer than 10% fail?

Because it’s a fix.

It’s fixed because each country interpreted the stress test conditions for unemployment and house prices and other economic conditions in their own way.

It's fixed because each regulator and central bank applied the test conditions against their bank's balance sheets in dfferent ways.

And it’s fixed by leaving out the sovereign debt exposures and potential defaults on the bank’s books.

Nevertheless, something useful did come out of it: data.

There's lots of data about the state of the bank's balance sheets released by CEBS that can now be analysed by the markets, rather than the fudge that the regulators applied.

Therefore, with the reservations stated above, I went through the numbers over the weekend and found an interesting result.

First, a little explanation of the numbers.

The tests are based upon three scenarios.

Scenario 1 is the benchmark, which is based upon the current ECB forecasts for macroeconomic developments across the European Union.

Scenario 2 is then based upon a double dip recession, which sees no growth in 2010 and a 0.4% downturn in GDP in the European Union in 2011, versus 1% in 2010 and 1.7% forecasted in the benchmark.

Scenario 3 studies the impact of a sovereign debt shock to the European Union on top of this recession, and is geared towards higher debt losses and impairments in the PIGS – Portugal, Ireland, Italy, Greece and Spain – than in other countries.

This does not assume a sovereign default, just corporate debt and sovereign debt on the trading books of the banks. That’s about 10% of the total exposure for the banks, should a country default.

In the CEBS tests, they looked at Tier 1 Capital Ratio – not core capital, just Tier 1 capital – and said that the ratio should not fall under 6%. Under the EU Capital Requirements Directive, as it stands uncorrected since this crisis hit, the lowest level by law is 4%. Meanwhile, the likelihood is that a minimum 8% Tier 1 Capital will be required in the future and, in this context, is a far better ratio to apply.

For example, based upon the CEBS view of the world, using the combined worst case of a double dip recession and a sovereign debt shock, they find seven banks would fall under the 6% Tier 1 Capital Ratio level: five in Spain, one in Germany and one in Greece.

Looking at the numbers using an 8% Tier 1 Capital Levels - a level that is rumoured to be required under revised terms for EU bank trading in the future - 39 banks would fail in the worst case scenario: one in Austria, one in Cyprus, five in Germany, three in Greece, two in Ireland, four in Italy, one in Portugal, one in Slovenia and twenty one in Spain.

Figure 1: 8% Tier 1 Capital Measures Failed by 39 Banks (double click image to enlarge)

Figure 2: Banks that Pass the 8% test (double click image to enlarge)

That would have been a far more realistic number to have announced and, based upon the fragmented application and interpretation of the tests by member states, is probably more likely to be the worst case scenario than the seven bank fails CEBS announced last Friday.

NOTE: failure does not means the banks are insolvent just undercapitalised, and so this would have been a much better way for CEBS, the ECB and the European Commission to have achieved some credibility from this exercise.

Skinner Says Stress Test Methods 'Pretty Weak' - Washington Post

Bloomberg appearance, 26th July 2010 from Chris Skinner on Vimeo.

Meanwhile, if you’re interested, here are the CEBS documents related to the stress tests:

• CEBS Press release (pdf)
• Summary report (pdf)
• Q & As (pdf)
• Joint Press Release CEBS, ECB, European Commission (pdf)
• Summary of the 91 bank-by-bank results, by country (pdf 5MB)

And a few of the more interesting tidbits that I picked up when looking at the background to these tests:

“According to a survey by Goldman Sachs, 10 of the 91 banks subjected to the stress tests are expected to fail. The poll of 376 respondents, shows that European banks are expected on average to raise £40.6bn in extra capital following the tests.” Money Marketing

“Hypo Real Estate’s Tier 1 capital ratio was 7.7 percent at the end of March, according to a presentation on its website dated June 2010. The lender said in May that it holds 72.1 billion euros ($93.4 billion) of debt in Greece, Italy and Spain, among the highest held by a bank in Europe, according to data compiled by Bloomberg ... Germany’s Soffin bank-rescue fund had provided Hypo Real Estate with 7.87 billion euros in funds by the end of March. The bank has said it may require a total of 10 billion euros from the fund. The lender said on July 8 that it received approval to establish a so-called bad bank to transfer as much as 210 billion euros of investments consisting of ‘non-strategic assets and risk positions.’ The amount represents more than half of Hypo Real Estate’s total assets at the end of 2009.”  Bloomberg

“According to CEBS, the other German lenders tested are Deutsche Bank AG, Commerzbank AG, Deutsche Postbank AG, Landesbank Baden-Wuerttemberg, Bayerische Landesbank, Norddeutsche Landesbank Girozentrale, WestLB AG, HSH Nordbank AG, Landesbank Hessen-Thueringen Girozentrale, Landesbank Berlin AG, DZ Bank AG, WGZ Bank AG and DekaBank Deutsche Girozentrale ... Among the banks on the list above, we note that e.g. Commerzbank has leverage of roughly 150:1 (tangible assets divided by tangible common equity), Landesbank Berlin has leverage of 75:1, WestLB 68:1 and Deutsche Bank 56:1. For the sake of comparison, by the time of its demise, Lehman Brothers is said to have been leveraged about 30:1. How can any of these banks not be de facto insolvent? If they hold any PIIGS bonds at all (and some of them do, in spades – e.g. 468% of Commerzbank's tangible book value was invested in PIIGS bonds as of about six weeks ago), it is a near mathematical certainty that they are.” Pater Tenebrarum

Why banks have no competition

I had a couple of really interesting dialogues with bankers yesterday.

The first was with a career banker who is now working with one of the New Banks on its launch. The second was with an Asian bank manager running his bank's UK operations.

As I talked with both, they expressed their frustrations with the UK regulatory system, the FSA, licensing and operations.

Here’s roughly how the commentary went.

The Government, Treasury, Bank of England and the FSA are all publicly stating that they want more competition in banking. They seek to actively encourage new entrants, according to their press, but then they do their darndest to ensure no-one can compete.

In particular, it’s the FSA’s stringent rules that create inordinate hurdles to getting approvals to open and operate in the UK.  These controls are needed, as loose control is what caused the crisis, but how much of a barrier such controls create to new entrants is a question we should also be asking.

For example, in order to get a banking licence you must first assemble a group of people of whom the FSA approve. Getting that approval can be hard.

First, you have to ask for approval for all key staff. That can be a lengthy process and is restricted to approval by the FSA for the individual to perform one or more strictly 'controlled functions' on behalf of an authorised firm.

These controlled functions relate “to the carrying on of a regulated activity by a firm”, which means that each time you change roles or add activities you need to be vetted again.

And that vetting is not just for one person, but for each member of the bank’s senior management from non-executive directors and executive directors, through Chief Executive and key functional heads of compliance, risk and audit.

For a new bank, that can be a phenomenally time consuming process but it is needed to ensure integrity and appropriateness (what happened when they vetted Andy Hornby, Adam Applegarth, Fred Goodwin ...).

Thing is, if you’re engaged in a controlled activity and not approved then the individual can be fined and possibly jailed, and their firm’s license rescinded.

This means that each time a person changes role or function, they need to be re-approved.

As you would expect, management of the bank’s processes, procedures and people to ensure compliance is a full time job and can be hard for an existing bank.

For a new bank or foreign bank, it can be near impossible.

For example, one of the individual’s selected for a senior role with one of the new bank entrants was a mighty talented chap ... from an Icelandic Bank. Once those banks found their assets thawing, the FSA immediately gave them the cold shoulder and the talented individual was shown the exit door before he’d even been hired.

In another case, the foreign bank operating in Britain tells me they have just appointed a new CEO. The CEO’s appointment was notified to the FSA in April but, due to the vetting process, he’s still not able to take up his key role and the bank is therefore headless ... they hope he can take his position in August.

Even with that, as a foreign bank they have to comply with FSA rules and with UK Home Office rules. These state that when a foreign bank employee changes their job title, they cannot have their business cards changed to reflect their new role until a work permit is issued reflecting the new title. That can also take months.

Phew.

This stuff is hard and it is getting harder, as the FSA are getting increasingly aggressive on enforcement and increasingly stringent on their criteria for approval.

But let’s say that you can be bothered gathering a group of competent and capable people who get FSA approval: is that it?

Nope.

You then need your banking licence.

That’s tough too.

Here’s how tough that is, as articulated by a compliance consulting firm:

“Applying for a UK banking license is a complex process. You will need to complete a comprehensive set of application forms and provide the regulator (the Financial Services Authority) with a full set of supporting documents such as your business plan, risk management policy statements, compliance manuals and procedures and other information.

“You will need to show the regulator that you have a clear and workable business plan. You will need to evaluate your capital requirements and to demonstrate that sufficient capital is in place.

“Applying for a banking license is officially known as a ‘Complex Application’, and is unlike the vast majority of Financial Services License applications.”

Jeez.

It’s so darned complex that you have to hire a consultancy to advise you how to do it.

For some banks, it's too much and they give up.  For others, it takes them about three years of administration and form filling to get to the start line.

Meanwhile, you may think you can short circuit all of this by buying an existing bank.

That's what I thought when I heard that JC Flowers is trying to acquire Kent Reliance or that Virgin buys Church House Trust.

Nope.

Y’see getting the people approved and gaining a licence has no relationship with your ability to conduct business.

That’s a separate matter.

By way of illustration, I thought that the likes of JC Flowers and Virgin were buying a banking licence so that they could take over the branches of RBS and Lloyds, and become a fully fledged bank with several hundred branches.

Nope.

The banking licence only provides you with a licence to take deposits and offer loans.

But the deposits and loan levels you can provide are restricted to the capital you have to cover the business from day one.

So if you have one branch supporting 10,000 customers, you must have the capital to cover the exepcted holdings of 10,000 customers; two branches, 20,000 customers; ten branches, 100,000 customers; and so on.  And you must have that capital coverage for all customer holdings before you open those branches.

This is illustrated in a recent speech by Thomas Huertas, Director for the Banking Sector with the FSA, who states that: “the only capital that really absorbs loss whilst the bank is a going concern (at least in the UK) is core Tier I capital or capital that is convertible into core Tier I capital whilst the bank remains a going concern.”

As a result, the FSA has increased the Tier 1 Capital levels a bank must reserve against its potential losses, with the rest covered by contingency capital (convertible equity).

This means a new bank must have enough capital to cover all of its projected exposures from day one ... a tough call, and one that means that even if you have a banking licence you cannot suddenly open hundreds of branches without loads of money in the bank.  And getting a return on that money will take years.

All of these challenges and issues are the reasons why we are not seeing massive new competition in banking in Britain, or anywhere else for that matter.

But then all of these rules and regulations are there to safeguard society aren't they?

So when you hear politicians saying that they want to see lots of competition in banking, it is a complete untruth.

In conclusion, and to quote Thomas Huertas again from a speech in June 2008 before the crisis:

“Regulations do not restrict competition. Entry into banking, especially in the UK, is free to anyone who can meet the threshold conditions for establishing a bank. The UK places no barriers to the ownership of banks on the basis of nationality, and under EU directives any EU-incorporated credit institution is, under the so-called passport granted to all banks under the single market, entitled to establish a branch or sell its services cross-border into the UK. This policy of free, but orderly, entry underlies not only London's position as one of the world's leading financial centres, but also contributes to competition in retail banking.”

What he actually meant was that banking is open to free competition, but only from other existing banks with banking licences from their country of operation, and with major capital assets to cover their exposures.

This is why there hasn’t been a new bank opening in Britain for over a century and the only new competition has been from existing foreign banks, such as Santander.

EU's bank stress tests creating more bank stress

It turns out that 91 European banks are to be put through a ‘stress test’ to see how well or badly they will cope with a shock to the system. The stress test itself was a little unclear until late last week, when the Committee of European Banking Supervisors (CEBS) detailed what would happen. As a result, a lot of folks think it’s a fudge, and the intention of creating more confidence in the EU’s banking system may actually have achieved the opposite.

Here’s the lowdown.

CEBS stress tests were announced after their initial approach was viewed as being too little and too narrow. The intention was to stabilise confidence in the EU banking system following the crisis in the Eurozone, and the approach was meant to follow the example set by America in May last year.

Back then, everyone felt the American banking system could not deal with the exposures they had to OTC derivatives, so the Federal Reserve tested the banks to see if they could deal with not just those exposures, but any other severe shocks to the system.

The US tests used two economic scenarios: one mirroring the consensus of economic experts on the course of the downturn through 2010, and the second modelling a worse-than-expected course of economic activity.

This resulted in recognition of a $74.6 billion shortfall, which was far less than the figures being bandied around before the stress test results. For example, the IMF estimating that the U.S. banks needed another $275 billion to $500 billion whilst some analysts throwing figures around that the industry may need as much as $1 trillion.

The less than anticipated shortfall led to increased confidence in the American banks. That confidence led to some stability in the system thereafter, financial stocks jumped 36% in the seven months after the tests, which is why it was worth doing.

This is why the US example was followed by the lengthy discussion of living wills in the UK regulatory sector, and the idea of reverse stress testing as implemented by the FSA last December. In these tests, banks are meant to imagine that they have failed and then have to work backwards to determine which risks and vulnerabilities caused their hypothetical collapse.

The FSA’s approach to stress testing consists of three main elements: companies’ own internal stress testing, where they assess their ability to meet capital and liquidity demands in a sudden downturn; the regulator’s testing of specific companies; and simultaneous “system-wide” stress testing, based on a common crisis scenario.

In both the US and UK examples, the stress test methodologies were completely transparent and now we come to the European bank stress tests.

In the EU tests, CEBS will study 91 banks, mainly in Spain and Germany, but also several other key banks including Britain's "Big Four" – RBS, HSBC, Barclays and Lloyds. In the latter example, thanks to the FSA’s scrutiny, they have already been subject to tough tests at home and should pass with flying colours.

The list is actually considerably longer than the original announcements in June which selected just 25 banks for review, and includes the German Landesbanken for the first time.

The significance of that decision cannot be underscored more deeply as BaFIN, the German regulator, announced a year ago that €800 billion of toxic debt sat on the balance sheets of these banks, particularly some of the Landesbanken, and that was double the amount they had estimated just three months earlier.

With almost $1 trillion in deposits, 2,500 banks and 45,000 branches, Germany also has one of the densest banking networks in the world, and hence a weakness in the German system would be a weakness for all, particularly as Germany has been bailing out Greece and, soon, Spain, Italy, Portugal and more.

In Spain’s case, as recently blogged, there is a big problem with the mid-size banks where the savings banks, regional banks and mid-sized banks are all closing, merging and consolidating, with anything from a quarter to a third of all Spanish bank branches to close.

That’s not good.

But the stress tests can turn this situation around by showing that Europe can cope with even the worst case scenario.

That’s a tough call, as we are all asking: ‘Can it?’

After all, a stress test if it turns out to be negative will worsen the situation but, if it’s positive, it will improve everything.

So the stress tests are being reported to be as transparent as the US version, with a three scenario test, according to the German newspaper Handelsblatt.

The first will analyse how banks perform if economic growth is at the rate forecast by the European Commission; the second will test the effect of a 3% drop in gross domestic product; and the third will look at how banks would cope with a "shock" situation in government bond markets, a scenario similar to events in May this year when Greece was downgraded by Standard & Poor’s.

It is that downgrade which has caused all of these jitters anyway, and created the uncertainty and lack of confidence in the Eurozone. Without confidence in the European banking system, then even worse scenarios could be considered, such as the collapse of the Eurozone and a return to national boundaries and nationalistic tendencies therein.

But there is already an issue with the European stress tests as the approach, structure and details of the tests have been changing over time, and many think the results – to be announced on 23rd July – will be a fudge. This view was given even more fuel when there were rumours that France and Germany were trying to suppress the methodology to be used for the tests.

This is bad news, as the lack of confidence in European banks will be made worse when or if there is a lack of confidence in the European banks’ stress tests, and the stress tests will only increase market uncertainty, rather than decrease.

All in all, my view is that Europe is caught between the Devil and the Deep Blue Sea.

If they complete the stress tests and release the results with complete transparency, there is likely to be some fallout. Unless the results show that the fears for bank counterparty risks in Europe are unfounded, which in the case of the Landesbanken and Spanish caja banks is unlikely, then it will just confirm what many already suspect: Europe’s broke.

On the other hand, if they complete the stress tests and release the airbrushed results that show some manipulation or opaqueness, then everyone will believe that their fears for bank counterparty risks in Europe are proven.

Therefore, what seemed to be a great idea to bolster confidence in the Eurozone may actually prove to be a lose-lose situation.

So how can the Eurocrats create a win out of this?

Just be totally honest.

If there are real issues in the heartland of Europe’s banks, be brutally frank about them.

It is only with total honesty, transparency and clearly washing any dirty laundry in public at the end of the month that Europe has any hope of surviving this current battering.

Think the unthinkable

Many interesting, weird and wonderful things drop into my inbox, Facebook newsfeed and twitter status updates.

Take yesterday.

I was sent:

• a copy of the BBA’s Annual Abstract of Banking Statistics,
• lots of notes from my accountant,
• various invites to press shindigs,
• a note from FatBoy Slim, who is an England groupie at the World Cup,
• a disgusting PowerPoint show detailing World Cup supporters of the opposite sex,
• a solution for the issues Apple iPhone4 users are having with signal loss if they hold the phone the wrong way around

• 

• and a note from my conspiracy theorist friend about the weird coincidence that, on 7th July 2005, a company was running a simulation of a terrorist attack in London using the exact situation that became a reality that very morning.

How coincidental was that?

Anyways, talking of simulations, I am also getting lots of emails from bank economists with the title generally being: THINK THE UNTHINKABLE.

The one that really grabbed my attention was from ING, looking at what will happen if the Eurozone collapses.

We’ve had this discussion a few times lately, since Greece and co have been under duress, but no matter how much dialogue there is over this, it never seems to quite go away.

But I’ve not seen a bank analysis of the consequences of a Eurozone breakup before.

Here’s the opening lines:

“Suddenly the unthinkable is thinkable. The possibility that one or more of the members of European Monetary Union (EMU) might leave is no longer being dismissed, even by Eurozone politicians. In this report, we discuss not the probability of this – readers will doubtless have their own views – but rather its potential economic and financial market impact. Complete break-up would have effects that dwarf the post Lehman Brothers collapse.”

Oh dear.

The report is written by Mark Cliffe, Global Head of Financial Markets research, who looks at two scenarios: what happens if Greece leaves the euro and what happens if the Eurozone falls apart.

The first scenario is bad: “While the initial economic damage of a Greek exit is naturally focused on Greece itself, the effects elsewhere are non-trivial. While Greek output falls by 7½% relative to our base case, the remaining Eurozone economies could see their output fall by as much as 1%. Losses on Greek assets spread the pain across Europe and beyond.”

The second is horrible: “the impact of complete break-up is dramatic and traumatic. In the first year, output falls by between 5%and 9% across the various former member states, and asset prices plummet. With their new currencies falling by 50% or more, the peripheral economies such as Spain and Portugal see their inflation rates soar towards double-digits. Meanwhile, Germany and other core countries suffer a deflationary shock. Indeed, with the US dollar surging on safe haven flows to the equivalent of 0.85 EUR/USD, the US also suffers a bout of deflation.”

He concludes that: “without extended preparations for EMU exit, the risk of at least a temporary breakdown in payments systems would be enormous. In our complete EMU break up scenario, the cumulative loss of output in the first two years is close to 10%, dwarfing the loss that followed the collapse after the demise of Lehman Brothers in September 2008.”

Yeuch.

So I do wonder what our banks are doing to protect us from such a disaster by preparing contingency plans for the Eurozone collapse. Believe me, they are creating contingency plans.

Mind you, it’s more cheery than the note I got from the economists at the Royal Bank of Scotland, who “strongly believe that a cliff-edge may be around the corner, for the global banking system (particularly in Europe), and for the global economy (particularly in the US/Europe).”

This one is written by Andrew Roberts, who is “amazed there is not now immense market & media focus on the new letters that will bring forward the end-game and worsen it.”

The 'new letters' to which he refers is the SEC Rule 2a-7 which came into force on 30th June, and demands that US money market funds take a safer position when it comes to their investment policies.

There’s US$2.8 trillion of 2a-7 funds, and this rules demands that they now own 30%, not 5%, of assets in sub 7-day liquid paper. In other words, money that is available for access if liquidity is needed within seven days.  This means investing a third of the portfolio in short-term bonds and gold, whilst avoiding longer term investing in things such as ... er, sovereign debt.

“We can all see the logic – the sovereign defaults from EMU have the power to hit EMU banks badly, and the USA does not want to repeat the calamitous ‘breaking the buck’ problem when” they let Lehmans collapse.

Mr. Roberts believes that “the USA is basically pulling up the drawbridge and retreating into its fortress, trying to protect its financial system from coming European banking problems. But the consequence is clear. Banking is about confidence. If you are reliant on markets to fund yourself and that confidence wanes, a total stop can occur immediately/within days. Northern Rock (75% reliant on wholesale markets) was the first example of this in the UK, though not the last. Once we apply 2a-7 to our economic slowdown/deflation themes, this means one thing. If there is a slowdown and sovereign trouble, the problems facing EMU banking have through this rule potentially become a whole lot worse. This worsens – and brings forward – the ‘cliff edge’ potential.”

Jeez, this sounds serious although one of my mates tweeted a response: “surely history tells us RBS haven't the faintest idea what the economy might or might not do?”

Thing is that it’s not the end of it.

Morgan Stanley, for example, put this chart in their gloomy outlook:

And state that: “euro area banks’ exposure to the EMU periphery could amount to about €140 billion. Germany’s banking sector seems most exposed to Spain, France’s to Greece and Spain’s to Portugal ...

European banks are more wholesale-funded than any other major banking system. According to our equity analysts, European banks have €3.3 trillion of senior wholesale funding – almost half due in 2010-12. We think that providing extra liquidity might help to buy time, though the fundamental problems are unlikely to go away very easily. Bank recapitalisation, further fiscal restraint and structural reforms might help to address the underlying issues.”

Looking at the other economic outlooks, thye’re all talking about the euro, the Eurozone and the probability of a double-dip recession being high.

That blows my tracker fund investments then.

Guess, I'll just have to put all my money on the Netherlands winning the World Cup finals.  After all, going Dutch only means spending half of the cost rather than having to take all of it!

The World's Top 20 Banks 1994-2010 ... Anglo-American Banking Rules!

I’ve just received this month’s Banker magazine which the editor, Brian Caplen, describes as their most important issue of the year as it covers the latest Bank 1000 listings.

This year’s listings show a surprisingly stable crew of American and British banks.

World   Bank                               Tier One              Pre-tax
Rank                                            Capital                profit
                                                      $m                    $m
1        Bank of America Corp        160,387.77           4,360.00
2        JP Morgan Chase & Co       132,971.00         16,143.00
3        Citigroup                          127,034.00          -8,445.00
4        Royal Bank of Scotland       123,859.00          -4,366.29
5        HSBC Holdings                   122,157.00           7,079.00

Considering the crisis was meant to have killed these banks, you may find it surprising to see that Citigroup and RBS have maintained their leading positions.

This is down to the fact that the Banker measures a bank’s strength by its Tier 1 Capital, and so their positioning is more of a reflection of the sheer size of these firms than by their brand or market capitalisation, which is used in some other studies of size.

The Banker’s data is fascinating though, as the database also contains profitability, revenue, cost-income ratio and more, so it’s a useful tool in all senses.  And the online data goes back to 1996, so you can do some useful comparisons.

Mind you, my data - old Banker magazines - goes back even further so I quickly took a snapshot of a few useful year’s – 1994, 1999, 2004, 2008 and 2010 – to see how things have changed.  Mapping out the Top 20 banks of the world for each year makes for an interesting picture (doubleclick the picture to see a larger version):

Back in 1994, Japan ruled the world.

Then their economy went South and Origami Bank folded, Sumo Bank went belly up, Bonsai Bank cut back their branches and something fishy went on at Sushi Bank where staff got a raw deal.

Post-Japan’s slump, the Anglo-American financial system ruled. So you would think that, as that system failed, it also would have gone South.

Not the case.

Maybe that’s a reflection of the sheer scale of investment American and European firms have put into these economies to avoid such a crash.

Well worth spending time looking at the data and looking forward to playing around with it further.

Y Viva Espana ... nein

Over the past week, I’ve spent time conferencing in the Spanish cities of Barcelona and Santander. In the case of the latter, my family thought I was going to a conference in the bank’s vaults, and I had to get a map out to show them that there actually is a city called Santander.

Now Spain has had a right old drubbing lately. Breathed in the same breath as Greece, Spain is viewed as being on the brink of failure and could bring down the Eurozone all on their own, although Portugal, Italy and Ireland may also have a say in this.

Their only saving grace is that they actually have a football team who played in this World Cup, unlike France, England and Italy.

Mind you, the Germans are also playing some pretty neat football with Sebastian Schoepp giving Spain a good kicking in the German newspaper, Sueddeutsche Zeitung.

The tone of his article may be summarised as follows:

Spain was a country full of donkey trails and decaying villages but now has the fourth largest Eurozone economy, behind Germany, France and Italy. But its economy is all built on sand, as it was all developed using the unsustainable property boom, where Spanish businesses sold sunshine to Brits, Germans and Scandinavians. The sad fact is that Spaniards have been living beyond their means and now need to pay the bill. Its banks sit on mountains of bad loans and foreign speculators will sell Spain short just as Sir Francis Drake did to their galleons three centuries ago (is this guy not English?).

OK, Spain is a bit of a sick dog of Europe, but is it really that bad?

In some respects, yes.

At the banking conferences I attended, a common theme is that Spanish banks over-expanded and now need to retrench. For example, there is a move to close down at least a quarter and maybe a third of all Spanish bank branches.

How come so many, I ask?

The answer is given to me that so many branches were opened to support and fuel the property boom that these branches are now desolate, unwanted, unnecessary and unforgiven.

Banks are on the back foot ... but not all banks.

I recently blogged about how Spanish banks are thriving in social media. But these are the big banks and community banks. Savings banks, regional banks and mid-sized banks are all closing, merging and consolidating.

Apparently, Zapatero’s government has been actively pushing for banks to merge rather than close, although regional and local governments across Spain also have a say in this.

Meanwhile, the economy sinks further with unemployment at 20%.

This makes Spain's economic mess one of the worst in the Eurozone.

In reality, that figure is underestimating anyhow, as these figures vary by city, town and village, with the average rate reportedly running at 25% unemployed rising to almost half the population in some areas.

Add onto this over developed property markets that cannot shift property, and this will continue to be an issue for the longer term.

The Spanish construction issues are also made worse by the fact that, like Dubai, a lot of the developments involved migrant workers from Eastern Europe, South America and Africa.

Money movement corridors for remittances are therefore well developed in Spain, but these have been impacted too.

First, many migrant workers have gone home as there is no new construction taking place.

Second, volumes and values of remittances have gone through the floor.

Third, there are too many money transfer agents.

On this third point, that's for a reason.

According to the remittances conference I attended last week, there are around 25,000 money transfer agents in Spain which is almost the same number as America, and these figures need to come down to around 10,000.

But then someone else tells me that Spain doesn’t have 25,000 agents. It’s just 10,000 but with 2.5 exclusivity licences each.

What?

Well, most money transfer operators want their agents to be exclusive.

This may be a problem but not for Spanish agents who have been getting around such rules for years. For example, papa signs an exclusivity agreement with Western Union, mama signs one with Moneygram and bambino signs one with Travelex.

This is going to change as the Payment Services Directive (PSD) says that money transfer firms cannot have exclusivity licences.

Well, says my Spanish remittances friend, the PSD is irrelevant here in Spain as we use derogation rules to get around anything that might cause an issue or impact our domestic markets.

Ah well, that’s Spain for you.

And this is why the German journalist was so vitriolic, as he’s not only worried that Spain will be another Greece but that, with their lackadaisical attitudes towards rules and regulations will be much worse.

This could be much more of a drag on the German economy and the Eurozone as a result.

To make matters worse, the FT reports today that the European Central Bank (Frankfurt!) has just put the hee-bee gee-bees up the Spanish Banks sails by refusing to extend their loans:

Spanish banks have been lobbying the European Central Bank to act to ease the systemic fallout from the expiry of a €442bn ($542bn) funding programme this week, accusing the central bank of “absurd” behaviour in not renewing the scheme.  On Thursday, the clock runs out on the ECB financing programme – the largest amount ever lent in a single liquidity operation by the central bank – under the terms of the one-year special liquidity facility launched last summer.

Oh dear?

Will this push Spain to the brink and, therefore, the Eurozone?

Is there any optimism here?

Maybe.

Spain does have problems, but many of the conference attendees told me that they think they are getting over the worst of it.

The exodus of migrant workers has halted, and volumes and values of money transfer are now stable.

The property disaster may come to an end.  OK, it’s unlikely that Brits, Germans and Scandinavians are going to come back to Spain with remortgages for second homes, but retirees and holidaymakers still want sunshine.

And, for all of its foibles and practices, Spanish folks are nice people to get along with. Sure, some folks might want to kick ‘em up the rear-end but that doesn’t mean kicking them when they’re down if we're serious about a European Union for the future.

And finally, for all of Spain’s economic issues, it’s still not a bad place to be.

However none of the optimisms above fix the loan mountain that Spanish banks sit on.

In summation, don’t expect Spain – or Portugal, Ireland, Italy and Greece – to get their act together fast or to sort out their issues without further hostility and acrimony between Europe's nations.

The EU will have its biggest test for the next decade to see if it’s getting its act together. In fact, as Gideon Rachman said in the Financial Times last week, Europe is having a midlife crisis and some folks emerge from a crisis with a new sense of purpose whilst others just get divorced.

Unless Europe continues to behave in a united fashion, where Germany and France keep banging the drum of the Eurovision, then we may well go back to a disenfranchised and disenchanted Eurozone.

A broken one.

And I guess that it is the net:net of my Spanish reality.

For the European Union to continue, it really just boils down to whether Germany and France can keep it together.

Oh dear ... think I’ll go down the pub to watch Spain and Portugal battle things out in the World Cup finals.

Sources: Private Eye for the cartoon and Fabio joke, and The Week for the links to articles

BIS report French and German banks $1tn exposure

French and German banks have almost $1 trillion exposure to Southern European economies according to a Bank of International Settlements (BIS) report released last Monday (Download BIS report).

“Exposures” include loans, loan commitments, and derivatives contracts, and represent the cost to the banks if there were a default.

All in all, Europe's banks have almost $1.6 trillion exposure to the four countries most susceptible to default in the Eurozone: Portugal, Ireland, Greece and Spain. $727 billion of exposures to Spain, $402 billion to Ireland, $244 billion to Portugal, and $206 billion to Greece.

This builds on the chart I posted at the end of last month, but provides a more in depth view of the goings on.

This is why the EU changed the rules last week for the way it looks at breaches of their rules on debt and deficits, by introducing a “dynamic debt” policy. This policy is based upon debt being allowable above the previous limits, as long as that debt is going down.

So that’s alright then.

Except that the level of debt is meant to be under 60% of GDP and yet, according to the latest economic forecasts by the European Commission, the average level of debt is going to reach 88.5% of overall Eurozone GDP in 2011 and 83.8% for the EU as a whole,

Eurostat figures published in April (12-page PDF) reveal that the highest debt-to-GDP ratios are 115.8% in Italy, 115.1% in Greece, 96.7% in Belgium, 78.3% in Hungary, 77.6% in France, 76.8% in Portugal and 73.2% in Germany. Malta (69.1%), the UK (68.1%), Austria (66.5%), Ireland (64.0%) and the Netherlands (60.9%) came next.

Mind you, this measures only public debt to GDP ratios, e.g. the government’s exposures, and many EU countries are arguing it should cover aggregate debt which would include the private sector borrowing levels. If this were taken into account, then the UK would lead the pack of debtors.

Expect this all to be reviewed and redeveloped under new EU rules announced on 30th June.

What fun!

Europe: broken nations borrowing from broke nations?

After the downgrade of Greece led to the Greek crisis and the Germans worried about bailing them out, the crisis continues with the downgrade of Spain at the end of last week by Fitch.

In fact, it looks like many European countries are worried, with the PIGS now the PIIGS – Portugal, Ireland, Italy, Greece and Spain – whilst Hungary, the Czech Republic, Andorra and Montenegro are so hard up they couldn’t even send their national broadcast channels along to Oslo, to cover the Eurovision song contest over the holiday weekend.

So we asked the question: what happens if the euro fails, and the answer was: a great deal economically, politically and nationally, but not much in banking. The EU creations of SEPA and Chi-X would continue.

But what is the real likelihood of the euro failing?

Not much to be honest.

If it were open to failure, there would be far more concern being demonstrated at this week’s G20 meeting, and the truth is the Americans and Chinese – the other two large regions exposed to the EU – are comfortable with the two-pronger approach being taken by the European Commission and member states.

For example, Reuters reports:

“Early this month G20 governments were clearly worried that some European countries might not be able to summon the political will to confront their public debt problems. U.S. President Barack Obama spoke personally to Spanish Prime Minister Jose Luis Rodriguez Zapatero to urge him to implement budget reforms. G20 officials held conference calls to discuss European policy.

“Since then, Europe has come up with a two-pronged strategy. One prong is a string of national austerity schemes designed to bring state budget deficits and public debt down to safe ratios of gross domestic product in the next few years.

“The most heavily indebted states on the periphery of the euro zone, Greece, Portugal, Spain and Italy, have announced austerity drives this month. Even France, a stronger country, has acted, announcing an intention to enshrine deficit-cutting in its constitution.

“The other prong is emergency liquidity support from rich nations to give time for austerity steps to work; this ensures countries retain access to financing even if they lose the ability to fund themselves in the debt market, as Greece has.

“In addition to a 110 billion euro bailout of Greece, European nations are creating a financial safety net for indebted countries that along with support from the International Monetary Fund could total 750 billion euros -- three-quarters of the total public debt of Greece, Portugal, Ireland and Spain.”

So all is well and good in the garden of Europe.

Or is it?

As mentioned before, Germans are pretty unhappy about the Greek situation.

So I was quite interested when Mike Warner, CEO and founder of Quantum4D – a data visualisation firm – sent me this graphic (doubleclick image to see larger version):

Ouch!

What this clearly demonstrates is that:

Germany thought they owned Greece but they don’t – France do;

The total Greek exposure is €120 billion;

Germany and France have far more exposure to Spain (over €450 billion worth); and

By comparison, Britain is getting off lightly ... about the same levels of exposure as the Dutch.

Who wants to be in the euro, you might ask, but the Estonians still do.

Why?

Why would anyone want to be in the Eurozone today?

Because tomorrow it will be better. It will be a region that is as resilient, strong and powerful as China and America ...

... or is it more to do with this lovely little news skit from our friends in Australia?

This is a comic news report from ABC News’ mirthmakers John Clarke and Bryan Dawes, and is based upon a million dollar gameshow format (in the UK, this is Mastermind).

Here’s my slightly edited transcript:

QUIZMASTER: Your name is Roger yes?

CONTESTANT: Roger.

QUIZMASTER: Good. And what do you do Roger?

CONTESTANT: I'm a financial consultant.

QUIZMASTER: Fair enough. Okay, Roger your special subject tonight is the economies of the European community. Your time starts now. Best of luck.

CONTESTANT: Thank you.

QUIZMASTER: How much does Greece owe, Roger?

CONTESTANT: $367 billion.

QUIZMASTER: Correct. And who do they owe it to?

CONTESTANT: Mostly to the other European economies.

QUIZMASTER: Correct. How much does Ireland owe?

CONTESTANT: $865 billion.

QUIZMASTER: Correct. Who do they owe it to?

CONTESTANT: Other European economies mostly.

QUIZMASTER: Correct. How much does Spain and Italy owe?

CONTESTANT: $1 trillion each.

QUIZMASTER: Correct. Who to?

CONTESTANT: Mainly France, Britain and Germany.

QUIZMASTER: Correct. And how are Germany, France, Britain going Roger?

CONTESTANT: Well they're struggling a bit, aren't they?

QUIZMASTER: Correct. Why?

CONTESTANT: Well ‘cause they've lent all the vast amounts of money to other European economies that can't possibly pay them back.

QUIZMASTER: Correct. So what are they going to do?

CONTESTANT: They're going to have to bail them out.

QUIZMASTER: Correct. Where are they getting the money to do that from, Roger?

CONTESTANT: That is a good question. I don't know the answer to that one.

QUIZMASTER: How much does Portugal owe?

CONTESTANT: Hang on a minute, what was the answer to that earlier question?

QUIZMASTER: Just keep answering the questions Roger. Where is Portugal going to get the money it owes to Germany, if Germany can't get back the money that it lent to Italy?

CONTESTANT: Just a minute. What was the answer to the previous question? The question was: How can broke economies lend money to other broke economies, who haven't got any money because they can't pay back the money the broke economy lent to the other broke economy, and shouldn't have lent it to them in the first place because the broke economy can't pay back?

QUIZMASTER: You are wasting valuable time Roger. How much money does Spain owe to Italy?

CONTESTANT: $41 billion. But where are they going to get it?

QUIZMASTER: Correct. What does Italy owe to Spain?

CONTESTANT: $27 billion but they haven't got it - they're broke.

QUIZMASTER: Correct. How can they pay each other if neither of them has any money?

CONTESTANT: They're going to get a bailout, aren't they?

QUIZMASTER: Correct. And where is the money coming from for the bailout?

CONTESTANT: That is what I'm asking you!

QUIZMASTER: Correct. Why are people selling the European currency and buying the US dollar?

CONTESTANT: Because the US economy is so much stronger than the European economy.

QUIZMASTER: Correct. Why is that Roger?

CONTESTANT: Because it's owned by China.

QUIZMASTER: Correct and very well done! And after that round you've lost $1 million.

CONTESTANT: I've lost $1 million? I thought you said well done!

QUIZMASTER: Yes well done - you've only lost $1 million. That's an extraordinary performance Roger.

Thanks to Philip Brady from Oz for the tip-off re Clarke and Dawes.

When's the next financial crisis and what will cause it?

WARNING: THIS BLOG ENTRY WILL NOT CHEER YOU UP [sorry]

I spent the morning with a group of futurists debating the long-term outlook for financial markets and am never sure about the usefulness of such debates, although there is definitely something of use in creating scenario plans for the future which is where we were focused.

The key question I kept asking myself during the conversation is: when will the next financial crisis take place, what will cause it and is it predictable?

To answer the first part of that question, we only need to look back in history.

If we take the first financial crisis as the fall of the Roman Empire then it was about 1,000 years until the second financial crisis occurred, with the collapse of the Medici banks of Renaissance Italy. Four centuries later, the South Sea Bubble and Great Tulip Collapse took place. 250 years after that, we hit the Great Depression; and 80 years after that we imploded in the Subprime Crisis and Global Credit Crunch.

Sure there were plenty of hiccoughs along the way - LTCM, Asia, Russia and Latin American implosions in the late 1990s for example - but global crashes have been notable.  Loosely speaking, global crisis are now occuring twice as fast as the previous ones:

• 1,000 years – the Roman Empire to the Medicis
• 400 years – the Medicis to the South Sea Bubble
• 250 years – the South Sea Bubble to the Great Depression
• 80 years – the Great Depression to the Subprime Crisis

On that basis, you could bet on the next crisis being anything between thirty and fifty years from now.

2040 to 2060.

So what would cause the next financial crisis? After all, we’re only just trying to get through this one. Surely we can regulate to avoid another one?

Maybe not.

Here’s a view you could take of the factors that contribute to the next financial collapse. I should say that it doesn’t make for fun reading, but the logic could have some grain of accuracy.

2011

Banks globally are heavily regulated, taxed and governed to avoid another subprime crisis. The focus is on derivatives, liquidity, capital and governance.

2012

The European Union struggles through a fragile and fallow period of financial and political instability with Portugal, Italy, Greece and Spain managing to just about maintain Eurozone requirements. Unfortunately, it is at the expense of citizens and governments in many of these nations.  In fact, the cuts and tight budgets in these Southern member states creates a major movement of economic migrants from Southern Europe into Northern Europe, with the associated tensions and fissures appearing between Northern Europe and Southern Europe as a result.

The outcome is that Europe never quite achieves the competitive economic zone it dreamed of becoming.

2016

China opens its markets to full financial servicing, with a rocking stock exchange in Shanghai that becomes the world’s second major investment banking city by volume and value by 2020, just behind New York  This is combined with a revaluation of the Remnimbi (RMB) that satisfies their critics but worries some, particularly the USA, as the Chinese currency is looked towards by the investment community as a possible alternative reserve currency.

2019

Rather than creating a reserve currency for the world, the investment community creates a basket of currencies to avoid too much exposure to risk in one economy – after all, they don’t want a repeat of the 2008 crisis. The basket includes Euro, RMB and Dollar, along with Gold and other commodities. Nevertheless, the decision to place a weighting towards RMB rather than the Dollar creates issues for the USA, which has spent most of the 2010s in stagnation.

2022

The Middle East enters a major crisis, as oil becomes less needed as a commodity due to the rise of alternative energy sources and conversion of many motorised vehicles to electricity. Iran and Israel go to War and there is a huge effort by the United Nations to bring stability to the region. Eventually, Sovereign Wealth from the GCC outflows towards new and rising economies, such as Africa, and tensions continue to rage across the region on an ongoing basis.

2025

Africa’s economy is raging onwards and upwards. Like the BRICs of the 2000s, Goldman Sachs creates a new investment portfolio known as CAGES – Congo, Angola, Guinea, Ethiopia and Sudan – where natural resources of platinum, cobolt, gold, diamonds, manganese, uranium, chromium and tantalite are abundant. Johannesburg is rising fast as one of the largest world financial centres.

China is now the largest trading partner and region with Africa, thank to their investments at the turn of the century. America finds this to be particularly challenging, as their view of Africa had been one of occupation and charity, rather than investment and growth, during this period.

But China doesn’t care too much, as China has now become the world’s largest economy.

2028

American and European investment firms decide to make RMB the reserve currency of the world, and drop the concept of the basket of currencies.

2032

The quiet rise of India as the world’s second largest economy had largely gone unnoticed but, in 2032, for the first time China’s economy had less than 3% growth. This was put down to the lack of skills in the country where skills were needed, and is a reflection of the aging population in China and lack of new blood. China’s one-child policy of the previous century, and a distinct lack of female population for the overly male populated society that resulted, means that 2 in every 5 citizens has reached or is near retirement age. This, combined with strict immigration controls, places a strain on continued growth and industry.

2039

India’s continually booming economy has created frictions between their Chinese border rivals, and a Cold War commences between the two nations. Like the Cold War of the previous century, no arms are traded or battles take place, but the economic controls freeze out much of China from India’s trading partners and vice versa. The result is an economic climate where India’s investment community trade with India and China’s with China.

There are ripples through the Shanghai and Mumbai stock exchanges as a result.

2044

India continues to see success as a stable and harmonised country. China appears to be becoming more unstable as the government struggles to maintain investment and trading, and avoid the inflationary pressures created by their exposure to investments in Africa for future commodities that can no longer be utilised.

The economy fails to achieve growth rates above 1% for three quarters, and the government determines that the Remnimbi needs devaluation. This angers the USA and Europe, who have major investments in Chinese land and other illiquid stocks, along with major reserves of Chinese currency.

The decisions taken by the Chinese government force them to look towards India and Africa.

2050

The outflow of investment by American and European investment houses from China results in aggressive currency arbitrage between the Chinese RMB and the Indian Rupee, with the latter winning as the RMB’s reserve currency status ends.

The resultant big time betting against the continued stability of China causes the Cold War between India and China to spill over into skirmishes.

The world sees a period of major instability ensue and the China Crisis is put down to currency speculation amongst the world’s capital markets created by complex foreign exchange instruments intertwined between the major economies.

Nothing to do with housing this time.

Jeez, that was a depressing vision and I told you this conversation wouldn't cheer you up.

Thank goodness it’s just fiction.

However, if you like this sort of future conjecture and dialogue, you are welcome to join us for two more optimistic discussions (hopefully) at the FSClub in June:

Monday, 07 June 2010
The Long Now of Finance
A panel discussion with Professor Michael Mainelli and guests

This evening is dedicated to a panel discussion focusing upon: "The Long Now of Finance - a Framework for the next 10,000 years".

Many financiers and academics are beginning to focus upon how to invest in long-term projects that secure the planet for our children and grand children and great grandchildren. Short-term thinking is killing the planet. So how do we think long term: the Long Now, and how do we fund it: Long Finance?

Long Finance is an initiative begun in 2007 by Z/Yen Group in conjunction with Gresham College, to establish a World Centre of thinking on Long-Term Finance. The initiative began with a conundrum – “when would we know our financial system is working?” and has worked on a variety of projects, including the signature program focused upon an Eternal Currency.

This debate will be chaired by Professor Michael Mainelli, a cofounder of Long Finance and Executive Chairman, Z/Yen Group.

Monday, 14 June 2010
The Future of Banking, a discussion with Professor Ray Barrell, Professor David De-Meza and Professor Donald MacKenzie of the Economic and Social Research Council, chaired by Brian Caplen, editor of the Banker Magazine.

The Economic and Social Research Council (ESRC) is the UK's leading agency for research funding and training in economic and social sciences. Established in 1965 as the Social Science Research Council, under a Royal Charter, the ESRC covers a wide range of disciplines, ranging from anthropology to statistics with a budget that has grown from £73 million in 2001-02 to £204 million in 2009-10. Financial services are a key sector for the Council's business engagement strategy. The ESRC is partnering with the Technology Strategy Board on the new Financial Services Knowledge Transfer Network. This evening the ESRC has kindly agreed to host a discussion focused upon the Future of Banking featuring three very distinguished scholars.

Professor David De-Meza is with the London School of Economics and has published many papers on banks policies in a wide range of journals. He is the on the Council of the Royal Economic Society and the Institute of Economic Affairs; Associate Editor of the Journal of Industrial Economics and Joint Managing Editor of the Economic Journal.

Professor Donald MacKenzie is a Professor of Sociology at the University of Edinburgh, with work that has constituted a crucial contribution to the field of Social Studies of Finance. He has also undertaken widely-cited work on the history of statistics, eugenics, nuclear weapons, computing and finance, and was awarded the Chancellor's Award from HRH Prince Philip, Duke of Edinburgh and Chancellor of the University of Edinburgh, in August 2006 for his contributions to the field of Science and Technology Studies.

Professor Ray Barrell is a visiting professor at Brunel University, Director of Macroeconomic research and Forecasting for the UK and World Economies, and Senior Research Fellow at the National Institute of Economic and Social Research. Previously, he has been a visiting Professor of Economics, Imperial College, London from 1996 to 2004, and was a part-time professor at the European University Institute, Florence, 1998-1999. He is on the editorial boards of Economic Modelling and was on the board of the Journal of Common Market Studies until 2007.

What happens to SEPA, Chi-x etc if the euro fails?

There’s the classic old joke about the European dream being a place where the police are English, the chefs are Italian, the car mechanics are German, the lovers are French and the bankers are all Swiss. The nightmare is that it is a place where the police are German, the chefs are English, the car mechanics are French, the lovers are Swiss and the bankers are Italians.

It seems that the nightmare is coming true, although the basket case is Greece and the bankers are German.

Last week’s surprising comments from German Chancellor Angela Merkel that “the euro is in danger” and “if the euro fails, Europe fails” sent shudders across the world’s markets, and probably made Brussels shake with rage.

But the Germans are shaking with rage. After Nicolas Sarkozy was rumoured to threaten Merkel with France’s withdrawal from the euro if she didn’t step up to the plate and support a Greek bailout, Germany’s citizens have been demonstrating their rage by printing deutsche marks whilst the national newspaper, Bild, is stirring anger towards the EU and the Greeks in particular with headlines such as:

• "How much more do we have to pump into this country?" April 26th
• "Why are we paying the luxury pensions of the Greeks?" April 27th
• "Greeks ready to cut back? They would rather strike!" April 28th

As I talk to German colleagues, they refer to Greece as the Golden Fleece and that they aren’t paying bills in Greek restaurants because they’ve prepaid to 2020.

All of this puts a huge strain on the European Union, in its fragile 53rd year of unity, particularly as Spain, Italy and Portugal are considered to be on a par with Greece by many, forming a Southern European Union called the PIGS [Portugal, Italy, Greece and Spain].

It raises a key question in my mind, and I’m sure all of the bankers I deal with: if the euro fails, what happens to the monetary union of banks, the Financial Services Action Plan and all those bank and insurance directives like Solvency II, MiFID and the PSD?

What happens to Chi-X, SEPA, the EBA and the rest?

In order to answer this question, you have to look at two key areas. First, is the economic and monetary union (EMU) broken? Second, if it is, do we throw away the eighteen years of change introduced by the agreement to launch the euro when the Maastricht Treaty was signed in February 1992?

Let’s take the first question: is the EMU broken?

We asked this question in 2005, when the French and Dutch threw out the EU Treaty. Answer: it is political union that they were rejecting, not economic union. Note: even with their rejection, and the Irish no vote, the Treaty became the Lisbon Treaty in 2010 regardless of such resistance. In other words, in the interests of the long-term vision of Europe, Europe wins.

Equally, America has taken years to gain its United status, starting with a nation of disparate states that had far less history than those of Europe.  Their Union was easier in comparison, and that still took years, so Europe’s union will take time and will face many more tests.

But this is the greatest test so far.

The size of this test should not be underestimated as it is the first time that we are seeing an economic union, resulting in a cascading effect upon money and politics. Historically, the tests for Europe have been mainly about how much power is ceded to Brussels. This test is showing the inter-relationship between economies and Germany’s anguish is that if they are to keep the vision of Europe in harmony, then they have to pay for it.

Therefore, returning to the rejection of the European constitution, that was a political rejection and when a country has an economic crisis, the monetary union means that other nations pay and, as a result, that political will is tested when one nation's tax dollars are taken to pay for another nation's debts.

That is why this challenge is so much greater than any before, because it is testing the political will of citizens, not just their ability to trade and compete.

The core issue though, is that it is not just the Greek economy and Greece that would leave the Union if they were allowed to fail.  It is the Union.

Should the Greek economy fail to honour their government bonds due to being economically bankrupt, the ratings agencies and banks would downgrade Spain, Portugal and Italy, and there would be a spiral effect. This means the European Union breaks apart.

That is why the Greek failure option is unpalatable ... but is the alternative palatable?

Why do we need a European Union?

Answer: Europe needs to be a Union to maintain its drive to be a regional superpower, and competitive commercially and economically with China and America. There’s the rub. If Europe fails, then the UK, Germany and France fail, as parity to compete internationally and intraregion becomes far more difficult.

This is why Greece needs the bailout and why Germans are paying.

It does not help Angela Merkel maintain her status or power hold in Germany – her popularity is sinking faster than the Titanic – but if Greece fails, it is felt that Europe may fail too. And that is not an option seen to be agreeable today.

Also, nations have been bailed out already.

Two years ago, Spanish banks received over €50 billion worth of ‘aid’, in the form of mortgage-backed securities with the European Central Bank (ECB), when they faced a property meltdown.

Did the Germans wail out about that bail out?

No.

Why?

Because it wasn’t on the front page of the Bild.

That bail out was smaller and less obvious, so no-one really noticed.

The Greek bailout is a bit bigger – €110 billion – admittedly, but it is supported by the IMF and is necessary for Europe’s future. ‘nuff said, although if you want to know more, Robert J Samuelson in the Washington Post provides a particularly good overview of why Europe needs to support Greece.

My summation is that Europe will survive this crisis, the euro will stay and the currently ridiculous pricing of US$1.24 to the euro will reverse within the next month or so, as forecasted by most economists.

But let’s look at the worst case scenario: what do we do if the euro does fail? Does it mean we unravel all we’ve done to date?

This is the second and, in some ways, more important question: is there a backup plan?

OK, if the Eurozone breaks apart, then it matters ... but it will not throw away all that has been built to date.

The banks will still want to use cross-border instruments that work. They will just bring back a margin to represent those cross-border movements whilst maintaining the efficiency of the infrastructure that has been built.

As Werner Steinmuller, Head of Global Transaction Services of Deutsche Bank, stated when we researched the Payment Services Directive (PSD) and the Single Euro Payments Area (SEPA) last year:

Deutsche Bank is in a comfortable situation. We spent quite a sizable amount on SEPA infrastructure and have a brand new system that is extremely capable of doing this that is also highly scalable. Others have not made this investment so this gives us a price advantage. We have built some conversion solutions for handling old volumes and now can run both old instruments and the new SEPA instruments so, if SEPA is coming, we are extremely well positioned. If SEPA fails, I can write off the investments and still win.

In other words, the SEPA process has forced the banks to build new infrastructure, new systems and new efficiencies in transaction processing. That will stay.  It does not go away if the euro goes away, as the new infrastructure is designed to handle efficient transactions, not euro payments.

So if we look at SEPA Credit Transfers and Direct Debits, the Euro Banking Association (EBA) and STEP2 ... it will all stay. The EBA will be a private consortium to operate efficient systems, rather than a government initiative to create efficiency, and it will stay. There will be a charge for this, and a charge that could provide a substantial return to the banks that created this infrastructure, but it will not go away.

The same will be true for Chi-X, and the capabilities electronic trading platforms have introduced into the European equities markets. Sure, some countries may want to block and reverse policies in these areas – Spain? – but the process of regional investing is unstoppable now. Goldmans, Merrill, BarCap and co, won’t want to see this go away, so it will remain.

Bottom-line: the efficiency of European payments and investing is in the interest of banks, corporates and institutions today, not just governments and policymakers.

So, if the euro fails, my answer is that the all the investment made by the financial markets in efficient systems will stay.

It will just be at a profit rather than a regulation.

Are Asian corporates the same or different?

After writing earlier this week about the bullish views of HSBC on China and Asia as a whole, with the clear view that the world has decoupled, Asia is self-sustaining and China will be the largest economy in the world by 2035 or sooner, I was really interested to hear the views of Damian Glendinning and David Blair.

Damian Glendinning is Vice President & Treasurer with Lenovo, the Chinese PC firm, having previously worked for IBM in NYC, USA. David Blair is Treasurer with Huawei, the Chinese telecoms firm, having previously been treasurer with Nokia in Helsinki, Finland.

In other words, we have two guys in senior jobs at Western firms who have moved East. If anybody can explain the world of China, their outlook and view of the West, it’s these guys.

The main discussion came from Damian’s presentation titled: Asian Multinational Corporations (MNCs) – are they the same or different?, with the point being whether they act like European or American firms, or whether they have their own unique outlook.

Again, not verbatim, but here’s the summary of Damian’s presentation and yes, it’s very useful if you really want to know what’s going on in the world of Asia:

Asian Multinational Corporations (MNCs) – are they the same or different?

First, I think the question is wrong. It’s not Asia we should focus upon, but emerging markets including Russia, Brazil and Latin America.

We’ve seen massive growth in emerging markets for the past decade. For example, according to JPMorgan, GDP growth from 2002 to forecast in 2012, not compounded, is an average 11% growth in China, 8% in India, 7.5% in emerging markets overall. This compares with an average 2.5% across the world, and an average 2% growth in the USA, 1.5% in G7 countries and just 1% in Japan.

As you can see, the country with the lowest growth rate for the last twenty years is an Asian country – Japan – whilst two of the main emerging markets are also in Asia – China and India. So my first comment would be: don’t treat Asia as just some homogenous mass and remember that there are other emerging markets, particularly Brazil, that should be included in this discussion.

The companies which dominate these emerging markets are now not just international firms, but major MNCs:

• the top three banks by market capital are Chinese
• Tata, Mittal are huge Indian conglomerates
• InBev of Brazil is a very large drinks company

Part of the reason for the fast growth of these firms is that their technologies are better. For example, Lenovo are ripping out the IBM IT systems and implementing Lenovo ones. We expect a huge increase in productivity as a result.

Another factor about these companies, is that their home markets are under threat from Western firms who are looking towards emerging markets for growth. These foreign competitors are a major threat, as they can invest significantly to gain market share.

This means that the critical question emerging markets MNCs are asking is that, if you are the market leader in a domestic emerging market, what do you do?

You either expand or you face severe threat from foreign firms and, as the best method of defence is attack, you end up creating aggressive expansion and acquisition plans because you have to. That is a major factor in the reasoning as to why Lenovo acquired IBM’s PC division, why TATA bought Jaguar and Land Rover, why Geely buys Volvo and why Arcelor were bought by Mittal.

Sure, these sound like major expansion plans into overseas markets, but all of these acquisitions are to expand in markets where growth rates aren’t great. These Western brands do not offer growth as they are in mature markets where growth is less than 2%.

If you compare that to the strength of emerging markets, which is based upon growth, then you realise that any acquisition of a western brand is a pure defensive move, not an expansionist one.

I had this realisation when I realised that a decade ago, I lived in New York driving a British car, a Jaguar, and working for an American firm, IBM. I now drive an Indian car, still a Jaguar, and work for a Chinese firm, Lenovo. I suppose the only good news there is that Jaguar, a UK firm, is now being subsidised by Indians rather than by Americans.

So why are these firms buying into mature markets?

What they are buying is brand, access and knowledge of how these markets work.

They then have the challenge of how to make these acquisitions work.

Any firm expanding overseas has challenges, and the challenge here is whether they want to be a true MNC, or an international firm head officed in China or India.

The difference between an international firm and a MNC, is that a MNC has a broad base with diverse senor management whilst an international firm is controlled its from domestic HQ, with key positions occupied by home country nationals and standards imposed by the home country.

The latter are always seen as foreign, whilst the former is far more integrated.

Asian MNCs would historically include examples such as Toyota, Nissan, Hitachi, Sony, Honda and more from Japan; Hyundai, Samsung and LG from Korea; Lenevo, Huawei from China.

This means to be a MNC you have to make acquisitions.

Then you encounter all the other issues, with the biggest challenge being culture. A MNC is different because corporate culture in MNCs is stronger than national cultures. This is why international firms don’t work as well as MNCs.

Another big issue is merging IT platforms, as rarely can a MNC operate on multiple systems, so there has to be an evolution towards a single platform.

A further issue is pride. A Western firm acquired by an Eastern firm has employees who may feel slightly lessened by being owned by Mumbai or Shanghai rather than New York or Frankfurt.

The recent movement in banking is a good example, with high street banks taking over investment banks. Investment bankers have many qualities, but being modest is not one of them, so moving from working for a prestigious Wall Street brand to a common High Street one is not appealing to many of them. This is why so many of these people have moved firms.

Equally, buying an American firm if you come from a low income market, creates challenges develop about pay differentials and attitudes.

So the real issues for an emerging market corporation is where do you go for growth, particularly when developed markets are not growing.

Today, it means that you do look towards other emerging markets, but that creates other risks.

Now risk is interpreted differently based upon your view of the world.

Risk in financial context used to mean that emerging markets firms would look towards working with Western banks, because banks don’t fail, right?

Now, Chinese banks don’t fail, right!

Emerging markets MNCs will therefore say to you today to explain risk management. What are the qualities of risk management that you can give to us in the East, developed in the West? And you complain about our strict regulatory environment, but maybe our regulations aren’t such a bad thing. And with all of your systems and controls, tell us how they work again.

In fact, emerging markets can be less risky because government intervention can prevent overheating in the economy. Remember that the current crisis was purely one seen in developed markets, not in emerging economies.

We actually like our regulations because regulations can prevent excesses. There is no subprime lending in India or China, there’s a lack of derivatives and leverage has been pretty much smothered ever since the financial crisis which occured over here in 1997 to 1998,

Payment disciplines are different too.

For example, Days Sales Outstanding (DSO) for Lenevo in Asia is 15 days. This is because everyone knows payments are a problem, so we offer early payment incentives. In the USA, 30 days is our typical DSO whilst, in Europe, it’s 60 days. So, tell me where the risk lies?

Equally, where are the countries with excessive external debt?

China, Brazil and Russia are down at the bottom of the league table for sovereign debt, because we do not have leverage in emerging markets; whilst, at the other end of the table, the UK, USA, Japan and many European countries are leveraged to the hilt. So tell me, where the risk lies?

In conclusion, we are seeing MNCs coming out of emerging markets, but more because they have to as a defence than that they want to. As a result, they have to grow in developed markets, but the risks and reward are poor and, for many, they would feel more comfortable acquiring and growing in other emerging markets, where there are better opportunities for growth and less issues with regulatory barriers and other hurdles because, as an emerging market firm, they are used to them.

We will see some convergence with traditional MNCs, but we will also see some big differences. For example, emerging market MNCs are far more open than their counterparts, because they are buying in skills and intellectual property to integrate the workforce, not alienate them.

So I can’t tell you what the world will be like tomorrow but I can tell you it’s going to be different, and the future MNC will be much more open and embracing than those of the past.

China will be world's largest economy by 2035

So I’m hiding out this week in Singapore at the Eurofinance Cash, Treasury and Risk show for Asia.

I love this conference as you get here and see the sponsor’s names – HSBC, JPMorgan, RBS, Deutsche Bank, Standard Chartered and Bank of America Merrill Lynch.

There ya’ go, you just know it’s gonna be a rich week of food, entertainment, wine and song. None of that cheapskate IT show stuff, where everything has to be managed on a teensy-weeny small budget. No, this is way beyond the small budget syndrome so I know it’s gonna be fun.

It’s also gonna be fun because it’s in Singapore, a place I first came to in 1987 when, if my memory serves me right, the Merlion fountain sat in the grounds of the Raffles Hotel which sat in its own unique position on the Peninsula Marina.

Today, Raffles is surrounded by buildings, hotels and skyscrapers, and the Merlion statue has moved.

That’s progress, but then Singapore is a progressive place.

I won’t say too much about Singapore though as, if you’re interested, National Geographic had a superb supplement analysing all features of the country. I won’t say too much about the article, except that it’s opening gives away that it’s a great story:

“How did a sleepy little island transform into a high-tech powerhouse in one generation?” by Mark Jacobson

If you want to get a Singaporean to look up from a beloved dish of fish-head curry—or make a harried cabdriver slam on his brakes—say you are going to interview the country's "minister mentor," Lee Kuan Yew, and would like an opinion about what to ask him.

"The MM? Wah lau! You're going to see the MM? Real?"

You might as well have told a resident of the Emerald City that you're late for an appointment with the Wizard of Oz. After all, LKY, as he is known in acronym-mad Singapore, is more than the "father of the country." He is its inventor, as surely as if he had scientifically formulated the place with precise portions of Plato's Republic, Anglophile elitism, unwavering economic pragmatism, and old-fashioned strong-arm repression.

Unfortunately, it’s also a country I find difficult to enjoy straight away as I took the overnight flight from London which gave me about three hours sleep in 36 hours, so I spent yesterday fitfully sleeping on and off and watching crappy movies on HBO and Star ... but at least in Singapore you can watch crappy movies in the English language, unlike hotels in Europe where fitful night hours are dulled with non-stop CNN news.

Back to the conference though and Robert Prior-Wandesforde, Senior Asia Economist with HSBC, gave the opening speech: Asia - aren’t you glad to be here?

Here are my brief notes:

Asia - aren’t you glad to be here?

The economic recovery began around the second quarter of 2009 for most economies, and Asia’s industrial production index is now back on track, exceeding the peak pre-crisis levels of 2008. This unlike the Eurozone and USA, which took such a shock that their output is still at levels below 2000.

This means that Asia has reached a self-sustaining cycle, without dependency on USA and Europe, and the concerns over decoupling have not materialised because Asia is no longer coupled with the other geographies as they were a decade ago. In fact, Asia now has a virtuous circle of growth, based upon strong domestic demand, which boosts imports and exports, which helps lift personal income and profitability, which creates more domestic demand.

That is why HSBC forecasts year-on-year export growth of 20 %+ in the region, which is crucial to the level of sustainability of a recovery here in Asia.

But how can that level of export growth be the case when you have the mess that’s in the EU and America?

Answer: a lot of increase in demand has just been within Asia.

So we have this old world view of the American consumer being the consumer of last resort, but it has changed. For example, Korea’s electronic shipments to China and China’s shipments of electronics to the USA were closely coupled at the start of the 2000’s. Today, they are not.

Over the last 18 months, Korea’s exports to China have surged significantly but China’s exports to the USA have not. So it does suggest that the Korean products are going to China and staying in china. This is true not just for electronics, but for motor vehicles and more.

In other words, it’s the Chinese who are shopping!

Historically, China has been an export and investment led economy. That isn’t going to change necessarily, but the fact that private consumption as a share of GDP in China is about 36%, it singles the country out from others in the G20, such as the USA where private consumption is over 70% of GDP.

Equally, savings as a percentage of household disposable income has risen to almost 40% in China over the last decade, up from under 30% at the end of the 1990s. That compares to about 3% in the USA.

Why they are saving so much is, according to a survey of citizens by the Central Bank of China, for their child’s education and their own retirement. These are Chinese citizens’ major concerns and the Chinese government are therefore trying to change this mindset to encourage consumerism.

This does not mean a massive swing to USA-style consumerism, but does mean giving more assurance to citizens about education and pensions so that they save less and spend more.

If this does change the mindset of the people of China, then even a few percentage points swing to spending rather than saving will have a massive impact as it will change the habits of 1.4 billion consumers, not just a few million.

This does not mean that Asia does not need the USA and Europe though, and the risks of continued growth or not are related to America and Europe’s issues.

America has delivered better than expected results for the past few quarters, and so there is recovery there.

In Europe, there are different issues and the concerns about Greece are major. But Greece is a small country in Europe, and the contagion kicked off is not necessarily justified as Spain and Italy, which have been caught in this maelstrom, are different to Greece. Spain’s government debt to GDP ratio is half of that of Greece’s, whilst Italy does have a government debt issue but the budget deficit there is half of Greece’s.

The fundamentals are different but, overall, we do expect governments in Europe to increase taxes and reduce spending, with the UK being one of the critical countries to face that challenge.

In summary, Europe as a region may be in continued recession but you have to look to Germany, which stands out and is still motoring forward. Germany’s economy is about ten times the size of Greece’s and is stable. So there are positive indicators in the region along with those negative ones.

Other worries may be things like the end of policy support from governments, which is unlikely; the end of inventory-led growth, which is also unlikely; exchange rate appreciation, but that assumes demand disappears, and we cannot see that happening as Asia is now self-sustaining.,

There are also concerns about an asset-bubble boom and bust in China. For example, seventy Chinese cities saw property prices were up 12% year-on-year and, in Singapore, it is even more marked with private residential prices up 30% in just the last nine months.

In China, you then need to look at GDP growth, which was up 12% in the first quarter and nominal GDP growth for the last year was 15%, so a 12% rise in property prices makes sense.

What about inflation?

Inflationary pressures are showing some signs of issue, as it is growing rapidly with a bigger underlying inflation problem in the region anticipated for 2011. This means that asset price bubbles could develop in a more meaningful way going forward.

The issue here is that many of the Asian central banks are unwilling to tighten interest rate policies, but interest rates will need to be watched and managed carefully in Asia this year if we are to avoid an asset bubble next year.

Remnimbi is also a topical issue, with the Yuan:$ exchange rate pretty well fixed over past few years. The more pressure the USA puts on China to untie that fix, the more likely China will not do anything but we do think that China will appreciate the exchange rate later this year. It won’t be a massive revaluation of the remnimbi, however. It will just be tentative.

This is because China is worried about their exporters and want to avoid any double dip recession within China, so we expect it to be around a 5 percent appreciation of the Yuan against the US$ over the next nine months.

Longer term, our view is that we expect China to overtake the USA economy by 2035.

In other words, China will become the largest economy of the world in 2035, with the USA and Europe closely behind, and India nipping at their heels.

The only thing that can hold this back is that China’s government are showing too much concern right now about a double dip recession and asset price boom domestically, whilst India does have an asset price bubble and inflationary issues.

The Central Bank of China and Reserve Bank of India must get to grips with these issues to realise these dreams.

 

What do criminals, bankers and Warren Buffett have in common?

Some years ago, I delivered a presentation as a keynote with the title: “All Bankers are Criminals”.

I actually didn’t mean “all”.

The chicken feed, battery farmed, commercial, transactional and retail bankers are pin-stripe suited, humble pie, nice guys.

I was talking about the evil animals of Wall Street and the City.

These jungle animals hunt you down, rip out your wallet and tear your money apart note-by-note.

OK, I exaggerate a little, but you get the idea.

The first time I gave this presentation was back in Summer 2005 at a European Conference, and repeated it again in Spring 2006, as an Associate Director of TowerGroup.

The theme of the presentation mainly came from Frank Partnoy’s excellent book Infectious Greed, which traces the growth of weapons of financial destruction: derivatives, as named by Warren Buffett in his 2002 shareholder letter.

It is quite clear from this book that unchecked investment markets will run free of scruples and morals. This is what happened with Frank Quattrone of Credit Suisse and the dotcom boom and bust, along with many other examples through history.

It is not necessarily as true when we talk about arbitrage strategies and the John Meriwether’s of this world. However, these people are far more dangerous because they create financial markets systemic risk that can bring down companies and countries.

For example, in case you are wondering who John Meriwether is, he was one of the first arbitrage players and built Salomon Brothers into the big swinging dick master of the universe world so brilliantly depicted in Michael Lewis’s book Liar’s Poker.

With his colleagues, the use of arbitrage instruments led to the downfall of Salomon Brothers – they were subsequently merged into Citigroup – and Meriwether went on to create Long Term Capital Management (LTCM).

In 1998 LTCM lost $4.6 billion in less than four months and became the leading case study for how systemic risk created by derivatives products, combined with massive leverage and arbitrage risk-models, creates a financial deck of cards.  A deck that can rise and fall in the blink of an eye, with the latter potentially ruining companies, markets, countries and governments, as happened in the most recent crisis.

Anyways, not to be dissuaded from his cause, Meriwether went on to found JWM Partners, another highly leveraged "relative value arbitrage" firm. Yet again, he built leverage through this hedge fund from its opening with $250 million under management in 1999 to a massive $3 billion firm by 2007. Of course, it was all just on paper as the latest crisis battered the fund, losing almost half of its value between September 2007 and February 2009.  The deck of cards strikes again.

It closed in late 2009 and guess what? Meriwether’s about to launch yet another hedge fund, based upon just the same concepts.

To me, this is the criminality of the financial system in action. Firms that build highly leveraged derivatives instruments for short-term arbitrage, with unproven skills and massive risk.

Not that I’m calling Meriwether a criminal, as it’s all perfectly legitimate under SEC and FSA Rules.

Or it was.

It may be that the Goldman Sachs furore will change all this.

You see, Goldman Sachs, like Meriwether, is very good at taking leverage and risk and managing the markets to gain short-term profit.

Like Meriwether, Goldman Sachs succeeded in using these tools and instruments to generate massive profits. They achieved a record 131 trading days last year, in which the bank made at least $100 million net trading revenue each day.

Unlike Meriwether, Goldman Sachs managed to offload and hedge their risks back to others, such as AIG and IKB, such that when the markets collapsed their clients, suppliers and partners got burnt, but not them.

Nothing wrong with that, as it’s all perfectly legitimate under SEC and FSA Rules. Unless the SEC and FSA find Goldman Sachs guilty of fraud.

But how can they be guilty of a crime that was not a crime at the time it was committed?

There’s the rub.

I’m sure the SEC will aim to build a bulletproof case, and their cause is a worthy one: clean up the financial system.

Is it worthy to do this so publicly?

Not sure.

Is it worthy to name the defendant up front, when the burden of proof has yet to be proven?

Not sure.

The Goldman Sachs case is actually more like watching a rape trial in action, where the defendant is a shifty looking guy who probably seems guilty whether guilty or not.

For example, if you name someone like Jack Tweed in the UK, you might still associate him with being a rapist even though he was found not guilty.

The guilt sits there, and that’s what will happen with Goldman Sachs.

Whether guilty or not – and they’ve hired the best team possible to defend themselves, including “Master of Disaster” Mark Fabiani – we will always associate Goldman Sachs with something smelly for the foreseeable years to come.

Ho-hum.

At least all of this seems to inspire some humour. For example, in an April episode of hit comedy US TV series This American Life (TAL), they tell the story of a hedge fund that comes up with an elaborate plan to make money. It sponsors the creation of complicated and ultimately toxic financial securities while, at the same time, betting against the very securities it helped create.

TAL commissioned a Broadway song to go along with the story:

Bet Against The American Dream from Planet Money on Vimeo.

The only thing that really gets me, in finishing this blog entry, is Warren Buffett.

The Sage of Omaha has made his billions through prudent focus upon ‘value investing’. That means investing in strong and robust businesses like Coca-Cola, American Express, Gillette and the Washington Post.

So when he referred to derivatives as ‘weapons of financial destruction’ in his shareholder letter of 2002, I respected the man and his integrity of thought.

Now, having found Goldman Sachs under attack, he has stepped up to their defence, and I wondered why.

Warren Buffett is an intriguing character, as we all know. The friend of kings and kingmakers, he walks a path separate to most.

He knows the dangers of arbitrage, derivatives and leverage, because he had to step into Salomon Brothers in 1991 to clean up Meriwether and his colleagues mess.

An extract from Carol Loomis’s in-depth review of Buffett’s experience at Salomon’s:

“You may reasonably ask what was going on in Salomon's stock while all of this was transpiring. It was emphatically down, from above $36 per share on Friday to under $27 on Thursday, when the second press release rocked the market. But the stock was only the facade for a much graver matter, a corporate financial structure that by Thursday was beginning to crack because confidence in Salomon was eroding. It is not good for any securities firm to lose the world's confidence. But if the firm is "credit dependent," as Salomon was to an extreme, it cannot tolerate a negative change in perceptions. Buffett likens Salomon's need for confidence to a mortal's need for air: When the required good is present, it's never noticed. When it's missing, that's all that's noticed.

“Unfortunately, the erosion of confidence was occurring in a company grown enormous. Salomon in August of 1991 had bulged up to $150 billion in assets (not counting, of course, huge off-balance-sheet items) and was among the five largest financial institutions in the U.S. Propping the company on the right-hand side of the balance sheet was--are you ready?--only $4 billion in equity capital, and above that was about $16 billion in medium-term notes, bank debt, and commercial paper. This total of about $20 billion was the capital base that supported the remaining $130 billion in liabilities, most of these short-term, due to run off in one day to six months.”

The result meant that Warren Buffett had to actually take over physically as manager of Salomon Brothers for a nine-month period, and it was emotionally exhausting for him.

Switch to 2010.

Warren Buffett invested heavily in Goldman Sachs in September 2008 – when Lehman Brothers, Merrill Lynch and Morgan Stanley were all imploding – buying $5 billion of preferred stock at a 10 percent dividend. These investments earn him $950 a minute, or $500 million a year today. No wonder he claims to be in love with that investment.

Trouble is that the alleged fraud at Goldman Sachs has really hit their share price.  For example, Standard & Poor's downgraded Goldman shares to "Sell" and lowered their target price by $40 to $140 the other day.

Goldman Sachs shareprice, courtesy of Yahoo!, already down $40 ...

Thinking back to Salomon's - if the firm is "credit dependent," as Salomon was to an extreme, it cannot tolerate a negative change in perceptions - Buffett must be seriously worried about Goldman Sachs losing its credit worthiness, especially as it depends on good credit.

Oh yes, and having called derivatives ‘weapons of financial destruction’, guess what? Berkshire Hathway, Warren Buffett’s investment firm, has a massive portfolio of derivatives investments.  From the Wall Street Journal last week:

“Democrats took a step toward their goal of overhauling financial regulation, reaching a tentative deal to set restrictions on trading in exotic financial instruments known as derivatives. Among the considerations still in the balance: A big provision being sought by Warren Buffett in recent weeks ... the provision, sought by Berkshire and pushed by Nebraska Senator Ben Nelson in the Senate Agriculture Committee, would largely exempt existing derivatives contracts from the proposed rules. Previously, the legislation could have allowed regulators to require that companies such as Nebraska-based Berkshire put aside large sums to cover potential losses. The change thus would aid Berkshire, which has a $63 billion derivatives portfolio, according to Barclays Capital.”

Hmmm ... maybe that greed is infectious, although Morningstar Analyst Bill Bergman supports Mr. Buffett's exemption by stating that: "claiming Berkshire poses a risk to the financial system is a difficult case to make."

Either way, the US movement towards an approval of a Financial Reform Bill to handle the issues of banks that are 'too big to fail' yesterday, takes it one step nearer to the American system taking a lead role towards a new financial architecture. 

Derivatives are next ... and Warren Buffett, like Lloyd Blankfiend at Goldman Sachs and all of those current and former bankers and brokers who dealt in toxic derivatives across the world, must be worried.

 

Postnote: here is Berkshire Hathaway’s full commentary on derivatives from that shareholder letter back in 2002:

Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.

Having delivered that thought, which I’ll get back to, let me retreat to explaining derivatives, though the explanation must be general because the word covers an extraordinarily wide range of financial contracts.

Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values. If, for example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction – with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration (running sometimes to 20 or more years) and their value is often tied to several variables.

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands.

The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).

At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. Or say you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. No problem – at a price, you will easily find an obliging counterparty.

When we purchased Gen Re, it came with General Re Securities, a derivatives dealer that Charlie and I didn’t want, judging it to be dangerous. We failed in our attempts to sell the operation, however, and are now terminating it.

But closing down a derivatives business is easier said than done. It will be a great many years before we are totally out of this operation (though we reduce our exposure daily). In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit. In either industry, once you write a contract – which may require a large payment decades later – you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability.

Another commonality of reinsurance and derivatives is that both generate reported earnings that are often wildly overstated. That’s true because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them.

Those who trade derivatives are usually paid (in whole or part) on “earnings” calculated by mark-to-market accounting. But often there is no real market (think about our contract involving twins) and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions. In the twins scenario, for example, the two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

Of course, both internal and outside auditors review the numbers, but that’s no easy job. For example, General Re Securities at yearend (after ten months of winding down its operation) had 14,384 contracts outstanding, involving 672 counterparties around the world. Each contract had a plus or minus value derived from one or more reference items, including some of mind-boggling complexity.

Valuing a portfolio like that, expert auditors could easily and honestly have widely varying opinions.

The valuation problem is far from academic: In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.”

I can assure you that the marking errors in the derivatives business have not been symmetrical.

Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.

Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. (At Gen Re Securities, we still have $6.5 billion of receivables, though we’ve been in a liquidation mode for nearly a year.) A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times.

In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain.

When a “chain reaction” threat exists within an industry, it pays to minimize links of any kind. That’s how we conduct our reinsurance business, and it’s one reason we are exiting derivatives.

Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.

Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.

On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.

Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-Term

Capital Management, caused the Federal Reserve anxieties so severe that it hastily orchestrated a rescue effort. In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM – a firm unknown to the general public and employing only a few hundred people – could well have posed a serious threat to the stability of American markets. In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market for weeks, was far from a worst-case scenario.

One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate

100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes.

Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.

Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

Do building societies have a future?

Great write-up by David Calder for the Caledonian Mercury of Monday night's meeting in Edinburgh:

Do building societies have a future?

That will be at the heart of discussions at the Building Societies Association annual conference in Manchester next week and it was the topic for debate at a meeting of the Financial Services Club in Edinburgh last night.

The Director General of the Building Societies Association, Adrian Coles, acknowledged that parts of the sector have been under stress. He showed slide after slide detailing its woes: the shrinking size of the market; repossessions up and savings down; the number of owner occupiers dropping for the first time since the 50s; the fall in new lending – down 88% – and the 60% fall in transactions.

He claimed that one of the reasons why building societies had “got into a mess” in the final years of the 20th century was that “…the FSA didn’t set up a dedicated building society team until 2008. And our problems came at the same time as the major banks were collapsing. They felt they had to focus on those financial institutions that could bring the economy down.”

But curiously, he was not pessimistic about the sector’s future ...

Read the rest on their website and you can find many of Adrian's slides here.

  

Joseph Stiglitz: Poster Boy

Just back from a short haul flight to Spain.  Reading the BA Business Mag, I stumbled across this  (doubleclick photo to see the full-size picture):

Yes, it's Joseph Stiglitz: Poster Boy!

Actually, it's the Nobel prize winner Joseph Stiglitz, economist and professor at Columbia University.

In a short interview, he talks about life and views of the world and the financial crisis, with a key section on the bank bailout:

You’re very critical of the bank bailouts worldwide and particularly in the US. Why?

The main reason is that the bailout failed to do what it was supposed to do, which is rekindle lending. It gave money unnecessarily to the banks without getting anything in return, the result of which is that we have a much bigger national debt than we otherwise would have had, if we’d done it better. And we didn’t have any vision of where we wanted the financial system to go, so we’ve wound up with a more distorted financial system with more weight on the gambling institutions and less weight on the institutions that actually create a better economy. Because we bailed out the banks, and not just the banks but the bankers, shareholders and bondholders, we enhanced the problem of moral hazard — we created a system of ersatz capitalism where we socialised the losses and privatised the gains.

Read the full interview here.

UK banks: over £1 trillion of maturing debt

Earlier this week Adrian Coles, Director-General of the Building Societies Association, gave a fascinating presentation to the Financial Services Club Scotland on the state of the UK's Building Societies sector.  

The presentation didn't actually say too much about Building Societies but was more of a reflection of where we are with the mortgage and savings markets in the UK, and a sad story he told.

Rather than writing down Adrian's presentation in full, it's probably easier to share a few hand-picked slides which tell the tale.

First, here's the gross and net UK lending figures for the past decade:

 

 

EEK!!  Net Lending is the lowest it's ever been.

No wonder house sales are so tepid ...

 

But what was really worrying is that Adrian had picked on two of the Bank of England's Financial Stability Report Charts to illustrate that the situation isn't going to get any better.

The first is the maturing funds of UK banks' wholesale liabilities, by instrument and year of maturation:

This was in the June 2009 chart section of the Bank of England's report, and shows the ballooning debt maturity mountain peaking in 2011.  In other words, banks' stringent lending conditions will probably remain in place until that debt bubble bursts.

Interestingly, this chart was dropped in the December 2009 Financial Stability Report, but is just as well illustrated by Chart 2.19:

[CGS and SLS are the Credit Guarantee Scheme and Special Liquidity Scheme introduced by the current government as our equivalent of TARP]

The figures speak for themselves.

UK banks need to cover £1 trillion of maturing debt over the next four years, including the re-securitisation of £250 billion worth of Residential Mortgage-Backed Securities ... don't expect another house price boom in Britain for a while.

 

Note: Adrian's presentation is available in full to all Financial Services Club members

 

Why the G20 will disagree with the IMF reforms

I don’t know if any of you read the IMF report recommending two new bank taxes:

• a bank levy based upon the risk banks represent, called a Financial Stability Contribution (FSC); and
• a straight tax on profits and bonuses called the Financial Activities Tax (FAT).

If you haven't, then I can recommend it's worth a skim.  For example, they reject the Tobin Tax / Robin Hood Tax idea, saying that this would just get passed on to customers by the banks. 

However, the fact that they support the idea of a levy and a tax – a double whammy – could have bankers worried ... except that bankers are pretty clever at tax avoidance and Canada and Japan have said they won’t implement these plans so it’s a G18 agreement right now, or less.

In my view, the document is also flawed.  Here's why.

The document itself is just for discussion for the G20 Ministers meeting this week, with the aim of agreeing something in June.  It was leaked by Robert Peston over at the BBC, and has created a fair bit of mileage for him with two blog entries: IMF wants two big new taxes on banks and How much would IMF bank taxes raise?

Robert's estimate for the latter is about £5 - £10 billion ($7.5 to $15 billion) per annum.

The leak has also sparked a whole range of other headlines, including:

Leaked IMF document urges two new taxes for banks - The Times
IMF recommends double tax whammy on the world's banks - The Independent
IMF urges double tax hit on banks to refund taxpayers - The Telegraph
IMF warns over sovereign debt - The Independent
Post-crisis banks must refinance $5 trillion - The Times

And here’s the document itself (Download IMF G20 Document, 57 page pdf).

All well and good.

Now the actual content is debatable and not set in stone.

As I said, it’s for discussion.

But it does contain some really interesting appendices which are noteworthy as useful research materials, covering diverse subjects from each country’s proposals for reform to their contributions to the bank crisis to date.

For example, here are the amounts announced or pledged for financial sector support so far, as a percentage of 2009’s GDP (doube-click chart to see a bigger version):

What this shows is that for the ‘advanced economies’ – think USA, UK, France, Germany, Japan et al – the cost has been 6.2% of GDP in direct support and a further 10.9% in guarantees.

The total of columns A to E represents 29.8% of advanced economies’ GDP in 2009.

That compares with 1.8% in the emerging economies – think the BRICs, Indonesia, et al. 

Mind you, they then go on to say that “for the advanced G-20 economies, the average amount utilized for capital injection was 2 percent of GDP, that is $639 billion, or just over half the pledged amounts. France, Germany, the USA and the UK accounted for over 90 percent of this. For the advanced G-20 economies, the utilized amount for asset purchases was around 1.4 percent of GDP, less than two-thirds of the pledged amount. Similarly, the uptake of guarantees has been markedly less than pledged.”

This is why the report reckons that the global financial crisis has cost about $533 billion less than originally estimated, and is now just a mere $2.28 trillion when all is said and done.

Now how much is $1 trillion again?

Thanks Mint.

So yes it’s still a lot, but it’s half a trillion dollars less than before.

Phew!

Now who’s the daddy when it comes to global bailouts and guarantees:

Wow, the UK wins!

We’re number one, we’re number one, we’re number wohohohohone.

Wait a minute.

That means we’re #1 in global bailouts of banks.

Hmmm ... not sure if we should be so thrilled with that accolade and maybe this is why Gordon Brown is so keen on the idea of a Tobin Tax or a Robin Hood Tax or a Financial Activities Tax or ... well, any tax really to help with our debt mountain to be honest ...

Source: the Daily Mail

... as the burden of national debt amongst the G7 nations is at a 60-year high, with the UK’s Treasury planning to increase national debt by over £560 billion between now and 2015. That’s about $800 billion or almost a trillion (how much is a trillion again?).

Meanwhile, the emerging economies paint a very different picture:

Apart from Russia, this crisis has cost the key future economies of the world urrmmmm ... nothing.

These charts make it clear that NINE of the G20 nations have had no crisis. Add to this the fact that Canada’s financial system has been the most stable in the world, and Japan do not intend to implement these tax and levy options, and you realise that under half of the G20 will be keen to support any radical changes to the financial markets.

It's not as clear cut as this, as the fact that the Advanced Economies bailouts allowed the Emerging Economies to survive this crisis without their economies also imploding is a key part of the dialogue.

Another useful chart shows why the IMF has reduced the bailout numbers by $533 billion where financial markets have used far less of the pledged amounts than those offered by their respective governments:

Finally, these charts are followed by a review of each country’s bank taxation policies implemented or proposed (Appendix 2, Page 32), a review of corrective taxation and prudential policies (Appendix 3) and the current taxation policies (Appendix 4).

This last section is also particularly intriguing as it demonstrates why banking has been so critical to Gordon Brown’s policies of the past decade. For example, here’s the percentage of a country’s total tax pool raised from financial firms by country.

G20 Corporate Taxes Paid by the Financial Sector (in percent)

This makes it clear that for every country, but particularly for Italy, Turkey, Canada and the UK, the role and influence of the financial sectors on their economies and government policies is fundamental to the country and its economic and public sector health.

Without bank taxes, countries fail.

But with bank failures, countries fail.

And that is their Catch-22 and the reason why this is so hard to change.

Between domestic interests and focus, aligned with the radically different ways in which this crisis has impacted each G20 nation, it is unlikely that we shall ever see a simple agreement of policy reform now, or at the G20 meeting in Toronto in June.

UPDATE: 23rd April 07:50

Looks like the head of the IMF agrees with me:

IMF Says Financial Revamps Could Thwart Global Deal

The International Monetary Fund's managing director said he worried that rivalries among countries could thwart a global overhaul of financial regulation, as governments split over the merits of an IMF proposal to levy a new tax on the world's banks.

"The risk…is that different parts of the world will have their proposals which make sense" to them, but "which may be somewhat inconsistent," Dominque Strauss-Kahn said at a press briefing ahead of this week's meetings of financial officials from around the world.

Come and join the Ryanbank

Going back to the idea that a bank could offer a widget-based business model of functionality and that everything these days is free, makes me realise exactly what tomorrow’s bank will look like.

The thought struck me yesterday when I took my brother-in-law’s lad to see Clash of the Titans – more my thing than his – and we purchased tickets via the internet. This meant that we self-served, but the cinema charged us an extra £1.80 handling fee for doing so.

Duh?

We have avoided their peanut paid staff having to say: “Which screen? What time? How many?” by doing it ourselves, and yet they’re charging us for it.

When we saw the movie, they charged us £6.90 for reduced size popcorn and coke, and then an extra 80 pence for 3D glasses, even though we’d already paid an extra £3.50 to get into the 3D theatre. 

Duh?

Why the extra charge for the 3D experience plus a charge for the glasses, and who is going to go into a 3D theatre without glasses?

All in all, the experience cost about £40 for drinks, petrol, treats and extras, for something that will be on Sky+ HD within a week or two.

Warraripoff.

And that’s when it hit me as the whole thing reminded me of Ryanair, who charge a levy of £5 ($7) per leg of a trip per passenger.

Why not open the Ryanbank, based upon building a bank services around the Ryanair (South West Airlines for Americans) business model.

Why Ryanair?

Well, love ‘em or hate ‘em – and most of my snobby business class flying mates hate ‘em – they offer a stripped down service with no bells and whistles but, if you want the bells and whistles, you pay for them.

The love em or hate em debate is raging right now over at the Telegraph, after columnist Bryony Gordon bet her flat on no-one using the words ‘marvellous’ and ‘service’ in the same line as ‘Ryanair’.

This debate intrigued me thanks to the over 90 respondents to her comments – most of whom love Ryanair's service.  I particularly liked Alan James’ response: “I think it bloody marvellous that Ryanair provides any service”, although he doesn't win her flat for that response (unlike Ryanair who just might, according to this press release: Ryanair to Seek Journalist’s ‘Flat and Contents’).

No, what really intrigued me is the number of people who get Ryanair, and this is evidenced by the comments.

What I mean by this is that you just need to understand their business model and, if it suits you – and it doesn’t suit everyone – then it’s brilliant.

Their business model is this: if you want to travel as cheaply as possible, then you’ll love us. If you want some snobby service, then get lost and fly with BA.

For example, I fly with Ryanair regularly to Dublin. Ryanair are cheap, punctual, regular, very convenient and it all flows incredibly well. For these meetings, I have no hold baggage, just a carry-on; I don’t want any special service; it’s a short haul flight; and I don’t mind the things that are irritating - their charging policies, especially their policy of adding £5 per leg per passenger for a credit card booking - as it’s appropriate for these needs.

On the other hand, they do have some things that let them down. For example, I flew with Ryanair to Rome last year for a holiday, and that was a disaster. Their limit of one 15kg bag per person in the hold was almost impossible to adhere to and meant that the whole experience left us feeling exhausted and disgruntled.

But hey, they’re not British Airways, which is what my family are used to, so take it or leave it. It’s cheap, cheerful and it works.

So get with the business model and work it.

That’s what many of the responses to Brynoy’s blog articulate very well. Here’s a small selection:

Jamie: All they have done is break the fare down into bits allowing you to pick what you do want and leave out what you don't.

Old Codger: I fly Ryanair whenever I can. Plan ahead, use your pre paid card, take on hand luggage - Yes that simple. Pisa for a £1 - yup, Rome for... you get the picture. Retire & travel the world (maybe?) with Ryanair. I Love Ryanair.

Alan: Ryanair only suits people that are able to read and understand the terms and conditions - like check in on line, don't bring check in size bags if you have not already paid for them, don't be late and read the destination information for where you arrive ... no Ryanair and we would still be paying the crazy prices of the 80s to travel and air travel would be for the rich only.

Geoffrey Walker: I have no complaints. Never late. Never on strike. Never loses baggage (if you have any). Dirt cheap if you know your dates and book in advance. What else do you want?

And so on and so forth.

So here’s the rub: Ryanair broke down the business model and made it clear that you could fly for nothing. Then they add on charges for all the other bits.

You want to take a lot of luggage. You pay.
You want to eat and drink on board. You pay.
You can’t be bothered using the internet to check-in. You pay.

In other words, for those who want cheap flights with no frills, you got it. For those who want BA or similar style services, go and pay more to fly with them instead.

I could labour the point further, as it’s a critical point, for this is the concept for one of tomorrow’s banks.

A bank that offers free banking, free cards and even free credit.

All core bank services are free.

But there are rules.

First, your services are all paid for through sponsorship.

Hence, before you can make any transaction, you have to wait for a 15 second video ad to play for Pringles, McDonalds, the next Harry Potter movie or whatever (all of which are personalised to your tastes of course).  For the more frequent transactions, such as balance checks, then they can just be supported by banner ads and google ads.

Second, you can only deal with the bank for free via an internet or mobile internet service. You cannot talk to someone or visit a branch.

Yes, we have branches and call centre operations, but the fee is £1 per minute to call us or £5 to visit inside the branch.

Third, any charges from correspondent banks for services you use – e.g. if you make a payment to someone and it is rejected – are added to your monthly billing.

You get the picture.

Gradually, you create a smorgasbord of services, some of which are free and some are fee-based. The customer can effectively have a whole bank service for nothing if they work the rules. However, break the rules and they pay.

Students and the thrifty Ryanair demographic audience would suit this bank.  Equally, for the unbanked and underbanked, a plain and simple sponsor-based system for bank services would work.

You want personalised service. Go away and deal with the big banks.

You want basic, cheap and cheerful banking. Come and join the Ryanbank.

Why ICBC didn't buy Citibank

Good friend of the FSClub Emmanuel Daniel joined us this week to talk, about the future of banking and the rising influence of Asian banks, especially those from China and India.

Emmanuel Daniel is the founder of The Asian Banker, a leading provider of strategic business intelligence on the financial services industry for the Asia Pacific and Middle East region.

He began with a review of the composition of the largest banks’ income streams, which shows that the truly global banks keep a small home income balance (doubleclick images to make them bigger) ...

... by comparison with banks from larger countries like the UK and US, which are essentially domestic in their income even if they were international ...

... whilst banks from smaller countries like the Netherlands and Switzerland, have large earnings from outside the domestic base of the bank. 

He thinks the same trend will be the case if Asian banks globalise, namely that the ones from smaller countries will be truly international whilst the ones from larger countries, such as China and India, will be essentially domestic.

Emmanuel then raised the striking point that at one point during the financial crisis – March 2009 – many Asian banks, such as DBS, UOBC and ICBC, were larger by market capitalisations than the world’s former big banks, such as Citi and RBS.

So why didn’t these banks buy an American or European bank to make themselves global?

Emmanuel puts it down to culture and a fear of repeating past mistakes.

After the Asian financial crisis, many Asian banks were beaten up by American and European financial markets for being too lackadaisical with their management of risk, especially credit risk. Non-performing loans (NPLs) were rife across the Asian markets, and this led to huge issues.

As a result, Asian banks had looked to American and European banks for leadership practices and, when China opened its borders to foreign bank entry in 2001, it was the world’s global banks they sought for knowledge.

Now, these banks are looking around and saying: “whoa, there’s no-one out there who can help us but ourselves”, and this has led to the realisation that these banks are leaders themselves today.

Not only that, but these banks are big.

ICBC has 20,000 branches and over 400,000 staff, so change is a challenge. But these banks are changing and changing fast. For example, the Asian Banker presented an award to ICBC for consolidating 1,000 fragmented data centres into two in a program that took under a year to implement. That’s the sort of leadership these banks are achieving – best practices in data centre management; branch distribution and transformation; use of new technologies especially mobile; and more.

Equally, Chinese banks are now clearly generating profitable leadership, as around $20 billion in profit is created in Chinese banks every year. So, after a couple of profitable years, China’s banks could buy an RBS or Citi.

But they didn’t because they were not ready.

Indian banks are even more risk averse than the Chinese in this process, as their Chairman is normally elected when he is three years from retirement. As a result, an Indian bank rarely wants to make decisions that are aggressive or growth oriented. They would rather be boring and safe, and are incredibly account driven with a focus upon stability.

Equally, there is a lot of unionisation in India which halts change. For example, the State Bank of India has tried to introduce branch automation programs over the years but the unions have resisted this strongly as they don’t want to see job losses.

In contrast, China wants to create a long-term, sustainable, commercial banking model. This is unlike the Japanese who have far more interest in gaining global credibility in capital markets, as demonstrated by the likes of Nomura.

Emmanuel finally left us with something to think about, by bringing in the impact of technology and customer expectations to realise that our biggest fear may not be Asian banks but any small player who can disintermediate the larger banks just by being relevant.

All in all, a really insightful review of the state of Asia’s banks and the thing that surprised me most is that we haven’t seen an Asian bank become truly global yet.

But we will, with ICICI (India) and ICBC (China) being the two most active players today.

That's why Emmanuel reminded us that two global banks originated in Asia – HSBC and Standard Chartered - albeit run by British Chiefs.  Now, the question is whether the banking talent found in banks like ICICI and ICBC will throw up ambitions to repeat what their colonial masters did a century ago.