Dear readers,
As indicated in the previous newsletter we are preparing an academic paper on a potential alternative for central banks being a liquidity provider in times of crises and acting as the lender-of-last-resort. As you all know this is closely related to the moral hazard and too-big-to-fail issues.
Recent events have once again shown we are unfolding an endgame where socializing losses cannot continue at the current pace. Instead of a too-big-to-fail risk we are now entering into a dangerous zone of too-big-to-rescue.
In this weeks’ newsletter will show why we have reached this turning point with illustrated data on accumulated outstanding guarantees governments are taking onto their balance sheet. As an example we would take the EUR-zone country Belgium, which has recently come into the spotlight of financial markets due to the forced bailout of one of its banks. The author would like to stress that this is not an isolated case and that a similar exercise is trivial for other EUR-zone member states.
In case of the Kingdom of Belgium the current total public debt as a percentage of GDP is around 98%. Like many other governments this percentage rose quickly at the end of 2008 during the first Great Credit Crisis, in an attempt to save its banking industry.
As a reminder we sum up the amounts that were in large responsible for this rise of debt:
• 29 September 2008: Fortis Bank NV/SA a EUR 4.7 billion cash injection by the Federal Government of Belgium in exchange of 50%+1 shares in common equity of which 75% of shares were transferred to BNP Paribas. In exchange the Belgian Government became a 11.6% shareholder of the French bank. (bear in mind that at the moment of conversion the BNP Paribas share price was still well above EUR 60 per share compared to a share price of EUR 26.85 today)
• 30 September 2008: Dexia Bank NV/SA a EUR 1 billion cash injection of the Belgian Government next to another EUR 1 billion investment by the 3 regional governments of the country.
• 8 October 2011: Dexia Bank NV/SA is bailed out by France and Belgium, of which the Belgian government will pay EUR 4 billion for the Belgian franchise.
• 20 October 2008: Ethias received a EUR 1.5 billion cash injection by the 3 regional governments of the country.
• 27 October 2008: KBC Bank NV receives a EUR 3.5 billion direct investment by the Federal Government, where the proceeds are used to strengthen its Tier 1 capital by EUR 2.5 billion plus a solvency margin on its insurance business by EUR 1 billion. This operation is completed on the 19th of December 2009 by issuing non-transferable, non-voting core capital securities to the Belgian government at EUR 29.5 per share (current share price is EUR 9.5 per share). Then, the Flemish Government supported on aggregate another capital injection of EUR 3.5 billion between January 2009 and May 2009 based upon similar terms and conditions as the Belgian Government.
• On a side note, car manufacturers Ford Genk and Volvo Ghent received subsidies and tax relieves of respective EUR 9.3 million and EUR 300 million.
Unfortunately the rescuing of the banking industry did not stop with direct capital injections. Additional government guarantees had to be put in place for outstanding liabilities. The latter is becoming a hazardous situation for public finances in general.
As Belgium is concerned the following guarantees have been underwritten by the government:
KBC Bank: EUR 20 billion of which EUR 5.5 billion of super senior CDO risk and EUR 14.4 billion of counterparty risk on the mono-liner MBIA which wrote credit protection on the banks structured credit portfolio. 90% of default risk is guaranteed by the Belgian government with a 1st loss of EUR 3.2 billion.
Dexia Bank: during the first bailout in 2008 an aggregate of EUR 150 billion of guarantees were granted to the bank by France, Luxemburg and Belgium. These were up to EUR 90 billion re-written during the nationalization of the bank in October 2011, where the Belgian government takes up to 60.5% or EUR 54 billion of guarantees with a maturity of up to 10 years. Next to this guarantee the government inherits, as it is from now on the owner of Dexia Belgium, an un-collateralized credit line of EUR 20 billion to Dexia France. Apart from this credit facility it also inherited a sovereign bond portfolio of EUR 20 of which EUR 8.5 billion has exposure on Greece, Portugal, Italy, Spain and Ireland.
FSA (Financial Securities Assurance Inc.) a US daughter of Dexia NV/SA: USD 16 billion is jointly guaranteed by the French and Belgian government if losses exceed USD 4.5 billion.
Fortis NV/SA: EUR 150 million is guaranteed by the government for interbank transactions. Then a larger guarantee of EUR 5.365 billion is granted for a SPV that is set up to isolate toxic assets of Fortis.
Gemeentelijke Holding ( a cooperative structure of Belgian local authorities: among the regional and federal governments a guarantee of EUR 1.5 billion had to be granted to cover a loan of the Holding to finance a participation for a capital increase in Dexia Bank.
Arco (a Belgian cooperation linked to the Christian Workers’ Union). Via the deposit guarantee system a guarantee has been granted for up to EUR 1.5 billion to cover losses on Dexia shares.
NMBS Holding (Belgian Rail Road) A Belgian government guarantee to cover 80% of a sale and lease back operation with AIG. Guarantee in EUR equals EUR 260 mio.
Then we do not take into account pension liabilities that have been taken over by the Belgian government, such as the Belgacom Pension fund for a minimum liability of EUR 5.8 billion, pension fund of the Port Authorities of Antwerp etc. The fee the government received in exchange of taking over the liabilities was deposited into a so called Silver fund which invested in EUR sovereign bonds such as Germany, France but also Italy, Greece etc…..
The above list already accounts for over EUR 140 billion of guarantees. The entire amount is not at risk. However, taken into account that a lot of these guarantees are related to sovereign and toxic paper that is facing haircuts of 50% and even more (Greece will eventually be faced with haircuts of up to 80-90% and the same can be argued for toxic assets in the portfolio of Fortis, KBC and Dexia), it is not unrealistic to assume that the outstanding public debt as a percentage of GDP can rapidly rise to levels far above 120%.
These are levels well above those like Portugal, and close to those of Italy, both countries that are already spit out by the bond market. Considering these levels, the government is hardly capable of executing its moral hazard role it has been playing over the last couple of years. This means that if one of their last standing banks, that is KBC, would need to ask for additional government support, the Belgian government would get stuck between a rock and a hard plate.
If it would be forced into a situation where it has to rescue the bank, the public debt would shoot well above the levels of Italy as it would have to take on additional guarantees such as an impaired Irish loan portfolio of EUR 18 billion, which the bank is carrying.
If on the other hand the government argues the bank is too-big-to-rescue, it would trigger a run on the Belgian banking system as we have seen in Iceland back in 2008, and as a result the Belgian government would see its liabilities sky rocket as well due to the deposit guarantee system that it is responsible for.
In both cases an eminent bankruptcy is around the corner and the country would need to ask for direct support from the ECB, which is more and more hesitant to step in, as we have seen in its recent market operations.
As we mentioned earlier on, the above described scenario can be applied on other countries such as Ireland, Portugal, Italy and even France. Between now and 2014 the EUR zone would need a sovereign refinancing together with a banking recapitalisation of close to EUR 4 trillion.
These are numbers that sends chills through your spine and show that Europe or more in general the world is in a structural state of balance sheet depression. Inspired by the work of Reinhart & Rogoff, the BIS recently published a report on "The Real Effects of Debt". (1)Its conclusion is that the deleveraging process will continue most of this decade. Taking the above mentioned numbers into account, we certainly are not going to challenge this.
Nevertheless this brings us to the one million dollar question which has kept us awake over the last 3 years: will it either be deflation or inflation that the world economy will be facing?
The answer is not straight forward. Most probably the outcome will be similar to what the EUR-zone has been coping with over the last decade. Certain regions will be struggling with deflationary price pressures. Other regions will see (considerable) upward price pressures.
As for Europe is concerned we share the view of analyst Simon Hunt.(2) Germany and the ECB will have to decide whether they want to safe the EUR project or allow it to explode with a big bang. Either they agree upon the ECB, probably in cooperation with the EFSF, to open up the printing machine where even Ben Bernanke would start feeling uncomfortable with. However, the chance that this decision will be vetoed by either the old Bundesbank lobby or the German’s Constitutional Court is immense high. Nevertheless, this would further destabilize the system and trigger acceleration in asset inflation.
If they decide not to walk down that road, they will be forced to throw in the towel and accept the fact that the EUR project has failed in its current form. This conclusion will cause even more chaos as this would push the European economy into a deep recession, not to use the word of depression, as all member states will have to introduce their own currencies again. This will put in motion a severe deleveraging process that would deflate all asset prices.
As both scenarios could come straight out of a horror movie it is up to our European and global leaders to start thinking out of the box and start working on a new monetary order as we are in the final stages of the End Game.
[1] Cecchetti, Mohanty, Zampolli "The Real Effects of Debt", Bank of International Settlements, September 2011
[2] John Maulding, Outside the Box, 21st November 2011
Wednesday 23 November 2011
Sunday 13 November 2011
A call for structural changes
Remember the Green Shoots back in 2009. It became such an hype that it got rewarded by becoming an official term on Wikipedia. Back then we were highly sceptical and with great disbelieve we saw the market taking off after that memorable G20 summit at the beginning of April which set the streets of London literally on fire.
This encouraged us to participate in the academic debate on causes of the crisis and the challenges we would face in the foreseeable future. All our findings were bundled in a book “The Future of Finance: a New Model For Banking and Investment.”
In brief we warned that nothing was done about the real issues, such as the systemic risk in the financial industry via its exposure on derivatives, the destabilising forces of central banks and governments, and last but not least the colossal debt built up both at the private and public side. All this would trigger a currency crisis which in the end would result in a global sovereign crisis. Hence, investment portfolios should have been protected against this by avoiding certain currency zones and sovereign creditors (cfr. The Rings of Fire) and searching for hard underlying assets.[1]
However, like so many out-of-the-box thinking economists, we were spit out by the system as being too cynical, doom-and-gloom and in the end we ended up shouting in the desert.
The last few months have been particularly interesting. From our desert we have seen the clouds packing together again and noticed a perfect storm is in the making: a sovereign crisis going hand in hand with a banking and currency crisis.
The interesting part is not because we warned for all this back in 2009, but due to the same indecisive approach and ostrich behaviour by our political leaders who still don’t seem to realize that the can they have been kicking down the road is about to hit a brick wall.
In this respect it would be worthwhile to update some of the data we referred to back in 2009-2010 and point at the mounting challenges we are facing.
One of the eye catching data back then was the total global outstanding derivative exposure. After reaching a peak of approximately $ 683 trillion mid 2008 the Great Credit Crisis caused a significant reduction in volume due to the deleveraging that was triggered through the market, however since 2010 volumes picked up again. At the end of June 2010 the exposure was around $ 583 trillion to rise further to $601 trillion by the end of December 2010 (see also most recent data of Bank of International Settlements (BIS))(cfr. Table 3.).
To give the reader an idea of the systemic risk, within the US banking system only 96% of the US outstanding derivative exposure is in the hands of only 5 US banks: JP Morgan, Citi, Bank of America, Goldman Sachs and HSBC Bank USA National Association.
Table 1: Derivative exposure by US commercial banks
Source: Office of the Currency Controller, 2011
The argument that these data are gross numbers, not taking into account the bilateral netting effect among banks and as a result are not representative to outline the risk, does not stand. The issue here is that bilateral netting assumes that in an orderly credit event the issuing bank will honour all its outstanding contracts. Back in 2008 with AIG the market was already confronted with this problem and trillions of dollars threatened to become worthless within a few hours, as those who had bought protection from AIG were at risk to be left empty handed, as Goldman was the only player that was hedged by buying protection on AIG itself.
Until today nothing has done about this issue either. On the contrary it hangs over the market as a very dark cloud. This risk is eminent as European, and among them especially French, banks are in the eye of the storm of the recent European sovereign crisis.
This brings us to our second issue: a perverse and vicious mechanism between a European banking sector which is in principle bankrupt and Euro sovereigns that face the same problem. Deteriorating mark-to-markets of Euro sovereign bonds is pushing banks deeper into insolvency.
Two of our favourite analysts, John Mauldin and Michael Lewitt, point at a too-big-to-rescue issue where European banks hold as much as $55 trillion of assets. This is four times larger than the U.S. banking sector as European banks surprisingly are more leveraged. Until now nothing has been learned from the past on how to fund this enormous position. Back then we made suggestions on proper ALM management that banks should take into account. The major principle in all this is becoming less dependent on wholesale or interbank funding. This has been further worked out more in detail by my co-author, Prof. Dr. Moorad Choudhry, in his recent book “The Principles of Banking” . [2]
Unfortunately European banks are still funding themselves for a large part via the interbank market, which is less stable than deposit money. From this $ 55 trillion almost $30 trillion has to be raised by European banks in the interbank market. Bear in mind this is roughly 10 times more than U.S. banks. As we have seen over the last several weeks, this market dried up completely for European banks, which forces them to pay back this wholesale funding by internal generated cash flows.
Michael Lewitt argues further that this wholesale funding has on average a three year maturity. This means that European banks need to generate approximately $830 billion each month to fund maturing wholesale money. It goes without saying this is not a situation that can take too long which is also indicated by the markets. The CDS market for European banks for example is back at or above the peak levels seen during the 2008 financial crisis. [3]
We could very quickly come into a situation where many other banks face a similar future as Dexia, i.e. nationalization. The problem however here is that governments’ balance sheets are stretched as well. This brings us to our last item of data to be updated, that is total outstanding debt of nations. Remember back then we referred to the famous Rings of Fire of Bill Gross of Pimco.
A similar exercise has recently been done by BIS and they came up with the following numbers:
Table 2: Total debt as a % of GDP
Source: BIS
Compared to the exercise Pimco did back in January 2010 there is a striking difference that much more countries are clustering together in a dangerous debt zone of + 330% of GDP. The only similar conclusion compared to back then is that Japan is still like a bug looking for a windscreen.
Levels like these are unsustainable not only because, as Reinhart and Rogoff concluded, for each 90% of debt in terms of GDP one full percentage of GDP growth is lost. Then we are challenged with the ageing of society which is going to put further pressure on both pension fund managers, who will not be able to realize the over ambitious returns their models are counting on, and public finances of our economies.
To solve this more drastic and structural changes will be necessary. It goes beyond doubt this will take political courage and leadership to say that we all have to make sacrifices and most probably have to take a step back from our current living standards.
My co-author, Prof. Dr. M. Choudhry, and I are preparing an academic paper which will focus on these structural changes we need to push through in the very near future and we will keep you updated on this via our Givanomics newsletters.
To give you a brief indication into which direction we are looking for, we argue that it will be as drastic as the events like Breton Woods (1944), the end of it in 1971 and the Plaza Accords (1985).
It will question our current capitalistic free market model where banks and central banks are the corner stones of the model. In the financial system as we know it we aim for stability. Central banks play a pivotal role in all this to guarantee this stability. In a stable environment liquidity is not an issue and central banks are not on the radar screen. Only in times of shocks one is challenged. The problem however is, there are different kinds of shocks. The question is when or where do we draw the line to step in and guarantee stability again. This is once again the moral hazard issue.
There are shocks of technical nature (such as the potential Y2K event 11 years ago) or geo-political nature (events such as 9/11) or international nature (retreatment of international capital flows such as the Asian and Russian crisis) and corporate nature (such as LTCM, Bear Stearn and Lehman).
We think there is a broad consensus that in principle in case of a corporate shock, we should not use tax payers’ money, as we should not throw good money after reckless behaviour. Unfortunately we let it come way too far as this is an impossible task nowadays due to the interconnectivity of our financial system. We do believe though a great opportunity was missed back in 1998 with LTCM not to do anything about it.
The Fed should not have come to the rescue and should have given an example that a liquidity shock, due to a corporate event, would be something a central bank should step in for. Or, after the rescue of the banks from LTCM one should have done something about the systemic risk in the market, which only grew exponentially since then. Table 3 gives a very good indication on this subject in respect to the rise of derivatives over the last 13 years. The question will be though where to draw the line? Do we only exclude a corporate shock, or even at an international level, such as the examples of Russia, Asia and now Greece etc….?
Table 3: Rise of Derivatives
Source: BIS
Then we also come to our paradox, as in our aiming for financial stability we created central banks. Remember that back in 1907 the US went through a similar deep recession and after the collapse of the Knickerbocker Trust Company, liquidity dried up and there was a run on the banks. It was the late J.P. Morgan himself who put his own private money and that of other fellow competitor bankers on the table to guarantee liquidity and avoid a further collapse of the system. This because of the simple reason, there were no central banks. It was due to this event that two years afterwards the Federal Reserve was founded.
However due to the creation of this type of institution, in order to safeguard financial stability, one put in place public financial safety nets, which are an incentive to moral hazard behaviour, which on its turn is just the very reason why financial instability is created. This is quite of a paradox.
Maybe we should go back to a system as in 1907, where banks had to put a pool of money together themselves to rescue each other. By doing this, you automatically take away the public floor or safety net from underneath the market. From the moment that banks have skin in the game, they probably will be more cautious towards each other when it comes down to wholesale funding and leverage, which were/are one of the major reasons why a liquidity crunch takes place when we are talking about a shock of corporate nature. In case something would go wrong and a bank has to turn to this facility pool, there would be a penalty involved where the bank is absorbed by the others.
This will not be the only challenge. As back in 1944 when Breton Woods was negotiated, we urgently need a new monetary order which would issue new rules on how we deal with global financial and commercial relations and the currency risk that is closely related to this. A question we will ask ourselves is whether abandoning the fiat currency system, which was introduced at the Plaza Accord in 1985, would reduce the leverage in the system.
These are according to us the topics that should come on top of the agenda of G20 summits. Unfortunately these discussions are being avoided and it is far more popular to pin point on a round of bankers bashing or focussing on marginal discussions like abandoning short selling. The longer this discussion is postponed the deeper the crisis will become. We can only hope one does not make the same mistake as President Hoover and his generation did back in the 1930s, which made the crisis even worse. We all know by now what price we had to pay for that.
This encouraged us to participate in the academic debate on causes of the crisis and the challenges we would face in the foreseeable future. All our findings were bundled in a book “The Future of Finance: a New Model For Banking and Investment.”
In brief we warned that nothing was done about the real issues, such as the systemic risk in the financial industry via its exposure on derivatives, the destabilising forces of central banks and governments, and last but not least the colossal debt built up both at the private and public side. All this would trigger a currency crisis which in the end would result in a global sovereign crisis. Hence, investment portfolios should have been protected against this by avoiding certain currency zones and sovereign creditors (cfr. The Rings of Fire) and searching for hard underlying assets.[1]
However, like so many out-of-the-box thinking economists, we were spit out by the system as being too cynical, doom-and-gloom and in the end we ended up shouting in the desert.
The last few months have been particularly interesting. From our desert we have seen the clouds packing together again and noticed a perfect storm is in the making: a sovereign crisis going hand in hand with a banking and currency crisis.
The interesting part is not because we warned for all this back in 2009, but due to the same indecisive approach and ostrich behaviour by our political leaders who still don’t seem to realize that the can they have been kicking down the road is about to hit a brick wall.
In this respect it would be worthwhile to update some of the data we referred to back in 2009-2010 and point at the mounting challenges we are facing.
One of the eye catching data back then was the total global outstanding derivative exposure. After reaching a peak of approximately $ 683 trillion mid 2008 the Great Credit Crisis caused a significant reduction in volume due to the deleveraging that was triggered through the market, however since 2010 volumes picked up again. At the end of June 2010 the exposure was around $ 583 trillion to rise further to $601 trillion by the end of December 2010 (see also most recent data of Bank of International Settlements (BIS))(cfr. Table 3.).
To give the reader an idea of the systemic risk, within the US banking system only 96% of the US outstanding derivative exposure is in the hands of only 5 US banks: JP Morgan, Citi, Bank of America, Goldman Sachs and HSBC Bank USA National Association.
Table 1: Derivative exposure by US commercial banks
Source: Office of the Currency Controller, 2011
The argument that these data are gross numbers, not taking into account the bilateral netting effect among banks and as a result are not representative to outline the risk, does not stand. The issue here is that bilateral netting assumes that in an orderly credit event the issuing bank will honour all its outstanding contracts. Back in 2008 with AIG the market was already confronted with this problem and trillions of dollars threatened to become worthless within a few hours, as those who had bought protection from AIG were at risk to be left empty handed, as Goldman was the only player that was hedged by buying protection on AIG itself.
Until today nothing has done about this issue either. On the contrary it hangs over the market as a very dark cloud. This risk is eminent as European, and among them especially French, banks are in the eye of the storm of the recent European sovereign crisis.
This brings us to our second issue: a perverse and vicious mechanism between a European banking sector which is in principle bankrupt and Euro sovereigns that face the same problem. Deteriorating mark-to-markets of Euro sovereign bonds is pushing banks deeper into insolvency.
Two of our favourite analysts, John Mauldin and Michael Lewitt, point at a too-big-to-rescue issue where European banks hold as much as $55 trillion of assets. This is four times larger than the U.S. banking sector as European banks surprisingly are more leveraged. Until now nothing has been learned from the past on how to fund this enormous position. Back then we made suggestions on proper ALM management that banks should take into account. The major principle in all this is becoming less dependent on wholesale or interbank funding. This has been further worked out more in detail by my co-author, Prof. Dr. Moorad Choudhry, in his recent book “The Principles of Banking” . [2]
Unfortunately European banks are still funding themselves for a large part via the interbank market, which is less stable than deposit money. From this $ 55 trillion almost $30 trillion has to be raised by European banks in the interbank market. Bear in mind this is roughly 10 times more than U.S. banks. As we have seen over the last several weeks, this market dried up completely for European banks, which forces them to pay back this wholesale funding by internal generated cash flows.
Michael Lewitt argues further that this wholesale funding has on average a three year maturity. This means that European banks need to generate approximately $830 billion each month to fund maturing wholesale money. It goes without saying this is not a situation that can take too long which is also indicated by the markets. The CDS market for European banks for example is back at or above the peak levels seen during the 2008 financial crisis. [3]
We could very quickly come into a situation where many other banks face a similar future as Dexia, i.e. nationalization. The problem however here is that governments’ balance sheets are stretched as well. This brings us to our last item of data to be updated, that is total outstanding debt of nations. Remember back then we referred to the famous Rings of Fire of Bill Gross of Pimco.
A similar exercise has recently been done by BIS and they came up with the following numbers:
Table 2: Total debt as a % of GDP
Compared to the exercise Pimco did back in January 2010 there is a striking difference that much more countries are clustering together in a dangerous debt zone of + 330% of GDP. The only similar conclusion compared to back then is that Japan is still like a bug looking for a windscreen.
Levels like these are unsustainable not only because, as Reinhart and Rogoff concluded, for each 90% of debt in terms of GDP one full percentage of GDP growth is lost. Then we are challenged with the ageing of society which is going to put further pressure on both pension fund managers, who will not be able to realize the over ambitious returns their models are counting on, and public finances of our economies.
To solve this more drastic and structural changes will be necessary. It goes beyond doubt this will take political courage and leadership to say that we all have to make sacrifices and most probably have to take a step back from our current living standards.
My co-author, Prof. Dr. M. Choudhry, and I are preparing an academic paper which will focus on these structural changes we need to push through in the very near future and we will keep you updated on this via our Givanomics newsletters.
To give you a brief indication into which direction we are looking for, we argue that it will be as drastic as the events like Breton Woods (1944), the end of it in 1971 and the Plaza Accords (1985).
It will question our current capitalistic free market model where banks and central banks are the corner stones of the model. In the financial system as we know it we aim for stability. Central banks play a pivotal role in all this to guarantee this stability. In a stable environment liquidity is not an issue and central banks are not on the radar screen. Only in times of shocks one is challenged. The problem however is, there are different kinds of shocks. The question is when or where do we draw the line to step in and guarantee stability again. This is once again the moral hazard issue.
There are shocks of technical nature (such as the potential Y2K event 11 years ago) or geo-political nature (events such as 9/11) or international nature (retreatment of international capital flows such as the Asian and Russian crisis) and corporate nature (such as LTCM, Bear Stearn and Lehman).
We think there is a broad consensus that in principle in case of a corporate shock, we should not use tax payers’ money, as we should not throw good money after reckless behaviour. Unfortunately we let it come way too far as this is an impossible task nowadays due to the interconnectivity of our financial system. We do believe though a great opportunity was missed back in 1998 with LTCM not to do anything about it.
The Fed should not have come to the rescue and should have given an example that a liquidity shock, due to a corporate event, would be something a central bank should step in for. Or, after the rescue of the banks from LTCM one should have done something about the systemic risk in the market, which only grew exponentially since then. Table 3 gives a very good indication on this subject in respect to the rise of derivatives over the last 13 years. The question will be though where to draw the line? Do we only exclude a corporate shock, or even at an international level, such as the examples of Russia, Asia and now Greece etc….?
Table 3: Rise of Derivatives
Source: BIS
Then we also come to our paradox, as in our aiming for financial stability we created central banks. Remember that back in 1907 the US went through a similar deep recession and after the collapse of the Knickerbocker Trust Company, liquidity dried up and there was a run on the banks. It was the late J.P. Morgan himself who put his own private money and that of other fellow competitor bankers on the table to guarantee liquidity and avoid a further collapse of the system. This because of the simple reason, there were no central banks. It was due to this event that two years afterwards the Federal Reserve was founded.
However due to the creation of this type of institution, in order to safeguard financial stability, one put in place public financial safety nets, which are an incentive to moral hazard behaviour, which on its turn is just the very reason why financial instability is created. This is quite of a paradox.
Maybe we should go back to a system as in 1907, where banks had to put a pool of money together themselves to rescue each other. By doing this, you automatically take away the public floor or safety net from underneath the market. From the moment that banks have skin in the game, they probably will be more cautious towards each other when it comes down to wholesale funding and leverage, which were/are one of the major reasons why a liquidity crunch takes place when we are talking about a shock of corporate nature. In case something would go wrong and a bank has to turn to this facility pool, there would be a penalty involved where the bank is absorbed by the others.
This will not be the only challenge. As back in 1944 when Breton Woods was negotiated, we urgently need a new monetary order which would issue new rules on how we deal with global financial and commercial relations and the currency risk that is closely related to this. A question we will ask ourselves is whether abandoning the fiat currency system, which was introduced at the Plaza Accord in 1985, would reduce the leverage in the system.
These are according to us the topics that should come on top of the agenda of G20 summits. Unfortunately these discussions are being avoided and it is far more popular to pin point on a round of bankers bashing or focussing on marginal discussions like abandoning short selling. The longer this discussion is postponed the deeper the crisis will become. We can only hope one does not make the same mistake as President Hoover and his generation did back in the 1930s, which made the crisis even worse. We all know by now what price we had to pay for that.
[1] See also Bill Gross, The Rings of Fire.
[2] Prof. Dr. Moorad Choudhry “The Principles of Banking: Capital, Asset-Liability and Liquidity Management”, Wiley Finance, 2011
[3] Michael Lewitt, “It’s all Greek to me”, Newsletter, November 2011
Sunday 2 October 2011
Update on the Future of Finance
In the last several months we have experienced increased nervousness around the Mediterranean Eurozone countries and their sovereign debt, with Greece in the spotlight and now Spain and Italy creating further political divergence among euro members. All this comes to a climax now with the US itself under attack by one of the rating agencies. These are of course the same agencies that were heavily criticised before for being too loose in their credit assessments during the build-up to the previous credit crisis.
We have absolutely no pleasure in reiterating that we warned about all of this in our book “The Future of Finance: a New Model for Banking and Investment”, which was written back in 2009. At that time, among many other issues, we pointed out the risk of increased volatility and sovereign debt crises of the magnitude observed during the Great Credit Crisis of 2007-2009. Furthermore we warned that this sovereign debt crisis would go hand in hand with a currency crisis, where hard underlying assets would function as safe heavens.
We are now in the middle of what can be described as the third and final phase of this Great Debt Cycle. The first one can be identified as the period where the seeds of the crisis of 2007-2009 were sown. This was characterised by a complex mixture of financial deregulation, globalization, increased financial innovation, a shadow banking system, political and monetary intervention, currency manipulations and moral hazard issues. By the end of this cycle, back in September 2008, governments all over the world had to step in to save the financial system from a total implosion, by transferring the debt liabilities from the private to the public sector. Remember banks, as well as corporates such as GM, were bailed out at the time.
The end result was that public deficits and debts as a percentage of GDP rose exponentially. The euphoria experienced on the stock markets back then from March 2009 onwards, was misplaced as the outstanding debt did not disappear. This can be identified as the second stage in the Great Debt Cycle, where central banks started expanding their balance sheets rapidly. Some of these monetary institutions were more reluctant than others, for example the Federal Reserve versus the ECB. However, now that the sovereign crisis is coming to a climax, the latter also has been forced to give up its final political independence and has stated buying up debt that cannot be absorbed anymore by governments.
This is the start of the third and final cycle where continuous balance sheet expansion will result to a point where it will no longer be accepted by the financial markets. These financial markets are blamed by indecisive politicians as the cause of the turmoil. Unfortunately they only act as a thermometer that displays that the patient has a high fever and is very ill. At this stage politicians lean back comfortably in their chairs as central banks once again will come to the rescue and reinforce the moral hazard principle. However this “kicking-the-can-down-the-road” game will come to an end in due course, as there is a limit to how much a central bank can stretch its balance sheet. Note that the ECB’s and Fed’s balance sheets are already leveraged approximately 1:25 (EUR 81 bio of capital versus EUR 2.3 trillion outstanding assets) and 1:50 ($51 bio capital versus $ 2.6 trillion outstanding assets) respectively. We point out once again that this does not make the debt issue go away. Sooner or later one has to start paying all this debt back. However in the meantime the central banks are running the risk of becoming insolvent themselves. Bear in mind that for example a decrease of only 4% of the value of the ECB’s assets is enough to erase its capital completely.
More then ever politicians need to face reality and bring their household finances in order. This will become even more urgent as the ageing of society is now just around the corner and will put further pressure on welfare payments and public finances. Just passing on the problem to the lender-of-last resort is not an option anymore, as this will end up in global demonetization and collective pauperization. Neither is throwing away the thermometer. The longer we put off the solution, the more painful the end implosion will be.
Gino Landuyt, Brussels, August 2011
We have absolutely no pleasure in reiterating that we warned about all of this in our book “The Future of Finance: a New Model for Banking and Investment”, which was written back in 2009. At that time, among many other issues, we pointed out the risk of increased volatility and sovereign debt crises of the magnitude observed during the Great Credit Crisis of 2007-2009. Furthermore we warned that this sovereign debt crisis would go hand in hand with a currency crisis, where hard underlying assets would function as safe heavens.
We are now in the middle of what can be described as the third and final phase of this Great Debt Cycle. The first one can be identified as the period where the seeds of the crisis of 2007-2009 were sown. This was characterised by a complex mixture of financial deregulation, globalization, increased financial innovation, a shadow banking system, political and monetary intervention, currency manipulations and moral hazard issues. By the end of this cycle, back in September 2008, governments all over the world had to step in to save the financial system from a total implosion, by transferring the debt liabilities from the private to the public sector. Remember banks, as well as corporates such as GM, were bailed out at the time.
The end result was that public deficits and debts as a percentage of GDP rose exponentially. The euphoria experienced on the stock markets back then from March 2009 onwards, was misplaced as the outstanding debt did not disappear. This can be identified as the second stage in the Great Debt Cycle, where central banks started expanding their balance sheets rapidly. Some of these monetary institutions were more reluctant than others, for example the Federal Reserve versus the ECB. However, now that the sovereign crisis is coming to a climax, the latter also has been forced to give up its final political independence and has stated buying up debt that cannot be absorbed anymore by governments.
This is the start of the third and final cycle where continuous balance sheet expansion will result to a point where it will no longer be accepted by the financial markets. These financial markets are blamed by indecisive politicians as the cause of the turmoil. Unfortunately they only act as a thermometer that displays that the patient has a high fever and is very ill. At this stage politicians lean back comfortably in their chairs as central banks once again will come to the rescue and reinforce the moral hazard principle. However this “kicking-the-can-down-the-road” game will come to an end in due course, as there is a limit to how much a central bank can stretch its balance sheet. Note that the ECB’s and Fed’s balance sheets are already leveraged approximately 1:25 (EUR 81 bio of capital versus EUR 2.3 trillion outstanding assets) and 1:50 ($51 bio capital versus $ 2.6 trillion outstanding assets) respectively. We point out once again that this does not make the debt issue go away. Sooner or later one has to start paying all this debt back. However in the meantime the central banks are running the risk of becoming insolvent themselves. Bear in mind that for example a decrease of only 4% of the value of the ECB’s assets is enough to erase its capital completely.
More then ever politicians need to face reality and bring their household finances in order. This will become even more urgent as the ageing of society is now just around the corner and will put further pressure on welfare payments and public finances. Just passing on the problem to the lender-of-last resort is not an option anymore, as this will end up in global demonetization and collective pauperization. Neither is throwing away the thermometer. The longer we put off the solution, the more painful the end implosion will be.
Gino Landuyt, Brussels, August 2011
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