Friday, June 29, 2012

First Steps Toward A European Banking Union

Did Europe really take its first steps toward a banking union?

It appears that they did in an all-night session of eurozone officials at the EU summit.  An agreement was reached concerning the creation of a single bank supervisor, under the charter of the European Central Bank.

The “change in banking supervision could be the most far-reaching of all the decisions taken. Instead of the hotchpotch of 17 different bank supervisors, there will now only be one for all eurozone banks, a major step towards a so-called banking union banking union that is arguably the most significant change to the single currency area since it was created.”

This would be significant step!

It would be significant because you now have 17 different sovereignties, 17 different banking regimes, and 17 different regulatory bodies.

Going to a single banking union would be very similar to going to a single currency…and, with all the problems of managing a single currency. 

Given the current system, many of the sovereign governments in the EU have used their banking to support their undisciplined fiscal policies.  Up until recently, all sovereign debt was considered to be riskless, so the banks were able to buy up lots and lots of this sovereign debt and use it in a way that allowed them to meet regulatory capital requirements.

As a consequence, these unconstrained national governments could rely on the banks to buy their debt and the banks could rely on national regulatory bodies to uphold their capital positions because they held this “riskless” national debt.  And on, and on it went in a “vicious circle” between the banks and the sovereigns. 

And, the affected national governments “talked up” their banks as the banks drifted more and more into trouble with some becoming insolvent.

In order to get through the current banking crisis, eurozone officials agreed to “radically restructure” the €100 billion recapitalization plan requested by Spain.  Under the new agreement the funds would go directly into Spanish financial institutions removing the responsibility for administering the bailout from the Spanish government itself. 

Also, in the agreement, Italy will get some concessions in how it is treated in the upcoming plans and further review will be given to Ireland, consistent with these efforts.

Bottom line, the eurozone nations will no longer have the responsibility for bailing out their own banks.  The fund that will be used to provide the pool of funds for these bailouts will be the European Stability Mechanism (ESM).  Currently, this fund has €500 billion in resources. 

Timing becomes all-important in the creation of this central banking supervisory authority, because the situation, as it stands, is unsettled.

The ECB is to have plans for this banking authority “before the end of the year” because the creation of this banking supervision is “a matter of urgency.”

Spain’s bank bailout will take place immediately under the new guidelines and then could be switched to the new supervisory authority when it is in place. 

The problem faced by those attempting to create the new eurozone banking union is that times have changed and the world is constantly moving into an electronic future.  The eurozone cannot just set up a regulatory system to just deal with current problems!

This is a problem that has been highlighted in the United States by the recent JPMorgan Chase losses.  Financial institutions have moved into a new world order, driven by the attributes of information technology.  Financial institutions are scaling up to operate within this virtual world.  The smaller banks will not be able to compete in this technology space and hence the average size of a financial institution is going to increase.

According to FDIC statistics, there are 525 banks in the United States that have assets in excess of $1.0 billion.  The average size of these 525 banks is over $22.0 billion.  According to Federal Reserve statistics, the 25 largest domestically chartered banks in the United States average $290.0 billion in total assets.  Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo have $8.0 trillion in total assets divided among them…an average of $2.0 trillion each.    

The largest 25 domestically chartered banks plus the offices of foreign-related banks, control more than 70 percent of all commercial banking assets in the United States.  It is these organizations that will be driving the introduction of the new technology.  Folks, this is what the future is going to look like…and the regulators, in my mind, cannot stop it from happening!

And, technology is driving this scaling up.  I call your attention to an edition of a journal published by the Institute of Electrical and Electronics Engineers called IEEE Spectrum.  The cover story of the June issue June issue is “The Beginning of the End of Cash”.  Let me tell you, if the electrical and electronic engineers devote a full issue of their journal to this subject…you better watch out!  How about this article...”Quantum Cash and the End of Counterfeiting.”

This is why, to me, that an article like the one written by Philip Augar in the Financial Times is scary.  The title of the essay is “Too big to manage and regulates is what matters now.”  His suggestions are: one, to break up the banks along Glass-Steagall lines; two, for banking supervisors “to leave as little as possible to management discretion and to go for bold, simple rules that are easy to understand and possible to enforce; and three, to remove the grotesque incentives that encourage corrupt behavior.

What universe does Augar inhabit?

The problem is that many suggestions about the banking system are along these lines today.

Yesterday, the officials of the eurozone took a bold, initial step in creating a new banking structure for Europe.  We all hope that they will continue along this road…and will continue at a fairly rapid pace.

However, it will not do anybody any good if those creating the new banking structure look solely at the past.  Finance is just information and the use of information is going to adapt to the technology available to it. 

Banks…financial institutions…are getting better and better at using the new information technology. 

Bank managements…and the managements of financial institutions…have not caught up with these new advances in information technology.  There ability to judge and control risk is just one place where these managements fall short of where they need to be.

Yet, I would suggest that these bank managements are light years ahead of where the regulators are in terms of understanding and managing the use of information in this modern era.  Creating a banking union and a regulatory structure that does not accommodate this fact is either going to fail, or, and this I believe, is going to drive all the technologically savvy organizations out of their sphere.  That is, the banks will find a way to leave the industry.

There is no question in my mind that these banks will do it…and leave the new banking union with just the “dogs.” This possibility will become more of a reality if the European banking union is formed.  But, I believe, the European banking union must be formed.

By-the-way…if you have not been reading my blog over time…I believe that the United States is leading this charge.

Who needs a commercial bank?  I don’t!    

Thursday, June 28, 2012

JPMorgan Chase and the Banking Industry

The morning papers report that JPMorgan Chase's loss on it bungled trading could reach as high as $9.0 billion.

Many of the large “universal” banks find their market value trading below, and sometimes substantially below, their book value.

And, many of the 5,700 banks whose asset size is less than $1.0 billion in asset size are struggling to keep their head above water.

The banking industry remains troubled and the financial markets recognize this fact.  Yes, there are banks that are stronger than others, but there are sufficient problems to raise questions about the banking system and how banking is conducted here in the 21st century.  And, the existence of these problems causes many in the financial markets to be skeptical of the banking industry in general…stay away from it!

Given the JPMorgan situation, risk management is certainly at the top of the list of concerns about the banking industry.

Capital adequacy and financial leverage are two other issues that are also on most everyone’s minds.

In addition, there is concern over just what products and services a bank should be dealing in.  The question is asked about returning to a separation of functions like the ones legislated by the old Glass-Steagall Act required.

To me, the questions are more complex because finance has changed so dramatically.

Many of the proposed solutions look backward to a more stable time and a more stable banking industry.  In this former environment, markets did not change as quickly as they do now and institutions were not as capable of moving “things” around as they are now.

Historically, banks held originated assets, loans, and held onto loans until they either paid off or where charged off.  Bank assets were generally longer term in length than were the liabilities that were used to finance them.  Consequently, one of the major problems banks had to face was that rising short-term interest rates tended to cut into the interest-rate spreads the banks earned and threatened profitability. 

In a previous life, there was something called “Regulation Q” that allowed bank regulators to limit the rise in what the banks could pay on their time and savings deposits in order to protect interest rate spreads but this caused another problem called “disintermediation.”

Yet, the banks held onto their loans…there was no place else to put them…and they either borrowed, short-term, from the discount window of the Federal Reserve, or they sold their investment securities, doing either or both, to handle any outflow of funds they experienced.  Almost all banks were “asset management” banks in this environment, as funds were primarily obtained from deposits. 

Given this environment, there was not much need for mark-to-market accounting or any “real-time” valuation of assets.  The environment was such that this issue never really became crucial in the running of banks.

And, as far as bad loans were concerned…well, the tendency was to postpone recognizing or writing down troubled loans since the lending officer could always make the argument that the bank was holding the asset to maturity and that the bad economy or the troubled industry or the individual business would correct itself and that all the loan needed was time.  Loans were only charged-off as a last resort…but, this never really created major problems in the relatively stable environment of the past.

This has all changed.  With all the financial innovation of the past fifty years, the credit inflation that drove the financial markets resulting in a large majority of the banks…even relatively small ones…becoming “liability management” banks, and with the advances in information technology, financial institutions became basically “information processors.” 

I have often written that finance is just information.  Almost everything that can be done in finance can be done with 0s and 1s.  For the more advanced organizations…primarily the larger ones…this has become true of a large part of their business.  This is another reason for the smaller banking institutions to be absorbed into larger ones or to just go out of business. (Note: my banking is all done electronically…I have little or no use for a branch…and I have little or no use for anything other than my iPad when it comes to my banking.  Most of my friends and business associates operate in a similar fashion.)

JPMorgan Chase got involved in some very complex and complicated transactions that were supposed to hedge certain positions against interest rate risk.  Unfortunately, due to the complexity of the transactions, the hedge did not work as expected and, in fact, worked to create more risk.  The hedge, according to the New York Times, “exposed the bank to greater risks even though it had been intended to minimize them.”

The size of the positions taken were quite large.  And, it has already taken several months to unwind the position, the reason why the exact amount of the loss is not known more exactly.  The new estimate of the loss…$9.0 billion…was projected from internal models.  It will still take several more months to determine what the exact size of the loss will be. 

The crucial point, however, is that this is what financial institutions do these days…and can do.  And, it is not just a matter of the bank using “federal insured deposits” to fund a hedge fund...which some professor stated was the case. 

In the environment banks work in today, it is hard to know where the money comes from and where it goes to because of the ease of moving money around and moving it so quickly.  Funds may seem to come from “here” for a while but then they go “there” in an instant and where things are depends only upon the time at which you try to measure them.       

This is not the way all banking is done these days, but it is the direction in which banking is going. 

But, it is also the reason why many banks in the country are not in such good shape these days because they were playing a game they were not trained for.  Many smaller banks, seeking growth looked for loans that they could “scale up” on…like commercial real estate loans.  Buying fund…becoming “liability managers”…became the thing.  How easy it became to buy money in these days.  However, many of these banks did not have the talent or the experience to handle such transactions.

And, what about the smaller banks originating loans and selling them off, buying back mortgage-backed securities and trading in futures markets?  I was asked to turnaround a small bank (which I did successfully) that had an investment policy that allowed the bank to deal in financial transactions that I would think only a major Wall Street bank should be allowed to do.  And, the investment policy had been approved by the bank examiners.

And, this just represents a start.

Bottom line: to me it is no wonder that the banking system is in the condition it is in.  Given this conclusion, I would argue that investors should be shy about having any banks in their stock portfolios…any bank!  (JPMorgan Chase was supposed to be the “best of the best.”)  We still don’t know what is the real value of assets in the banking system.  And, our regulatory system is still designed to regulate commercial banks coming from the 1970s and 1980s.

No wonder bank valuations are so low!

Tuesday, June 26, 2012

No Confidence in Europe

“Fears that policy makers will again fail to come up with a credible solution to problems in the eurozone at an EU summit this week continue to affect market sentiment and weigh on the borrowing costs of other peripheral eurozone countries, including Italy.”

Confidence in European decision makers continues to slide in financial markets.

Spain's Treasury sold €3.08bn of short-term debt on Tuesday.  Interest rates were substantially higher: The Treasury auctioned three-month bills at an average rate of 2.362 per cent, compared with 0.846 per cent at the previous sale last month, and six-month bills at an average 3.237 per cent, up from 1.737 per cent.
Italy also is caught in this market concern: Italy sold on Tuesday €3.9bn of zero-coupon and inflation linked bonds near the top end of the range. It paid 4.712 per cent to sell two-year paper – the highest since December.
Confidence is nowhere is sight.
Also, in Italy, Prime Minister Mario Monte is attempting to get legislation passed that would provide some reform for Italian labor markets.  Yet, even though the bill may be passed, no one seems at all happy with the contents of the reforms. 
And, analysts argue that the bill falls fall short: “The labor reform is inadequate because it does not address shortcomings in the labor market that stifle the economy,” writes Roger Abravanel, a former management consultant.
Still some officials continue to talk about a eurozone finance minister and a joint banking union.  Yet national interest and the desire to control a nation’s independent fiscal policy and banking system make such talk seem far from reality.
Some believe that this is evidenced by the fact that Germany and its Chancellor Angela Merkel have not fully let on what path they ultimately want to follow.  Germany, the creditor nation, “is acting as creditors always do. It wants to be paid back or put debtors through default proceeding to extract maximum benefits.”
Germany, it is argued, can ultimately achieve its goals by one of three paths: deflation, inflation, and writing checks. 
“Deflation in the periphery would eventually make it competitive, and is Germany’s favored option.  But, as we are seeing, it naturally leads to default by weaker banks and governments.”
With inflation, Germany loses because it gets paid back in cheaper euros.
By writing checks, Germany would pay off the periphery for leading an undisciplined life.  Another case of moral hazard.
To others, Germany has made a decision.  They have opted for the first of the three…European deflation.  The idea here is that the deflation would become so painful to the periphery nations that they would finally move to correct their situation. 
But, as the quote above mentions, this would lead these nations to recognize their insolvency and the insolvency of their banking systems in their any solution they arrive at. 
Do you think this might win any friends for the Germans?
Still, it seems at this time that Germany holds the cards. Post-war Europe has been built on the premise that governments would always intervene in the economy to insure that workers would be employed as fully as possible and that economies would grow as fast as they could.  The result of this policy approach is the situation Europe now finds itself in. 
Germany may be trying to say that this post-war European model no longer works.
But, how much pain is Europe…and Germany…willing to go through to shift policy paradigms? 

Monday, June 25, 2012

More Banks Downgraded

Today’s news: 28 Spanish Banks were downgraded by Moody’s Investors Service.  Included in this list were Banco Santander SA (SAN) and Banco Bilbao Vizcaya Argentaria SA (BBVA).

Moody’s’ cut the ratings of 16 Spanish banks on May 17. 

Again, the argument can be made that this move was "too little, too late."

Yet, perhaps the most important thing to realize is that especially if the move by Moody’s is “too little, too late,” the situation in the banking system has not improved even though a substantial amount of time has passed since the banks entered into this “dark” region.

That is, maybe the banks should have been downgraded six months ago…or, nine months ago…or twelve months ago.  What we should reflect upon is that the banks have not improved their financial condition over this six months…or, nine months…or, twelve months…so that the ratings would not have had to be dropped!

The banks did not respond to the conditions because everyone in Europe seemed to believe that the problems faced by the banks were “liquidity” problems and not “solvency” problems, and that eurozone governments also did not face “solvency” problems.

The conditions cited by Moody’s for the downgrade included the weakness of Spain’s sovereign debt and the increasingly larger losses being recognized by the banks on commercial real estate loans.

Today, Spain requested funds for a banking bailout from members of the eurozone.  The lingering question still remains about when Spain, itself, is going to ask for a formal bailout.  Spain’s bonds are now trading near peak level spreads over German bonds of the same maturity.  The concern here is that these high yields cannot lead to a sustainable financing of the national government.

The situation of Italy is not unlike that of Spain, so there is concern over when the financial markets are going to turn more strongly on the government of Italy.

But, no one seems to have the will to act.  Still no leaders have arisen.  The general belief that the solution must ultimately rest with Germany receives cries of strong protest from German officials.  Short-term plugging of the dike is about all anyone can do. 

It is becoming more and more obvious that the only way the European situation will be corrected will be when the European governments “bite-the-bullet” and actually accept the fact that there is a massive need for structural reforms in most countries.  However, these government officials, in the past, postponed actions over and over again arguing that the problems were just ones of “liquidity.”  Now they have moved to claiming short-run cash injections will solve the “solvency” problems. 

The possibility that European government officials will really consider structural reforms for their societies still seems a distant fantasy. 

There has been talk of a banking union with the eurozone.  Yet, no one really seems serious about giving up their national interests when it comes to forming a banking union.  And, no one seems to want to create a system of deposit insurance like we have in the United States. And, no one seems to want to bear the burden of forming some central regulation agency.  Without some give, somewhere along the line…nothing will happen!

The deeper problem is that banks are not seemingly resolving their balance sheet problems with the time given them by their respective central banks.  Liquidity has been pumped into both the United States financial system and the European financial system.  Yet, few banks seem to be lending indicating they are in a “holding pattern” until things get better.

Still, things have not gotten appreciably better.  If they had, Moody’s would not have had to downgrade all the banks they have downgraded…at this late date.

And, this applies equally to the United States banking system, where commercial real estate loans also plague many banks.

Furthermore, in Europe and in the United States, economic recovery is not going to take place as long as their banking institutions are not lending. 

To me, moving to a QE3 will do no more to right the banking system in the United States nor will a QE3 do anything more to help the economy start growing faster.  Just as in 1937, having more excess reserves in the banking system does not mean that the banks are solvent or that will start lending.  Other things must happen for the banks to start lending and one of these things is to honestly recognize the serious weaknesses that exist within the banking system and continue to re-structure the banking system as smoothly as possible so as to bring solvency back to the industry.

And, this is true of Europe.  Further provision of liquidity to European banks is not going to help them.  European officials, as well as the banks themselves, must accept the reality of the situation and move on.  The banking system needs bailing out.  Several governments in Europe need bailing out.  Solvency is the issue.  Recognizing this and re-structuring their societies is necessary to move forward into the future. 

Any bright future for Europe will only face further delay by postponing the re-structuring that ultimately needs to take place.      

Saturday, June 23, 2012

The U. S. Banking System: Weak Yet Still Supplying Europe

Downgrading large, internationally significant financial institutions did little to change market attitudes about the financial condition of these institutions.  The general market response was “too little, too late.”

As is too well known, rating agencies tend to be followers not leaders.  The question always is…well how far behind are the rating agencies this time?

In this respect, the rating agencies are in the same boat as are the regulators…they are always behind the curve.

As far as the banking system itself…the banking system is not doing all that well…but, we knew that…but the U. S. banking system is doing better than the banking system in the eurozone…if that is any consolation. 

The U. S. banking system is still holding almost $1.5 trillion in excess reserves. 

To me, this means that the banking system, in general, is still is such bad shape that it does not want to make many loans and is perfectly content to be sitting on all the excess reserves that the Federal Reserve has supplied it.  

This situation is not unlike the one that existed during the Great Depression.  In general, commercial banks are not in good shape. 

This general condition also existed at the time of the Great Depression.  Too much debt had been created and individuals and businesses could not pay off the debt that they owed.  Many banks were technically insolvent.   Commercial banks continued to be closed and many of the banks that still had their doors open were just waiting for the regulators to visit them and pull down the shades on their windows.

As we have seen this year, the FDIC continues to close smaller banks, more than one per week, while many other weak banks are acquired and so go out of independent existence.

While lending in the banking system has increased in aggregate over the past year there still are disturbing signs.  For one, cash assets at the smaller, domestically chartered banks increased over the past year by about $33 billion while cash assets in the whole banking system declined.  That is, it looks like the demand for excess reserves in the small banks has actually increased, a sign of management concern.

Secondly, the commercial real estate sector continues to cause the domestically chartered banks problems.  These loans continue to decline at the largest 25 domestically chartered banks in the United States as well as in the rest of the domestically chartered banks over the past year.

Whereas there is some signs that the residential real estate market may be leveling off, problems continue to exist within the commercial real estate area.  It is here that we find why many of the smaller banks are under such stress. 

During the “glory days” of the recent expansion, many of these smaller banks strained to put commercial real estate loans on their books to generate bank expansion.  In order to support this expansion the smaller banks became “liability managers” something small banks hardly ever did in the past.  So these managements made two mistakes…they got into commercial real estate loans, which they did not have the expertise to do…and they got into the purchase of funds, again something they had never done before.

Now, these smaller banks are paying the price for their lack of discipline.  But, it was the thing to do in another time period.

The smaller banks will continue to face balance sheet problems for some time and the number of commercial banks in the banking system will continue to decline.

Another thing to watch, however, is what is happening between banks.  Nearly 40 percent of the increase in bank loans over the past year came in a category titled “Other Loans and Leases” and this category includes Federal Funds and reverse repos with nonbanks and “All Other Loans and Leases.”  This latter group is defined by the Federal Reserve as Including “loans for purchasing or carrying securities, loans to finance agricultural production, loans to foreign governments and foreign banks, obligations of states and political subdivisions, loans to nonbank depository institutions, loans to nonbank financial institutions, unplanned overdrafts, loans not elsewhere classified, and lease financing receivables.”

Foreign-related commercial banks increased loans in the first category by over $66 billion.

Large domestically chartered banks increased loans in the second category by more than $34 billion.  In order to explain this I would like to concentrate on the subset “loans to foreign governments and foreign banks.”   Indications are that these large banks committed a lot of money to “foreign governments and foreign banks” over the past year.  This is where some of it shows up.

And, what was the biggest item to increase on bank balance sheets in the United States?

Net deposits due to foreign related offices of foreign-related financial institutions in the United States.  The total increase over the past year was almost $290 billion!

It looks to me like a lot of the lending activity that took place in the United States and particularly in the largest 25 domestically chartered banks were to “off shore” entities.  In other words, a substantial portion of the funds the Federal Reserve injected into the United States banking system has migrated into foreign hands.

Thus, the Federal Reserve System is not only supporting a weak United States banking system it is also going to help support a weak world banking system. 

One final point of the current situation in banking: fundamental Keynesian economists have argued that the current dilemma facing the monetary authorities today is a “liquidity trap” much as the one they claim the central bank faced during the Great Depression.

In my mind, these Keynesian fundamentalists are as wrong about the current situation as they are about their interpretation of the Great Depression. 

Interest rates are low and yet the economy is not expanding because the banking system is still so weak that the banks are not lending, not because the economy is in a “liquidity trap.”  The problem is a supply of loans problem not a demand for money problem!

And, this applies to Europe as well as to the United States. 

A stronger recovery in the United States will not occur until the U. S. banking system becomes solvent once again, debt balances in the economy are reduced, and governments realize that they are not the solution to every problem.

Monday, June 11, 2012

The Piggy-Bank Got Smashed: The Collapse of Median Wealth of the American Family

The Federal Reserve just released figures on the median wealth of the American family. 

“The median family, richer than half of the nation’s families and poorer than the other half, had a net worth of $77,300 in 2010” according to the New York Times.

The 2010 is almost exactly the same as it was in the early 1990s when the latter figure is adjusted for rising prices.  The recent financial crisis has, therefore, erased “almost two decades of accumulated prosperity.”

This accumulated wealth reached a peak of around $126,400 in 2007, the Fed said.

The primary culprit for the roughly $50,000 decline? 

Well, the “crash of housing prices explained three-quarters of the loss.”

Over the past fifty years or so, homes were the piggy back of the middle classes.  Most of the income earned by the middle classes went into their homes with little else left over for any other kind of wealth accumulation.  And, the middle class saw their wealth rise over this time period.

Over the past twenty years or so, the federal government tried about as hard as it could to create a similar piggy bank for people with little or no personal wealth and little or very little income.

Now this goal of the government has all come crashing down.  To a great extent, the credit inflation begun in the early 1960s aimed at building up the housing piggy bank has unwound.

The aftermath of the federal government’s great experiment has left a confused and, in many cases, a desperate number of households.  And, this is after three years in which the United States economy has been growing.

Why can’t fiscal stimulus correct the problem as so many fundamentalist Keynesians recommend?

The answer is that the government programs aimed at keeping the price of houses rising, year-after-year-after-year could just not continue to sustain this inflation forever.  There had to be some real earnings supporting the continually rising prices.  Somewhere, sometime the “bubble” had to stop.  The cash flows supporting the increasing market values of the housing stock could not keep up…so the market values of the housing stock had to, at some time, collapse.

The continued credit inflation created by the federal government resulted in a dislocation of resources.  And, where there is a dislocation of resources, the economy must, over time, attempt to return the allocation of economic resources to a less artificial distribution. 

That is what we are going though now.  Of course, some pundits recommend more of the same.  If the credit inflation being created by the government is not “getting things going again” then the government must step up its efforts to produce more credit inflation. 

The problem with this is that constant application of credit inflation cannot continue on forever and forevermore.  The dislocations created by such a policy grow and grow and grow and the amount of credit inflation applied to the economy must also grow and grow and grow in an effort to sustain the dislocations.  The burden becomes heavier and heavier and heavier.

Eventually, the bubble bursts. 

The United States economy is now going through a re-structuring attempting to remove the dislocation of resources created by fifty years of almost steady credit inflation on the part of the federal government.  We are seeing the consequences of this policy, not only in the collapse of the median level of wealth of the American family, but also in the growing inequality in the distribution of wealth in the country.

Unfortunately, these unintended consequences just inform us that “good intentions” do not always produce the results we want.     

Sunday, June 10, 2012

Spain: Is This The Start of Something Big?

“Spain on Saturday agreed to accept a bailout for its cash-starved banks as European finance ministers offered an aid package of up to $125 billion (or €100).”

Note: this is for the banks only…not for Spain, itself…

The IMF had suggested that the minimum needed to stop the drain at Spanish banks was around $46 billion.  So, for once, it seems as if the finance ministers are finally trying to get their arms around the problem and not just “kick the can down the road”. 

After what we have seen over the last three years of so, it is easy to be skeptical.

To raise the credibility of the officials in the eurozone, this effort is going to have to be followed up by something more. 

Yes, the agreement has not really been signed and sealed yet, and I am looking further down the road. 

That, however, is the only way that credibility is going to become established.  One still shudders at the lack of leadership that exists within this community.

But, next steps are going to have to be made and they are going to have to follow right on the heels of this effort to halt the decline of the Spanish banking system.

The next steps are going to have to strongly indicate that the eurozone is following up this action with a real effort to create a European Banking Union!

This will not be a simple task, by any means, but it is the next thing on the agenda.

Yes, Europe needs a new unified fiscal authority to keep the eurozone together and to stabilize the euro.  This will be an even greater task than the building the European Banking Union.

The banking system needs to be saved first and this must be done in the short run.  The fear of a run on European banks seems real and this fear must be dealt with before we get to the sovereign debt issue.  Thus, full attention must be given to the issue of a banking union for it is the short run issue of consequence right now!

A major issue that will overshadow much of the debates relating to the creation of a European Banking Union is the giving up of sovereignty over banks that now reside within national jurisdiction.  That is, each individual nation in the eurozone is going to have to give up something very dear to them in order to achieve the creation of a banking union.  This surrender involves centuries of history, pain, dislike, and, in some cases, outright hatred.

Can the officials get over this hang-up?  Can they put the past behind them in order to save the future? 

Creating a banking union, however, is just the start.  If there are national issues that must be given up in creating a “federal” banking union, these issues pale when one considers what these nations must give up to create a “federal” government that oversees and controls the spending and taxing and so forth that have formerly been completely under the control and oversight of the individual nations themselves. 

But, it seems to me that there is very little to choose from in the present situation.

Let’s consider three possible outcomes from the current state.  First, a European Banking Union is formed followed by the formation of a federal European government that oversees and controls spending for the eurozone. 

Second, the eurozone falls apart and the individual nations now making up the union go on their merry way.

Third, some nations form a banking union and a federal government and other drop out of the community.

To me, the suffering and pain that would accompany the second and third choices would be very substantial.  The second and third options are just not pretty!

But, human beings can be very self-destructive at times and make choices that are stupid and against their own best interests.

In my mind, there is no real choice.  Somehow, someway, European officials are going to have to form a European Banking Union and are then going to have to follow this up with some kind of federal government that deals with the combined fiscal issues of the eurozone.

Therefore, I am pleased to see the discussions concerning the rescue of the Spanish banks going forward.  I am hopeful that these discussions will be followed up by the formation of a European Banking Union. 

Then, the big task…a federal European government that will discharge the responsibilities of the eurozone with respect to the fiscal affairs of the community.  Of course, this federal government will also have to deal with the restructuring of economies, work-rules, pensions, and so forth.

Seeing real, credible movement on the part of European officials, I believe, will be seen positively by international investors.  If these investors react positively to the movements to create a European Banking Union and then to the further efforts to create a federal European government, I believe that financial markets will rise and this will provide the support and encouragement for the project to continue. 

If this process gets started the European officials must not let the momentum or the international investment community will lose heart and argue that the officials were not fully into the idea in the first place.  Skepticism will set in again.

I see the possibility of getting started on the European Banking Union, however, as a real opportunity.  The issues here are not as great as those connected with the formation of a federal European government.  So, this is a chance to start on issues that are smaller and are clearer. 

The important thing is to get the process jump-started and then build on the momentum.      

Thursday, June 7, 2012

The Bad News Continues: German Banks Downgraded

Moody’s has been traveling around Europe over the past four weeks or so and leaving its mark about everywhere it has gone.

On June 6, Moody’s lowered the credit rating of six German banks and three Austrian banks. 

Deutsche Bank was not included in this round of downgrades for it will be examined later this month when Moody’s does a review of the “biggest global banks” with large capital market operations. 

The latest round of bank downgrades followed three downgrades in Sweden on My 24, sixteen downgrades in Spain on May 17, and twenty-six downgrades in Italy on May 14.

The news release that accompanied the June announcements stated that the German banks still had a large exposure to structured credits, a substantial exposure to peripheral countries in the eurozone, and exposure to industries that were going through hard times, like shipping and finance. 

In addition the banks still faced a great deal of exposure to possible loan charge-offs due to weak profitability. 

And, these banks had only small amounts of capital relative to total assets.

The weak profitability can be attributed to the fact that German banks…and European banks in general…are not expanding their lending.   On reason is the reality of the current recession taking place in Europe.  However, with weak capital ratios and additional regulatory pressure to re-capitalize, the banks are not in any mood to move more aggressively on the lending front. 

The whole re-capitalization issue is also caught up in the discussions about forming a European banking union that would make almost all banks in the eurozone, European, and not just a member of a particular country.  This is not a non-issue!

And, if the banks are not lending, it will be difficult to achieve faster economic growth. 

One can see why the issue of a possible bank run on continental banks is being tossed around.  And, one can see why European officials are concerned.

The problem here is that if one ignores a problem for a long, long time, the problem does not necessarily go away.  And, in many cases, the problem can get worse.

The banking situation is Europe has been ignored for a long, long time and combined with the sovereign debt crisis, which was also ignored or action was postponed for a long, long time, things got worse. 

The added problem is that when things get worse, the solution is not always the same as in situations where the problem did not get worse.  And, when the problem gets worse, it often takes a much longer time for things to get back to normal. 

Liquidity actions on the part of central banks and deficit spending on the part of national governments may resolve a “more normal” banking or “more normal” sovereign debt problem within a reasonable period of time.

When the problems become ones of solvency and bankruptcy, the “more normal” prescriptions to solve the problems may not work and the time to return to “business-as-usual” may be an extremely long time.  But, when the problems become this great, officials often deny them and try to postpone getting to the real core of the issue for as long as they can.

We have seen this situation evolve in Europe. 

Now, the solutions have become structural and the potential disruptions to the existing culture have become enormous.  Where all this will end is unknown.

But, the pressures to act are growing.  Everything seems to be culminating in the need for eurozone officials to do something.  Financial markets react to news about what officials seem to be doing.  If it looks like the officials are moving to resolve an issue…financial markets improve.  If it looks as if the officials are deadlocked due to irreconcilable differences…financial markets tank.

Economic news does not do that much to move the markets these days.  The conditions of official discussions are the primary thing that the participants in the financial markets seem to be focusing upon.

Here again is another factor that arises when action is postponed.  The news never quite seems to be positive.  The German banks have been downgraded today.  Moody’s will soon have a report out on the “biggest global banks.”  And, then there will be something else. 

I know that the nations of the European continent have issues with one another that go back centuries.  I know that it will be very difficult for many people to lay down these issues and get on to what is real.  But, all I can say to the officials in Europe is…GET OVER IT!  Get on with business. The rest of the world cannot wait for you to fight another world war…if only on the conference table.