Tag: bank

Europe’s Money-Go-Round Saves the Day – for Now

European Central Bank (ECB) actions taken in December to counter a potentially devastating liquidity problem in the euro zone are gaining some traction, at least for now. The key step: making $650 billion in new money available to euro zone banks over three years under the Long Term Refinancing Operation (LTRO).

This week, for example, Spain sold one-year debt at a little more than half the rates markets demanded just last month, despite a recent downgrade of its sovereign credit rating. Also, the bailed-out banks have used some of their new-found capital – though not nearly as much as was hoped for — to buy up some European sovereign debt, further easing rate pressures.

The move came just in time. European banks last month were locked in a devastating credit crunch that could have brought the continent’s economy down hard. Banks were refusing to lend to each other, mostly over fears that sovereign debt held on the banks’ books could go bad. That could have caused some bankruptcies, and bank failures could have spread quickly.

The credit situation has improved, if only for the short run, thanks to the LTRO funding. But the big picture remains risky — and in some ways confusing — because of the unusual, circular way in which funds are changing hands between banks and governments. As The Economist noted recently, banks from Spain, Greece and Italy have the deepest capital shortfalls. “Several may have to tap government bail-out funds to raise the capital, creating the circular prospect of governments bailing out their banks that are in turn supposed to bail out the government.”

Similarly, Satyajit Das notes in this piece from the website Naked Capitalism, that French President Nickolas Sarkozy has urged banks to buy euro zone government securities, to be used as “collateral to borrow unlimited funds from the ECB or national central banks.” The French President noted that “earning 6% on Italian bonds that could then be financed at 1% from central banks was a ‘no brainer’….” Das adds that “Sarko-nomics perpetuates the circular flow of funds….”

So if money is simply on a merry-go-round, why have markets responded positively, if only in the short term? Notes Wharton finance professor Franklin Allen: “… Essentially they are trying to monetize the debt.” Since the Maastricht Treaty forbids the ECB from simply printing money and buying up debt, “this is an attempt to do the same thing by allowing the banks to borrow and then buy the debt.”

In the ongoing European debt crunch saga, all sides seem willing to use more debt to continue gambling on an eventual economic recovery that can reverse the tide. But with Europe now widely believed to be heading into – or already in – recession, many economies are shrinking and so are government revenues, and thus the ability to service all of this debt.

And the LTRO approach, while relieving the private and public credit crunch in the short term, carries significant new risks, Allen points out. “First of all, the banks are taking on risk. If there is a default on the government bonds they buy, they will likely go bankrupt. This is quite possible and this why so far they have been reluctant to do this in large quantities.” The ECB also is taking a risk – “if the banks go bankrupt, they will be technically insolvent. This will cause a significant political problem.”

In this article from The Telegraph, Ambrose Evans-Pritchard and Louise Armistead cite “nagging concerns over how long the ECB itself can keep shouldering the euro zone burden, given that it has no sovereign entity behind it. The LTRO … may save the day but it also concentrates risk further for the Bundesbank and other central banks in the euro zone system, as well as private banks. The ultimate disaster could be even worse if it all goes wrong.”

So far, while the LTRO has had the effect of lowering sovereign borrowing costs for some pressed European sovereigns, it has not yet accomplished another key goal – getting banks to lend to each other in a way that increases business and consumer credit. “We see that the key refinancing markets for banks are clogged; the interbank market is basically not functioning,” European Central Bank President Mario Draghi said this week, according to Bloomberg.

Meanwhile, some debt rating agencies have downgraded credit ratings for France and Austria. Both have lost their AAA rating this week, while Spain, Portugal and Italy were dragged down two more grades recently. Portugal’s debt is now rated at a junk-bond level. Spain’s credit rating was slashed from AA- to A shortly after it announced last week that it will miss its budget deficit target by about 33%.

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Europe’s Banks under Pressure. Are U.S. Banks Next?

The euro zone debt crisis is spreading to the real economy, banks and even German bonds as potentially catastrophic financial stresses continue to climb up in the absence of a comprehensive solution.

According to the latest economic reports, new orders for goods fell 6.4% in September compared with August within the zone, and overall economic growth stagnated at 0.2% in the third quarter, the same as in the second quarter.

Other reports noted that wholesale credit markets were tightening significantly for European banks out of concerns over their “creditworthiness,” as the Financial Times put it. The article quoted one money broker saying that lending markets have not been so stressed since Lehman Brothers collapsed three years ago. “There is plenty of money out there, but more and more banks are deemed too great a risk to lend to.”

There is a self-feeding frenzy about current conditions. As European sovereign bond yields rise, the overall market value falls for the large amounts of sovereign bonds held by many European banks. That makes it harder and more expensive for the banks to raise new funds, which can threaten their solvency. And all of this reduces the banks’ ability to invest further in sovereign bonds, which adds pressure on yields and pushes the cycle to repeat. Potential downgrades of government debt and the banks make matters worse. Now Standard & Poor’s has indicated that it could lower its credit ratings for euro zone countries if the region goes into a double dip recession, something that many see as highly likely in the New Year, particularly given the latest economic indicators.

Meanwhile, the stress on European bonds has spread not only to France, but also to Dutch, Finnish and even German bonds. In a separate article, the FT quoted one trader saying that rising German yields reflect worries “about Germany and the fact that many clients are now asking: ‘Is my money safe even in Germany if the euro is going to collapse? What will happen to my euro-denominated debt?’”

And of course, the stress on European banks ultimately gets conveyed to U.S. banks. Notes Wharton finance professor Franklin Allen: “So far, the focus in recent days has been on the sovereign debt market. But the focus should shift back to the banks soon. With current sovereign debt prices they are probably sitting on large losses on their government debt. A recession in Europe is quite likely, so the banks will come under increasing pressure. This will inevitably affect U.S. banks as they are all interconnected. The real question is what the ECB (European Central Bank) will do in terms of supporting the sovereign debt markets. If they don’t, then the likelihood of a Lehman-style — or worse — meltdown is significant.”

Others analysts also say that the only way to prevent a full-scale financial meltdown in Europe is for the ECB to announce it will become the lender of last resort for all euro zone debt. But the ECB itself, Germany and several other countries in the euro zone say they are dead set against that, and treaties setting up the euro zone forbid it. The new ECB president, Mario Draghi, says that the role of final guarantor of euro debt is not part of the ECB’s mission, and German Chancellor Angela Merkle was quoted last week in a speech as follows: “If politicians believe the ECB can solve the problem of the euro’s weakness, then they’re trying to convince themselves of something that won’t happen.”

Instead, the officials driving financial policy in Europe remain committed to austerity policies that they say will eventually improve liquidity and solvency issues for the troubled borrowers.

Whether or not attitudes would change about using the ECB as the lender of last resort — should a chain-reaction meltdown begin in Europe’s financial system — is anybody’s guess at this point. But any action at that point may be too late because of how quickly events can cascade.

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The Fed Launches a Wall Street Roller Coaster

In another highly volatile day on Wall Street, Federal Reserve chairman Ben Bernanke and the central bank’s Federal Open Market Committee (FOMC) took center stage in the drama. Equity markets opened higher after Monday’s punishing 634-point sell-off in the Dow Jones index, but turned down sharply when the Fed announced it would keep interest rates at record lows. In a slap to hopes for a strong recovery, the Fed went so far as to say it would hold rates down for a specific period of time, through mid-2013.

Initially, that glum prognosis sent shares down. However, in the final plot twist of the day, Treasury rates plummeted and stocks enjoyed a powerful rally after a week of declines.

Wharton finance professor Jeremy Siegel said the Fed spooked investors with its grim assessment that the economy is so weak that it would have to hold rates down to near zero levels for two more years. Despite that troubling outlook, the Fed’s decision to effectively declare a two-year hold drove bond rates down so far that investors piled back into stocks, according to Siegel. Stocks had tumbled in the past week following a bitter U.S. debt ceiling debate, concerns over European sovereign debt and Friday night’s Standard & Poor’s downgrade of U.S. debt.

Siegel noted that 10-year; inflation-protected bonds are currently generating unprecedented negative returns. “People are saying, ‘What’s the alternative?’ Stocks are a huge buy right now.”

While the Fed’s decision on long-term rates led to a strong finish for the day in stock markets, Siegel said he has concerns about the central bank’s policy. By prescribing action so far out into the future, he argued, the Fed effectively ties its hands, limiting its ability to respond to new challenges that may emerge. Of course, he adds, the Fed could always reverse direction – the Fed’s statement says only that it is “likely” to keep rates low for that long.

“I think they are going to have to renege on their pledge in the future,” Siegel predicted. While an earlier-than-expected recovery might be viewed as a happy cause for an early Fed policy change, Siegel warned: “I don’t think that’s good for their credibility long term.”

Still, Siegel applauds the Fed board for taking some action, although he noted that three members of the FOMC dissented. Siegel would have preferred that the Fed lower interest rates on reserves or buy long-term securities and sell-short term holdings to reduce long-term rates.

The stock market might have preferred a new program of quantitative easing, Siegel said, but he believes it would have been “premature” for the Fed to take that step only weeks after it completed a $600-billion Treasury bond-buying program.

Despite the dramatic developments that have been driving markets lately, Siegel said today’s gyrations were all about the Fed. “This is the most important thing,” he concluded, “at least for today.”

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A Brief History of Modern Banking

The roots of modern banking can be traced, in some ways, back to 1960, when Charles Sanford joined Bankers Trust. He rose up the ranks to become chairman and chief executive in the late 1980s. During his tenure, which lasted until 1996, the bank pioneered a number of practices that would later become common in the industry, including the development of new ways to measure risk. 

However, the most important innovation that Sanford is most often credited for is the originate-to-distribute model of lending. By writing and then repackaging loans for sale to other market participants, Bankers Trust established a secondary market for loans. This freed up capital from loan originators’ balance sheets, which could then be used to generate even greater volumes of finance. It also placed loans with owners whose funding profiles were a better match for the long-term nature of the credits.

Ten years before the collapse of Lehman Brothers kicked off a global financial crisis in 2008, Bankers Trust was sold to Deutsche Bank as rumors swirled of large losses in its trading book. A few years earlier, derivatives deals for some of its corporate clients went sour, bringing several lawsuits and damaging the bank’s reputation. After agreeing to sell itself, Bankers Trust reported losses of more than $2 billion in late 1998 and early 1999.

The bank’s somewhat ignominious end as an independent institution is “one of the great ironies of modern financial history,” according to Gene D. Guill, a Bankers Trust employee and now a managing director at Deutsche Bank. In “Bankers Trust and the Birth of Modern Risk Management,” a paper written for Wharton’s Financial Institutions Center, Guill describes how a “well-capitalized, highly profitable wholesale financial institution fell victim to the very forces it had sought to manage.”

This observation could also apply to Bear Stearns, Lehman Brothers and other financial firms that suffered when the subprime bubble burst. Now, as financial regulators rewrite rules and customers rethink their relationships with banks, the jury is out on whether a “new normal” will emerge or whether history is destined to repeat itself. 

For Richard J. Herring, a Wharton finance professor, a new normal is emerging, although the precise details remain uncertain. But one thing is for sure, he says: “Users of finance are inevitably going to have to pay more.” When demand from borrowers returns to pre-crisis levels, however, “it remains to be seen what kind of innovation will enable banks to generate the same kind of credit,” he adds.

Herring worries about the “clumsy” way in which financial reform efforts, such as the U.S.’s Dodd-Frank Act passed last year, address the shadow banking system. In some ways, pushing for more simplicity and transparency encourages those who prefer their services to remain opaque and complex — not an insignificant part of the financial services sector — to continue to operate in the shadows. Imposing higher capital and liquidity requirements on risky products may also prompt banks to redouble their efforts to shift certain securities off their balance sheets.

It’s not surprising that bankers and bank supervisors don’t see eye to eye on the best way forward. Last year, the Institute of International Finance (IIF), an association of financial firms, openly criticized many aspects of the new capital and liquidity requirements developed by the Basel Committee on Banking Supervision, a forum for the world’s central bankers and financial regulators. “There is a price for making the banking system safer and more stable, and that price will inevitably be borne by the real economy,” said Peter Sands, CEO of Standard Chartered Bank and chairman of the IIF’s Special Committee on Effective Regulation. The “headwinds” resulting from the Basel Committee’s proposals — which have since been adopted, with some softening of certain requirements — will result in slower economic growth and more sluggish job creation, Sands argued.

Whatever the arguments to the contrary, banks will stress that the extra funds they are forced to set aside is capital that they could otherwise lend. By extension, the credit that remains will be more scarce and expensive than before.

As economies recover and interest rates begin to rise in the U.S. and Europe, banks are likely to reassert themselves, even if some of their customers permanently shift to other sources of funding. For all the anger over the banks’ role in the financial crisis, customers are notoriously reluctant to sever banking relationships. Thus, although customer satisfaction scores for smaller lenders and credit unions consistently outperform the biggest banks, meaningful competition for business remains confined to a select club of large institutions.

Other aspects of the emerging landscape for banks (and their customers) will be familiar. Governments are browbeating lenders over extending more credit to small businesses, homeowners and other important constituencies. The size and nature of bankers’ bonuses also remain a source of tension. But the ultimate measure to promote more competition and diversity in the sector — forcibly breaking up the biggest banks — does not seem palatable to officials. “When push comes to shove, legislators and lobbyists for the banking industry make a good case that banks, by and large, do a pretty good job of allocating capital,” says Herring. He wrote papers in the 1980s and 1990s that explored the concept of “narrow banks” — institutions with limited functions in specific business lines — but Herring is “much less optimistic than I was that it will ever be a solution.”

Of course, whether a truly new banking order emerges that encourages a safer yet productive industry depends on “the extent that you believe that the regulations that have been imposed will actually be enforced,” notes Herring. Left to their own devices, “the financial markets have remarkably short memories.”

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