Tag: finance

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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Occupy Wall Street Raises Concerns about Banks

As support for the Occupy Wall Street protests grows globally, some of the ideas that appear to power the movement are getting some level of understanding from surprising quarters. This week Wells Fargo CEO John Stumpf said, “I understand some of the angst and the anger. This downturn has been too long, unemployment is too high, and people are hurting. We get that,” according to a report in the Financial Times.

The New York Times reports that Citibank’s CEO, Vikram S. Pandit pointed out that the protesters’  “sentiments were completely understandable. I would also corroborate that trust has been broken between financial institutions and the citizens of the U.S., and that it’s Wall Street’s job to reach out to Main Street and rebuild that trust.” The protesters should hold Citi and others “accountable for practicing responsible finance and keep asking us about how we’re doing,” he added.

That Times article, however, opened by explaining  that lip service about such understanding by bankers in public can mask opposing sentiments expressed privately by other bankers that the protesters represent “ragtag” or “fringe” groups along with a rejection of protestors’ implicit critique of large banks.

While the protestors’ complaints span many issues – a core critique is that large banks and financial services companies, centered mostly around Wall Street, created the financial crisis when they took on excessive risks, then relied on huge taxpayer bailouts to save their companies and the entire financial system when those risky bets flamed out. Fallout from the crisis, according to this view, led directly to a deep and long recession, accompanied by unusually high unemployment, which has become a leading feature of a severely stunted economic recovery.

Much of the debate over the past and future role of financial services following the crisis has been the topic of articles by Knowledge@Wharton, including whether steps taken by regulatory bodies to prevent a similar meltdown will be effective.

Below are some of the more noteworthy pieces:

In a two-part video interview, Simon Johnson, a former chief economist for the International Monetary Fund and author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, argues that new U.S. legislation aimed to prevent a repeat of the recent financial crisis is not up to the job, and that the only effective cure for the problem of banks that are “Too Big To Fail” is to make them smaller. The Dodd-Frank Financial Reform Act does little to prevent the biggest financial risk of our time — banks that are becoming “too big to save,” argues Johnson, either because potential losses could overwhelm government resources, or because the public will not approve another round of large bailouts. Either way, the world economy could crash again.

Johnson added, “Over time, as we go through the cycle, we’re going to have the same sort of risk taking. Jamie Diamon [CEO and chairman of JPMorgan Chase] says you have financial crises every three to seven years. Hank Paulson [former Treasury Secretary] says its four to eight years. [Former Treasury Secretary] Larry Summers says four to nine years. Doesn’t matter, these big guys agree and they’re right, that you do it again because the system of incentives and the structure of these organizations are essentially unchanged.”

View the video interview here.

Nouriel Roubini, a professor at New York University’s Stern School of Business, agreed that “the problems of the financial system on Wall Street have not been resolved. People talk about Dodd-Frank, but have we really changed the system of compensation? Have we dealt with the corporate governance problem? Have we divided commercial banking and the more risky shadow banking and investment banking? No. So that remains.” Knowledge@Wharton reported his comments in Unheeded Lessons: What Did We Fail to Learn from the Financial Crisis? – which was based on a recent conference, at Wharton.

And a current Knowledge@Wharton article – “U.S. Attorney Preet Bharara on Cleaning up Wall Street and the Thin Line between Confidence and Arrogance” outlines the views of a tough prosecutor of white collar crime on Wall Street. Bharara has earned a reputation for taking aggressive stands against white collar criminals, including the successful insider-trading prosecution of Raj Rajaratnam, billionaire founder of the Galleon Group. Rajaratnam, who was convicted of insider trading in May, was sentenced last week to 11 years in prison. In the article, Bharara noted that many suspected criminals on Wall Street are extremely intelligent people who are paid handsomely to assess risk for hedge funds or other financial groups. He said convictions and harsh sentences are designed to “convince rational business people that the risk is not worth it.”

Bharara also said he noticed a phenomenon within organizations of employees trying to stay as close as possible to the line between legal and criminal behavior in an effort to make as much profit as possible. “If that’s the way you are thinking about your business or decision-making process, you are bound to run afoul of regulators or prosecutors,” Bharara said. “Inevitably, bad things happen.” He urged leaders to build a culture that encourages employees to “ring the alarm bells early” if others are engaging in unethical or illegal behavior. He called employees who tolerate bad behavior enablers. “A lot of this is hard,” Bharara conceded. “It is hard to turn in friends.”

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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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