US HEALTH ECONOMIC FORECASTS ARE SICK?

USA Health Care has a spending budget from government and medical insurance that is 15% ratio to GDP. It employs 16 million people in full and part-time jobs (the same number as are employed in all retail trade). Is it remarkable to consider a nation's propensity to fall sick supports as many jobs as its propensity to go shopping?
Total USA employment is 151 million. 20 million net new jobs are expected over the next decade and a fifth of these in health care (according to US Dept. of Labor forecasts).
Health care has grown faster than other sectors of the economy. Its employment growth over the next decade is only expected to be exceeded by employment growth in all of business services. Health has grown faster than the economy generally and may continue to do so, but some foresee it growing out of all proportion. The Congressional Budget office (CBO) projects health care spending to a ratio of 50% to GDP over the next seven decades and doubling to a third the size of total GDP by the 2030s! It is such projections including massive concomitant increase in national debt that is excercising objectors to Obama's Health Care reform bill (plus private health sector and pharma lobbying, which in this Congressional election year can make unlimited political contributions following a decision by the Supreme Court). The complexity of the facts of health care makes it easy prey for rabble-rousing politics. Both sides of the debate, which is polarising the electorate almost exactly along party lines, claim that a majority of voters oppose the reform. In this political balance statistics and damn lies play a dominating role, none more so than the Congressional Budget Office's forecasts (see www.cbo.gov) for federal debt & deficit. It is in my memory a report very similar to that on future pension costs by the CBO used in the mid-90s CBO attack on Clinton's budget, which also projected that half of national debt and 50% ratio to GDP costs for state pensions by mid-century. That furnished the Republican Party with an attack on Clinton for being negligent of public finances even as he was balancing the budget (before heading for a budget surplus). The current report on health care provides technocratic arguments for attacking Obama's medical insurance plan. CBO reports are authoritative sounding and may be capable of swinging the vote on The Hill, but that is where the realism ends! . One has only to ask, when health spending is 80% labour costs, how it can ever be possible for health care to attain a size of 50% ratio to GDP? Can anyone envisage a USA economy in which one in every 3 or 4 employed works in health care? - maybe 60 million health care jobs in the US total of 280 million jobs by 2080? This is the CBO implication, although its study did not ask questions about jobs. 60 million is 40% of the total of jobs in the USA today. To understand it, that is twice the population of California, twice the economy of France or Italy or the UK as they are today! Could it come about that 5-10% of the US population? Well, a quarter of the population is obese and people over 50 require 5 million surgical procedures. 15% of the USA population will be aged 65 or over by 2025.
Short of mass Euthanasia to save the economy, the CBO has little to offer except a monetary and fiscal cause for general anxiety or inter-generational panic!
This is not about hospitals. There are 6,000 in the USA of which over half are not for profit publicly-owned. Total hospitals budget is about $800 billions (under 6% of GDP) with 1 million beds and handling 40 million admissions (ave. cost $20,000). Hopsitals are less than half the total health care cost.
But, will all health care grow to requiring long term health care necessitating a quarter or more of all jobs to be in health care? CBO's trend projections are silly and artificial. The weaknesses are:
- CBO projects real GDP at steady 2.2% but ignores inflation on amortising debt (an average of 2% in this aspect would transform the debt to GDP ratio projections)
- CBO ignores multiplier/ feedbacks between health revenue & spending in the wider economy
- tax revenue rises in real terms, but spending costs rise with inflation
- interest on fed debt is 3% above inflation (i.e. always above nominal growth?)
The CBO's The Long-Term Budget Outlook, June 2009, on page 26 shows a graph showing excess cost growth + ageing population together costing equivalent to 15% of GDP by 2080. If US economics undergraduates produced this, the professor would send them back to Economics 101 (or advise them to apply for a job at CBO). Reputable economists should look at this charlatanism and publish a strong critique or I fear Obama's medical policy and with it much of his domestic credibility (including at the mid-terms) will be lost. There are many ridiculous assertions in the CBO forecasting reports - my list would be nearly as long as the June '09 report!

SEVERE WINTER AND DISCONTENT HIT ECONOMICS

Winter 2009-10 has been especially severe across USA, Europe and Asia all the way to Northern China. There was a similar deep freeze in 1994/5 that knocked a full 1% off economic growth and that panicked treasuries including USA and UK to boost deficit spending for fear this was an advance indicator of a severe economic downturn. Winter even effects policy formation. Mr Bernanke began unveiling details of the Fed’s exit from bank support strategy two weeks ago in congressional testimony, but his actual appearance before lawmakers was cancelled because of a snow storm. It convenes today.
When January's UK tax revenue for 2009 was predictably low at 6% down, slightly below expectations, and government cash-flow borrowing appeared high, there was also a Winter effect in this. Do not expect first quarter 2010 GDP therefore to be a sound indicator of how recovery and fiscal deficit impulse are behaving.
In addition there is palpable weakening in consumer confidence driven by political cynicism, party ya-boo politics, all the normal uncertainties in election years (UK general election in May and USA mid-terms: House - all 435 seats - and Senate elections - 36 seats - in November, to form the 112th Congress) when the voters will among other matters judge how well governments have dealt with the credit crunch and recession. In China, the response has been erratic, much juggling with ups and downs of money supply and snowing us with unbelievably positive statistics.Yet, the country’s banking regulator has had to order lenders to cut back on credit to local governments’ financial arms in an attempt to reduce future bad loans. Bnks exposure to property development is only rivalled by Rmn 6 trillions (c. $1 tn) of exposure to state entities, much or all of which is non-recourse loans! No politicians anywhere underestimate confidence factors e.e. the Brown-Darling spat recently reported in Andrew Rawnsley's book over whether to tell the public last year that this would be the longest deepest recession or not! The 3 letters to the newspapers signed by 87 economists focus on market confidence, loose or tighter fiscal stances for longer or not, but acually UK recovery will be dictated more than anything else by what the USA policy makers do - twas ever thus for over a century, one reason why we go to war together. Commentators are confused about the virtue of prudence and not having national debt or the private business and household sector debt overhang, and the risks or benefits of higher private saving, failing to appreciate that you cannot have private and public sectors exhibiting the same prudence at the same time; private savings are the exact (in macroeconomic accounting terms) counterpart to higher public sector borrowing, plus the economy's external account balance. Inbetween, private and public debt balances and the net external account, is also the new (on an unprecedented 'peace-time' scale) and very fuggy world of central banks and treasuries off-budget and off-balance sheet operations. And central to that are the length of commitment and exit strategy by government from providing liquidity and capital support to banks. This is the subject of Ben Bernanke's grilling on Capital Hill a fortnight ago on the 10th. What the USA decides will be scrutinised and in some form copied by the UK though policy inspiration also flows from UK to USA.
What may be surprising to those who know that banks remain very stressed, US banks have $1.2 trillions in reserves, also called "excess liquidity", not to be confused with 'capital' that is also about $1 trillion. The UK equivalent is about $500 billions, much higher in proportion to the size of the economy reflecting the immensity of international banking in the UK and UK banks' international exposures. The Federal Reserve’s following after its Quantitative Easing comes Supplementary Financing Programme to drain excess liquidity from the financial by selling $200bn in short-term debt and store the proceeds at the central bank. The Fed is shrinking its balance sheet to begin preparing for when it is economically a good time to tighten monetary policy. Congress at the same time has authorised a raising of the Federal Debt Ceiling by $1.9tn to $14.3tn when the limit on total public debt of the USA is just shy of 12.4tn, after it was raised by $290bn in December to ensure the government could continue to function. This limit has been reached. The Senate and House similarly also passed amendments to legislation raising the debt ceiling requiring new budget items to be paid for, dubbed "pay-as-you-go."
Ben Bernanke on the 10th faced US legislators about his central bank’s “exit strategy” from banking sector support - like preparing to packing his resources onto the down escalator as soon as it is clear eveyone else is on the up escalator. “BB Gun” as he is affectionately known in some quarters, has had to deal with criticism from both Republicans and Democrats over the Fed’s role in the financial bail-outs, the ballooning of its balance sheet and its inability to foresee and prevent the boom and bust in US housing (mid-2005 – 2010). This is not unrelated to his plans to shrink the money supply in order to avert any splurge in inflation even if a dose of this might be helpful to shrinking debt burdens.
US realtor firms websites all have picture of keys being handed over to represent 'sale agreed' - today the pictures are as likely to mean the opposite 'un-agreeing the sale'. Unlike in Europe, US mortgage borrowers cannot be pursued for the balance of the debt, and unlike Japan where mortgage debt can be pursued through three generations to the grandchildren of the original mortgage borrower - the only collateral for mortgage deals in the USA is the property itself, and getting foreclosures processed in court can take up to a year and a half. When non-defaulting mortgagees decide to 'hand in the keys' without recourse, to become defaulters on houses that say were worth $500k and are now only $400k and maybe sit tight rent-free for 16 months saving $40k before foreclosure, the question arises ‘would it be better if banks took some of their mortgage credit losses by reducing mortgagees’ debt’ to ensure voluntary foreclosures are less, and, if so, how can this be done cost-efficiently and fairly? Sub-prime mortgages (a fifth of the total) are showing 25% defaults when prime borrowers’ defaults are less than 2%. The possibility of higher interest rates, and therefore higher borrowing costs for consumers and businesses, and mortgagees has politicians of both stripes concerned – particularly in an election year, r stoked by the Fed’s move last week to raise the discount rate – at which banks can borrow emergency loans from the central bank – 25 basis points from 0.5 per cent to 0.75 per cent, even if for now this will not filter through to impact borrowers much who are already bearing a high credit risk margin in rates of at least 100-200 basis points above un-stressed, more normal, period risk margins.
The Fed has explained several times that the move represents an unwinding of emergency liquidity measures set up during the crisis, and is not a shift in monetary policy. That is yet to come and may be some way off, given the fragile state of the economic recovery.In written remarks BB indicated that the central bank would tighten monetary policy in this cycle after ramping up tools, such as “reverse repos” and a “term deposit facility” to shrink the Fed’s balance sheet, which increased from $800bn to more than $2,000bn during the crisis.
The $200bn plan – which also would have the effect of reducing excess reserves – is seen by some economists as another helpful manoeuvre .The FT view is that the Fed is developing its option – which central banks rarely have – of choosing by how much it wants to affect short-term interest rates through rate rises or, conversely, long-term interest rates through mortgage asset sales. I’m not sure this is totally the case given that US banks, if not so much as EU banks, have to buy and hold far more government bonds than in the past, for regulatory reasons, to increase and improve the quality of their capital reserves, and therefore demand for government paper remains high.
The main issue that should be addressed is how to halt banks and borrowers deleveraging to narrow their net personal and company debt or grow spare surplus, or in case of banks narrow their funding gaps.
The FT makes a spendid observation that the Fed (and we may add bank of England too) now have a significant degree of flexibility, by having entered the politically tricky territory of being able to allocate resources via the banking sector and other agencies within the economy.
The Fed, by holding so many mortgage assets on its balance sheet, “has opened itself up to criticism from various sources and has encouraged the idea that monetary policy decisions may be influenced by political or other special interests”, said Charles Plosser, Philadelphia Fed president in a speech on Fed independence last week. His view is that “This is not a healthy development.” Why not? His solution was that the Fed should, at the earliest opportunity, sell the mortgage assets and return to its pre-crisis balance sheet composition of mainly US Treasuries.
BB in his congressional testimony on the Federal Reserve’s “exit strategy” made clear that there were no imminent plans to tighten credit in the US economy, whose recovery is still early and fragile. But, he signaled that the US central bank is preparing for unwinding the extraordinary support for the financial system – and the enormous increase in its balance sheet – that it built up during the crisis. This means taking profits from the support, or if early letting other investors in banks have more of that? “He’s walking a tightrope,” said John Canally, an economist at LPL Financial reported by the FT; “He can’t afford to make a mistake.”
The Fed chairman did not give any hints about exact timing; that depends on US economic and financial conditions. The UK government’s stated view is similar, although the Conservative Opposition is more gung-ho to exit earlier, seemingly more confident about economic impact and less concerned about the profit to taxpayers. When the moment comes, the Fed is considering tightening the money supply through a combination of several measures, including an increase in the interest rate on reserves, which is now 0.25 per cent. “to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Fed banks.” The interbank wholesale money market rate spreads are currently still 100 basis points.
That focus on interest rates on reserves – though expected by many economists – represents a big departure from previous practice at the Fed, which for years has used increases in the Fed funds rate as its main policy tool to remove money from the system. But BB indicated that the Fed funds rate might not be as reliable in this cycle because activity and liquidity in that market declined with massive increase in the Fed’s reserves during the crisis. He added that a “term deposit facility”, which would encourage banks to store more money at the central bank instead of lending it out, and “reverse repos”, to allow the US central bank to borrow short-term (t-bills)in exchange for cash, to allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quickly if it choose to do so. One has to wonder whether the Fed's measures and indications may bestir the banks to stop building up the Fed's reserves by doing more themselves to unravel the bank-support by reversing the swaps or buying back pledged assets and re-conditioning these as instruments to support their liquidity and capital balances.

The real overhanging question, however is when will the banks stop deleveraging and at last begin expanding their lending. Surveys all show that consumer and business investor confidence are highly linked to ease of borrowing. This is circular, however, since banks take their cue as to whether and when to let lending expand based on consumer and business investor confidence!
Note that just like the Fed is sitting on measures to tighten credit conditions, it is sitting on massive mortgage assets it could see, just as banks are sitting on massive real estate portfolios they could sell, but none want to do this while the economy remains fragile. Hence, for now, the US Fed has no plans to sell mortgage assets before they reach maturity and is not expected to do so at the beginning of any credit tightening phase.
One of the earliest moves, as a sign that it view economic recovery to be hardening, Fed officials might increase the discount rate – at which commercial banks can borrow money from the US central bank at a preferential rate. Before the crisis, the discount rate stood 100 basis points higher than the Fed funds rate. This spread was lowered to 25 basis points amid the credit crunch turmoil after mid-2007.
“The economy continues to require the support of accommodative monetary policies,” BB said, adding,“However, we have been working to ensure that we have the tools to reverse, at the appropriate time, the currently very high degree of monetary stimulus.” Should we see this as a firm indicator? BB says no, because of the large amounts of reserves in the system there was a possibility the Fed funds rate would for a time be a “less reliable indicator than usual”.
It only hurts when I laugh!

STATES OF USA RECOVERY?

Economic recovery is arriving in fits and starts – the starts are positive growth and the fits are restructuring including using fewer jobs to produce goods and services i.e. rapid productivity gain, also banks and borrowers deleveraging and continuing bouts of short-term profit taking and anxiety attacks. All that is said here about the USA, applies almost exactly to the UK as well, which is lagging 6 months behind the USA, which is the UK traditional response lag with a century of consistent history in support.
USA unemployment remains unacceptably high, hence President Obama’s new supplementary spending initiatives announced in his address to both houses of Congress in January to focus directly on job creation.
Real GDP, the broadest measure of total output, rose at a robust 5.7 % (annual rate) in Q4 2009 - best gain in 6 years. If sustained this would be a V-shaped upswing as in the last few recessions, in which case consumer and investment confidence would rapidly recover – but that is unlikely, not least because of the deeper and longer recession period of Q1’07 to Q2 ‘08 !
The Q4 ‘09 leap in GDP overstates the underlying bounce-back of the economy - much of it reflects slowdown in manufacturing businesses selling off inventory and a resort to more new production. Less than half of the Q4 growth reflected higher consumption - it only grew by 2.2%. Manufacturing and retail & distribution are getting inventories more closely aligned to short term sales, but such adjustments can only deliver a growth spurt only for a few quarters. The government’s deficit spending effects including shifts in composition to focus on job creation have to take up the slack. A sustained robust recovery will only be certain when realised sales to end-users and consumer are seen to grow at 4-6%.
Consumers and investors remain cautious. The big weight hanging over everyone’s heads is jobs security and the sight of construction projects at standstill – the cranes aren’t moving and recovery in property housing values and office occupancy rates are uncertain. Real estate market recovery will not be uniform but patchy by area, county and state. Shift in spending and demand will also see industries and services recover in a similarly patchy manner – not uniformly across the country except in those sectors that directly benefit from government deficit spending and which are relatively recession immune.
The current persistently high level of non-farm payroll unemployment is severely restraining income and undermining confidence as people worry whether they can be confident of their paychecks in the year ahead, and see some signs of new jobs, plus signs of easier credit. Even those with secure jobs worry about debt burdens that where close to historic highs at the onset of the financial crisis and wealth factors after equity and house prices fell sharply. Households are paying down debt and saving more, a development that partly reflects banks reluctant to lend to households and businesses as the banks restructure their balance sheets, making them smaller to reduce their own borrowing, the gap between loans and deposits.
The housing sector appears to have stabilized, but there remains a large overhang of empty housing and office properties held off the market. So, no continued sharp turnaround. New home sales and construction finally stopped declining in 2009 and appear stable, but at low levels. Home sales surged in late 2009 in temporary response to the Homebuyer Tax Credit - it expires this spring. The housing sector also benefits from the Fed’s buying of mortgage-backed securities, but the Fed is now tapering off these purchases and plans to stop them by end of March. The housing market could then weaken again.
In past recoveries, business investment typically grew rapidly once the economy turned up, but banks were in much better shape then to respond rapidly to the upturn. In this recession, businesses sharply curtailed capital investment. There is some rebound in business replacement spending on equipment and software. Businesses remain nervous and exceedingly cost conscious, focused on process efficiencies, core sales not new developments, keeping supply chains lean, waiting for purchase orders before they produce, and meeting increases in demand with higher productivity from existing workforces. Similar is true in services – there are always some sector exceptions. Generally, bank financing remains an impediment to fully-restored confidence. Credit is available, but collateral requirements are onerous. What’s more, the crisis made businesses keenly aware that they can’t count on being able to get credit.
Meanwhile, commercial real estate will stay depressed for some time yet with high vacancy rates for office, retail, warehouse, and other income-producing properties, despite lower rents, severely reducing demand for construction. Lenders and investors demanding extra compensation for risk, drove up commercial real estate financing rates compounded by banks anxiously and urgently reducing their exposure to property. The market for commercial mortgage-backed securities remains distressed, despite support from the Fed’s Term Asset-Backed Securities Loan Facility, or TALF.
Put it all together and you have a recipe for a moderate growth. Q1 2010 appears on course for around 3% annual rate GDP growth – perhaps 3½% for the year as a whole, maybe 4½% in 2011, with private demand and consumer spending tightening the slack as government stimulus programs fade.
Much depends on banking and financial systems recovering as asset values restore and much lower losses are realised and capital reserves are shored up by higher equity values. Second, losses on mortgages, commercial real estate credits, and other loans continue to arrive, and the full weight of foreclosures and bank failures on the economy has yet to be felt, but net interest income and asset sales should recover sufficiently to ensure rising profits. Monetary policy reached the limit of its stimulus and fiscal policy is facing political limits. Despite the high deficit spending ratios in government budgets it is not clear that these can give the same kick-start to a low-inflation economy as in past recoveries.
The “output gap,” the difference between the actual level of GDP and the level where GDP would be if the economy was at an optimum low-inflation near full employment was at minus 6% at end of 2009, based on Congressional Budget Office estimates - equivalent to $1 trillion of lost annual output, or roughly $3,000 per capita. This will continue. The San Francisco Fed estimated potential level of output grows roughly 2½% annually due to growth in the labor force and higher productivity. Hence, over the next two years, potential output will increase by about 5 %, and if real GDP grows 8% ( 3% more than potential output) then the output gap will shrink to around minus 3% by end of 2011 and that may not reduce to zero until 2013.
The U.S. economy shed 8.4 million jobs since December 2007, more than 6 % drop in payrolls, the largest such decline since the demobilization following World War II. Unemployment was 5 % at the start of the recession, rose to around 10 % in late 2009, 0.7% in January. New jobs are at very low levels. The pace of job losses has slowed dramatically and there may be a turnaround in the labour market soon.
The unemployment rate rose sharply last year, partly a delayed effect from loss of service sector jobs and the particular nature of a banking-crisis triggered recession.
GDP was basically unchanged over the four quarters of 2009. But payroll employment fell by 4 percent over the same period. In other words, the economy produced roughly the same output with 4 % fewer workers, a productivity growth well above the long-term trend. Is that a temporary aberration or a new trend? The government is very concerned not to have a repeat of the relatively-speaking jobless recovery of the early 1990s and early 2000s.

EUROPE TO REJECT OBAMA BANKING REFORM

Michel Barnier (on the left), the newly appointed EU internal market commissioner at a meeting of European finance ministers explained it wouldn't be possible to "transpose" Obama's banking rform idea to the EU. This somewhat confirmed US anxiety triggered when France’s President Sarkozy characterised Mr Barnier’s nomination as a “victory” against Anglo-Saxon capitalism, which is a rhetorical concept i.e. one fit for political grandstanding in the long postwar tradition of fingerpointing across the English Channel and that larger one called the North Atlantic. Is there a gameplan afoot here to win a transfer of wholesale banking from the US to Europe, and will EU's rejection of the Obama plan to ban prop desks be torpedoed by banks' lobbying in Congress not to pass what Obama proposes - his plan to limit proprietary trading by banks now that not only UK government but also the European Commission say this will not work in Europe? yet, the ECB seems to think it is a step in the right direction while JP Morgan's analysis suggests it could be severely damaging including to traditional banking! Obama’s plan to curb proprietary trading if implemented will cost Goldman Sachs Group Inc., Morgan Stanley, Credit Suisse Group AG, UBS AG and Deutsche Bank AG about $13 billion in revenue in 2011, according to JPMorgan Chase & Co. analysts. Of the five banks analyzed, Obama’s proposals will impact Goldman Sachs the most, resulting in an estimated $4.67 billion drop in earnings in 2011. UBS stands to lose the least, with revenue declining an estimated $1.92 billion. Sounds quite good to me? The 'against the ban' lobbyists might include a slurry of high tech firms who supply the banks and the Exchanges and market data vendors such as Bloomberg and Thomson Reuters? Those who support the ban are supposedly Main Street sickened by the carpet-bagging gains (read 'bonuses') of Wall Street traders.
There is sense in the idea. It is clear that banks got into trouble (credit crunch) when they could not finance (via wholesale financial borrowings) their funding gaps between deposits and assets, now made even more difficult by having to divert additional substantial own funds to capital reserves and the still bottom feeding level of their share values. Much of the funding banks borrowed was to support their own trading in the markets and corporate loans including lending to hedge funds via prime brokers or to fund their own internal private equity and hedge fund operations. The idea is to restrict banks' operations as deposit-takers to serving their customers in traditional ways and not chase after higher profits (realised or simple paper profits) from speculative trading and investments.
Distinguishing these two sides conventionally known as commercial banking and investment banking is not entirely straightforward notwithstanding how they were so divided until President Clinton as almost his last act in office repealed the Glass-Steagal Act. Many concur with the view that this repeal was the start of a slippery slide into a situation where banks focused far too much on speculating directly on their own accounts instead of only net interest income and fees from serving their banking customers and investment clients.
How far the split would go is as yet unclear. Would banks have to give up offering retail investment products, underwriting and asset management as well? Would banks be restricted in how much they could trade in the markets in FX, money markets, bonds and equities wherever this is not merely executing customer orders e.g. market-making to churn and keep testing market prices. 85% of wholesale markets liquidity (turnover) is churn. Would the result be merely that a host of new trading firms would be spun out of the banks perhaps in rteurn for loan contracts that include share of profits, or would any profit sharing and minority stakes in trading entities by banks be banned? Will some banks deregister as banks and will this mean that many new financial firms will be created who are less regulated than before when part of the highly regulated banks? There may be some sort of compromise that emerges allowing banks to limit their prop trading to a % ratio to total assets such as say 10%. But a great deal of derivative and other trading by banks is arguably hedging of their risks, but that is very hard to distinguish cleanly from speculative poprietary trading?
One effect may be that much of market trading is done by less well capitalised firms who are therefore forced to trade even more on a short term basis and thereby skew the quality of the markets. There may be a net reduction in trading desks and a shift further towards algorithmic trading i.e. where computer programmes rather than human beings drive selling and buying in the markets using questionable models that are very hard to risk assess when they are employing extremely short time horizons? The abolition of Glass-Steagal may prove to be a genie that cannot be put back into the bottle.
What is the European (and Asian) perspective. Like many big banks in Asia many big continental European banks such as the Germans especially have relatively small retail networks and rely on wholesale funding more backed by their corporate loans and have become very dependent on own trading revenues. A major reason for creating the Euro was to create bond and equity markets in Europe to compete on the scale of those in the USA. In truth, while the European primary markets were smaller, the secondary markets were already as big or bigger than the USA's pre-Euro but the conception was based on primary market calculations, while the secondary market calculations were confused by the many currency and money market interest rate differences. Post-Euro trading volumes shrank in Europe because currency and interest rate differences between 10 currencies had been removed and banks lost massive trading income for years as a result. Nevertheless, the idea was to compete on at least level terms of similar scale to the USA and in part compete with what was then beginning to be termed Anglo-Saxon capitalism. This idea today extends to seeking to replace the dominance of the US ratings agencies, much blamed rightly for the credit crunch shock in the second half of '07.
Barnier says, "[In Europe] there are more problems with interconnection of banks rather than specific nature of operations or scale of individual banks.” This reflects a view that systemic risks in future must focus on how failure by any one bank can trigger losses via how banks are networked, which is essentially a piss-poor approach that ignores the wider macro-economic analysis. The Credit crunch is not a shock created by a few but by all banks influencing and being hit by economic and credit cycles. That some banks lost more is mainly due to to the the roll-over timings of the borrowings as much as their exuberance about structured products and property loans.
Barnier believes, however, that although markets are different, meaning Europe's from the USA's, though how he figures that I'm unsure, there needs nonetheless to be a global approach to reform in line with the G20 agenda. Obama's problem is therefore whether he can get his proposed cap on prop trading by banks onto that agenda and this now appears very doubtful. There is a commitment to cap bonuses, but the banks so far, while at first politically naive or insenitive in under-estimating the political force of public anger, now feel they can simply postpone the matter by translating current bonuses into shares and share options for staff to be encashed at a future time.
President Obama’s reforms were drawn up by the octogenarian former chairman of the Federal Reserve Paul Volcker that would directly and indirectly limit the size of banks beginning with allowing none to have more than 10% of total US bank capital (i.e. market share) or assets of more than 10% ratio to GDP (an absolute size constraint that if Citicorp including its foreign assets was so measured it would have to shrink) and the new proposed US legislation (not yet published) would also prevent commercial banks from making investments in hedge funds or private equity operations - or these may be limited to minority shares much as institutional investors in both US and EU are limited in their shareholdings of banks.
In Europe the desired limit of any one bank's market share is 15% on a state by state basis in retail and corporate banking but with no caps on investment banking arms. problems with this however are that market shares are not reliably calculated and banks are also trading with each other and act in collusion including with other financial firms i.e. they do not necessarily compete. determining what is real competition is a very complex matter.
Part of Europe's difference in financial culture terms is its invention of unversal banks who combine retail and investment banking with asset management and insurance. Regulators in Europe have in practise, however, sought to divorce insurance arms from their parents such as in the cases recently of Fortis, ING and RBS, but they face a pronlem of insurance companies forming banking subsidiaries. Fortis for example began as an insurer.
The ECB - European Central Bank - response to Obama’s bank reform is was indicated in Milan by Lorenzo Bini Smaghi, ECB exec. board member, that the “Volcker rule” - splitting traditional banking from high-risk proprietary trading - was “heading in the right direction” and “a first step to ensuring the financial system can effectively support the real economy and is not weakened by the most volatile market fluctuations”.
But he worried such a step may drive higher risk trading beyond the control of regulators. He added that while initially there had been a global determination that no part of the financial system would be left uncovered, “Over time, this resolve has dwindled and attention has mainly been focused on banks” and the US initiative should not distract from strengthening independent supervisory authorities, and “regarding the developments in the current debate in the US, where the most independent institution, namely the Federal Reserve, is subject to attacks and pressures from various corners, including legislative initiatives aiming to curtail its powers.” FT comment: Central bankers of the world unite!
JPM is worried by all this. It echoes others in suggesting this is regulatory overkill, that fixing “too big to fail” (TBTF, that some quip should read "too big to feel") will take a compensatory toll on the economy.
Research by JPMorgan estimated total cost of the regulatory initiatives now targeting the world’s big banks following shot-gun weddings between banks and a few suspicious deaths during the credit crisis. In 1990m there was only one bank with total assets worth more than 50% ratio to its home country's GDP. Today, more than half the world's top 25 banks are in this position. Is that important in respect of banks' insolvency risks, and is there a level at which TBTF begins?
Recent bank failures show low correlation with size. But, that is only true when %numbers of failures is unweighted by size of assets. Many failures were small single-product banks alongside large, diversified ones. But, the dependency of the former on the latter is a factor. Arguably, what failures have in common is therefore not scale but high leverage, low underwriting standards, inadequate risk management and excessive reliance on wholesale funding.
Actually, that's not exactly right. What killed some banks more than others was the timing at which their wholesale funding had to be rolled over. Inadequate risk management is universal among banks, but some were better had disguising the fact. High leverage was undoubtedly a problem, but required excessive concentration in illiquid instruments and markets. Generally, all banks risk diversity was dictated to them by their markets, their size and competence whereby small size and incompetence to engage in some complex areas saved them while not being an indicator of superior judgement. Mostly, all banks showed themselves to be economically insensitive and naive.
In the worst scenario, JPMorgan reckons regulators imposing higher capital requirements and the the idea of separating casino banking from more socially directly useful activities such as deposit-taking to suppor traditional lending could reduce the profitability of the big bank model by about 60% - maybe therefore too, however, reducing exposure to unexpected loss by the same %? Returns on equity would plummet from 13.3% (expected in 2011) to 5.4%. This is a bizarre conclusion since traditional banking can generate 15% net interest margin returns on capital. JPM has not convinced me! Truth is that a prudently managed traditional bank will earn 1-1.5% return on assets and that delivers 10-15% return on equity.
JPM estimate that to keep profits (return on capital) constant, banks will need to hike prices of (retail) financial products by a third. If big banks have half their assets in non-traditional banking, does this imply double returns on assets and equity in investment banking compared to retail banking - if so surely far too high, and may be much of that return is paper profits in unrealised asset gains and treating good years as normal. Much of banks' profits were in the past inflated by unrealisable asset gains e.g. when banks sought to realise their structured credit assets the secondary market proved to be illiquid showing that so much profit recorded in the past was illusory/delusional - merely gains over several years of one-way markets where issuers kept issuing and primary investors kept buying but no one was selling much into secondary markets i.e. the instruments were not really tradable except as derivatives of derivatives.
One alternative is to slash compensation, perhaps by making bonuses dependant on realised profits not paper profits. Taking compensation down to 35% of revenues from the historic average of 45-50%, would mean raising prices by a quarter to keep returns on equity constant. Customers of retail banks, which have higher fixed compensation costs, would be milked for higher charges. I calculated that happened in Europe in the wake of the Euro's introduction and consequential loss of liquidity in intra-European FX and fixed income markets.
What JPM forgets is that stock-quoted banks had for a decade double the return on equity of the rest of the stock markets - it should be a good thing to align banks better to the economy they serve.
The Governor of the Bank of England, Mervyn King, in late January called for a "radical" overhaul of the banking system, which could include a break-up of the banks, and praised President Barack Obama's controversial plan to take on Wall Street. King told MPs yesterday that "we have to reform the financial system" and warned that if anything less than extreme measures were taken "we are doomed to make the same mistakes on a bigger scale".