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".