Tuesday, September 30, 2014

The Coming European Depression

[Published by International Banker on July 9, 2014]

Over the past five years, there has been a profound shift in the transatlantic bank regulatory regime. Following the 2008 crash, insolvent banks were recapitalized by governments, and bondholders and uninsured depositors were fully protected from credit losses. Indeed, a very large number of major banks in the US and Europe were rescued and recapitalized by governments during this period, at no loss to their creditors or depositors.                          
Subsequent to these unpopular bailouts, financial policy has shifted from protecting bank creditors to exposing them to loss in the event of a capital shortfall. This is variously called “private sector involvement”, “stakeholder bail-ins”, and “market discipline”.
The rationale for this shift is that taxpayer funds should not be spent to protect bondholders and depositors, that creditors should take losses prior to governments, and that creditors should “do their homework” before investing in a bank’s liabilities. This new policy is seen as fair and prudent, and it is expected to lead to better policy outcomes in future banking crises.
Going forward, bank creditors will be expected to discriminate between strong and weak banks on the basis of their external financial reporting. This concept extends even to uninsured retail depositors such as those that were wiped out in the Cyprus banking crisis.
The policy architecture of market discipline rests upon four fallacious assumptions: (1) bank creditors are skilled in bank credit analysis; (2) bank financial reporting is sufficiently transparent to enable creditors to discriminate between solvent and insolvent banks; (3) the default of a large bank upon its liabilities will not create contagion and a general bank run; and (4) a flight to quality would not impact the real economy.
Each of these assumptions is erroneous: few bank creditors or depositors know much about bank credit analysis; bank financial reporting bears little relationship to bank solvency; a major bank default will likely result in runs on other banks perceived as weak or illiquid; and banking crises have macroeconomic ramifications–deflation and depression.
Creditors Know Little About Bank Credit Analysis
The foundation of bank credit analysis consists in the entering the reported financial data of a banking peer group (e.g., Irish banks) into a multi year database on a comparable basis, and then calculating ratios to enable comparison across banks and across time periods. This, by itself, is a monumental and labor-intensive task, and is generally performed by data vendors on a subscription basis.
Retail depositors have no access to these databases, and would not know how to use them if they did. There are credit rating agencies who perform their own bank credit analysis and offer credit opinions, but are the rating agencies supposed to be the foundation upon which rests future financial and macroeconomic stability? Do the authorities really intend to outsource financial and economic stability to the credit rating agencies? If not, then bank creditors and uninsured depositors will face a very steep learning curve indeed, and are likely to make serious mistakes.
Bank Accounting And Bank Solvency Are Often Unrelated
Banks typically report good profits and strong capital ratios prior to rescue or failure. An analysis of the financial reporting of failed or rescued banks will reveal that almost all of them were reportedly profitable and solvent before they failed. This is for two reasons: (1) failing banks generally accrue interest on bad loans, recognizing this fictitious interest as income; and (2) such banks generally hide their bad loans and do not create remotely adequate loss provisions prior to their recaps (see: Bankia, Banca MPS, WestLB, Depfa, RBS, Anglo-Irish, BofA, Citi, etc.).
This is why, when a bank fails and has to be resolved, the cost of resolution will typically reveal an insolvency much deeper than ever suggested in its public financial statements. Often the insolvency is a multiple of the bank’s reported capital; the difference between 6% and 8% capital under such circumstances is irrelevant. Speaking from my personal experience, the single best source of information about bank solvency is market rumor–because that’s generally all there is besides the official lies.
Uncontained Bank Failures Create Contagion
When a major bank is allowed to default upon its liabilities, the market reacts by withdrawing credit from banks with a similar profile. This phenomenon occurred most recently in 2008, when the bankruptcy of Lehman Brothers Holdings lead to a withdrawal of credit from the other Wall Street banks, which necessitated the TARP bailout and the extension of extraordinary credit from the Fed. In a banking crisis, the mutual withdrawal of credit tends to be indiscriminate and fear-driven. The idea that, in the midst of a financial crisis, participants will choose to make fine distinctions between banks is not borne out by historical experience. In a flight to quality, many dominoes will totter. If one weak bank defaults, the market will attack the rest of the herd.
Banking Crises Have Macroeconomic Ramifications
Banking crises affect the macroeconomy in two crucial ways: credit contraction and monetary contraction. Following the shocks of the Lehman and Greek crises, credit contracted in both Europe and the US in what is characterized as a “Minsky Moment”. Prior to the shocks, credit growth was strong; after the shocks credit growth turned negative (credit growth did not merely decline; the credit aggregates contracted). Borrowers who were considered bankable before the shock instantly became unbankable afterwards. The desire of creditors to call in their loans during a crisis has immediate implications for confidence and growth because forced asset liquidations are deflationary. Economies cannot grow when credit is contracting. The “healing process” is in fact a prolonged disease.
Secondly, banking crises interfere with the efforts of the authorities to maintain adequate money growth as banks seek to shrink their balance sheets. Unless heroic measures are taken by the authorities to force money into the system, the money supply will contract along with the banking system, thus unleashing powerful deflationary forces. We saw this briefly in the US in 2009, and we are seeing such a deflationary spiral today in southern Europe, where money growth, inflation and economic growth are all near or below zero–and this is without any major bank failures so far.
The Coming European Depression
We are now awaiting the results of the ECB’s asset quality review of the largest banks in the Eurozone which, if it is honest, will reveal large unrealized loan losses at many banks, and not just in the Club Med countries. In some cases, it is likely that these banks will be unable to raise sufficient additional equity to restore their solvency, thus creating the preconditions for a bail-in, whereby creditors would be required to transform their debt claims into equity. Should the bail-in policy result in major debt defaults, the consequences will be highly contractionary no matter what the ECB does.
The European authorities have created a lethal policy brew, imposing deflationary monetary policies while withdrawing the financial safety net, repeating the American experiment of 1930-33. As Irving Fisher wrote in 1933:
“Unless some counteracting cause comes along to prevent the fall in the price level, a depression tends to continue, going deeper, in a vicious spiral, for many years. There is no tendency of the boat to stop tipping until it has capsized. Only after almost universal bankruptcy will the indebtedness cease to grow. This is the so-called natural way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.” (The Debt-Deflation Theory Of Great Depressions)
There are two ways that Europe’s banking problems can be resolved: by default or by inflation. Inflation is regarded as sinful and “the easy way out”. Why take the easy way out when depression is so much more painful? Europe has chosen the path of default, deflation and depression, and in the process will relearn the lessons that Professor Fisher identified over eighty years ago.

Tuesday, September 9, 2014

The Scottish Referendum May Already Be A Black Swan

  • A binary risk with a credible adverse scenario is a real risk today.
  • There is a real risk today of a Scottish Black Swan.
  • It could happen before the referendum on September 18th.

Last week I discussed the financial implications of a Scottish “Yes” vote in the referendum on September 18th. Today I would like to discuss the risk that exists today because of the referendum. There is no doubt in my mind that a Yes vote next week would constitute a Black Swan event for the UK capital market and possibly beyond. A Yes vote would materially raise the level of uncertainty associated with UK financial assets. I don’t think that is in doubt.

But what I want to say today is this: The risk today of a Scottish Yes vote may be enough to move markets in advance of the referendum. A rational investor needs to think now about positioning his portfolio for a possible Yes vote. Such anticipatory market activity could have a self-fulfilling impact. For example, if investors worry that a run on Scotland could result in a deposit moratorium, a run could occur before the 18th. Furthermore, a run on Scotland could prompt a run on UK financial assets. Already the pound has fallen by 6% over the past two months. I’m pretty sure that sterling will fall further next week in the absence of official intervention.

The Independent reports:
“Figures from investment bank Societe Generale showing an apparent flight of investors from the UK came as Japan’s biggest bank, Nomura, urged its clients to cut their financial exposure to the UK and warned of a possible collapse in the pound. [Nomura] described such an outcome as a ‘cataclysmic shock’...Investors have been pulling out for weeks and months, according to data on UK stock market funds cited by Societe Generale, which show a worsening exodus of global money from shares in British companies. From its best position this year of a little under $14bn (£8.6bn) flowing out from the UK earlier this year, the flight has accelerated to nearly $20bn (£12bn).”
This is still small potatoes, but the Yes risk is only now being analyzed in board rooms and investment committees around the world.

Thus, the risk today is not that Scotland ultimately redenominates, but rather that there can be no insurance against such a scenario, and that poses a risk right now. Two weeks from now, the risk could be gone, or it could be very real. Goldman: “Even if the Sterling monetary union does not break up in the event of a ‘Yes’ vote, the threat of a breakup would provide investors with a strong incentive to sell Scottish-based assets, and households with a strong incentive to withdraw deposits from Scottish-based banks.”

Moody’s: “The new Scottish government would, in all likelihood, need to issue its own currency, into which many if not all domestic private sector debts would be redenominated….One form of debt that would certainly face redenomination risk is bank deposits...It is inevitable that at least some types of deposits would come to be denominated in Scottish currency rather than pound sterling.”

I may be an alarmist from time to time, but I would not accuse Nomura, SoGen, Goldman or Moody’s of being alarmist. The next ten days could be very exciting, especially in London.

Thursday, September 4, 2014

Financial Implications Of A Scottish Yes Vote

  • A Yes vote would create great uncertainty about the future of the Scottish financial system.
  • Both a new currency and sterlingisation are very risky.
  • The shock could be immediate.

Should we be spending our time worrying about Scottish independence? I’ve got to say yes, because it is a major contingent risk that should be understood before it happens, if it happens. The polls are quite close, and the referendum is only weeks away.

I don’t want to discuss the long-term issues such as viability or governance. I’d prefer to focus now on the short-term risks. Goldman Sachs has just published a paper on the short-term risks of a Yes vote. Among other risks, it discusses the adverse implications for Scottish assets and Scottish banks:

“Even if the Sterling monetary union does not break up in the event of a ‘Yes’ vote, the threat of a break-up would provide investors with a strong incentive to sell Scottish-based assets, and households with a strong incentive to withdraw deposits from Scottish-based banks. The Bank of England would retain responsibility for the whole of the UK financial system until 2016 (at least), so it would be able to prevent the worst of the short-term consequences. However, the decision as to whether Scotland remains part of the Sterling monetary union will ultimately be a political one, so the BoE would be unable to credibly commit to the currency union remaining unbroken (implying some negative consequences for Scottish-based assets, even in the short term).”

Douglas Flint, chairman of HSBC, recently wrote in the Telegraph that “At the extreme, uncertainty over the Scotland’s currency arrangements could prompt capital flight from the country, leaving its financial system in a parlous state.”

So if you’re looking for something to worry about,, you should worry about the immediate future of the Scottish financial system. Yes, maybe the UK will relent and agree to monetary union. But right now, the risk is not that the monetary union will break up, but that it might. The UK has said that monetary union is off the table, and the EU has said that Scotland must have its own central bank. Remember that the EU wants to discourage regional secession from its member states. Almost every country in Europe has a region that seeks greater autonomy-- or worse. Scotland will have no friends in Brussels or Frankfurt.

Whether Scotland decides to print its own money, or whether it decides to unilaterally adopt sterling, there are substantial risks to holders and issuers of Scottish financial assets. If Scotland decides to print its own money, the currency will be entirely novel, and Scottish monetary and fiscal policy are complete unknowns. If Scotland instead decides to unilaterally “sterlingise”, its banks will lack a lender of last resort. In either case, there are substantial risks. A Yes vote would create great uncertainty for a very long time.

In addition, the rump UK’s credit would suffer if Scotland chose to repudiate its debt, which has been discussed. This would leave the UK with a higher debt-to-GDP ratio, since the UK can’t repudiate its own debt. Every pound of UK debt is a liability of HM Treasury.