“You will find that the State is the kind of organization which, though it does big things badly, does small things badly, too.”
John Kenneth Galbraith
“All my life I wanted to be a bank robber. Carry a gun and wear a mask. Now that it’s happened I guess I’m just about the best bank robber they ever had. And I sure am happy.”
Too Big to Fail—Then Who Needs their Stock
From an investment point of view, there are several fundamental realities concerning banks which exist in virtually every country. These have led me to conclude that on a long term basis, large too-big-too-fail mega banks are always going to be an unexciting investment. OK, maybe someday when everything settles down the dull large banks can be bought as dividend plays. Maybe my Avoid Forever title is a little bit of exaggeration. But that day is a long way off.
First, large banks will not be allowed to go bankrupt. Therefore they should not and will not be allowed to take risks and earn high rates of return. Governments won’t allow these banks to take risks since the governments will have to pay if, as in 2008, the risks turn out badly. I cannot argue with this government logic. If governments are going to socialize the risks, then governments should socialize the profits as well. Or to put it another way, bank risks should be limited and bank capital should be enhanced to protect the governments from losses. Unfortunately, on a long term basis this makes for a rather unattractive equity outlook for global commercial banks. For a mega bank, if it’s too-big-to-fail, then you don’t want to own it.
The Lehman and J.P. Morgan Fiascos
The failure of Lehman Brothers in 2008 and J.P Morgan’s recent huge derivatives losses are two signature events. Regarding Lehman Brothers, the American regulators followed the free market, Austrian School prescription and allowed Lehman to go bankrupt. It was as if one hundred years of populist thinking and an ever greater government role in the financial sector was suddenly forgotten. But not for long. The American officials quickly lost their nerve as they realized in horror that the entire global financial sector was lined up to go down next. One hundred years of coddling and risk backstopping – starting with the creation of the Federal Reserve in 1914—had created a financial industry that wasn’t ready to be released in the wild. Maybe after the financial sector completely crashed a new and better one like a phoenix would have risen from the wreckage. But Hank Paulson, the American Treasury Secretary, wasn’t going to take the chance and find out. He knew quite correctly that the American people—indeed the entire world — did not want him to take that chance. We’ll never know what might have been. The Austrian school economists can write all they want. The global public and the economics intelligentsia have a closed mind on this subject. Ramsey MacDonald, a now forgotten British Labour Prime Minister in the dismal1930s, once said that the financial sector is the nervous center of capitalism. No modern elected government anywhere can allow its financial sector to have a nervous breakdown. Even if it’s a good idea.
But how do regulators draw the line between preventing mega banks from taking undue risk and totally stifling initiative and innovation among these institutions? All of this keeping in mind that government’s implied guarantee to these banks creates a major case of moral hazard. If the government is going to pick up the losses, why, mega bank managements may ask, not take more risks on less capital? Of course that is what happened over the years.
Various approaches have been suggested to curtail big bank risk. The so-called Volker rule is one. Under this rule, big publicly guaranteed commercial and investment banks shouldn’t be allowed to engage in speculative or non-hedged proprietary trading since the government has to pick up their losses if they lose. But then we have the spectacle of J P Morgan Chase announcing a multibillion dollar loss on what it considered a hedged trading investment. JP Morgan Chase is considered by many to be the best run of all the large American banks. Its CEO Jamie Dimon is considered to be the most gifted bank executive, perhaps in the world and one fit to fill the shoes of the original J P Morgan himself. But here we have JP Morgan Chase stumbling in a most egregious manner. And its gifted CEO proclaiming before Congress that he doesn’t really know what the Volker rule is. In other words, how do you draw the line between a normal bank hedging of its books and proprietary trading?
Jamie Dimon before Congress essentially said he could not. Maybe nobody can. But unfortunately the government will have to try. One would hope the rules would be drawn up by economists and not lawyers. The Dodd-Frank Bill (discussed below) includes the Volker rule, but the regulations on this, have yet to be issued. No doubt the army of regulators currently being added by the Obama Administration will happily devote themselves to this task. Don’t expect regulations on this to be fifty words or less in length.
Over the years, large commercial banks gave the public an illusion that they were safe and protected by their governments. The banking crisis in 2008 shattered this illusion. The large global banks are now subject to tougher oversight by all bank supervisors. Governments and central banks realize that large global banks are no longer their friends. These banks took high risks, distributed handsome bonuses to their star employees, and paid good dividends to their international shareholders. However, they came back to their governments to ask for support after serious losses.
Basel Rules a Complete Failure
A second approach to mitigating bank risk is the Basel III. Bank supervisors realized the risk of commercial banks in the 1980s, when they implemented Basel Accord (known as Basel I). This bank supervisory standard linked capital to asset risk. Nice theory, the regulators hearts were in the right place. Well we know what happened. Basel or no, so many banks have required bailing out in Western countries. (Basel can’t be blamed for the hapless Lehman or Bear Stearns and Merrill Lynch which were not classified as commercial banks.)
In 2008-2010, Basel III was developed by central banks via the Basel Committee. Two simple words can summarize Basel III: higher equity. Banks must have higher equity requirement to support their high-risk activities. The equity requirement in Basel III is substantially higher than what is required in Basel II. Basel III becomes effective in 2013-2018. In this 5-year period, all the banks, regardless of large size or small size, need to issue new equity to support their operations. Another big depressant for bank stocks. There will be an enormous supply of new bank equity in the coming years. That is if they can get anybody to buy it.
Still, in view of what has happened in Europe and the looming sovereign debt crises in all the advanced countries, the entire Basel approach could be viewed as regulatory stand-up comedy. Government bonds even under Basel III are treated as risk free assets, requiring little or no capital. As it turns out in Europe today government bonds are frequently the riskiest asset banks can own. In Europe we have bankrupt governments bailing out bankrupt banks so they can buy the “risk-free” bonds of the bankrupt governments.
And From the Solons Who Help Do In Fannie and Freddie – There is the Dodd-Frank Bill
An additional regulatory negative piled on to the banks in the US is the Dodd-Frank Bill, or to call it by its proper name, the Wall Street Reform and Consumer Protection Act. Passed in 2010 with the Volker Rule and many of the Basel III rules included, its sponsors were none other than Representative Barney Frank and Senator Christopher Dodd, the two Congressional leaders who so zealously pressured Fannie and Freddie to lower their standards and who “protected” these institutions from being forced to have more capital.
The 2300 plus page Dodd-Frank Bill is going to be a nightmare. It would seem that the primary purpose of this bill is to tie up all banks with enough regulatory requirements so as to make the fulfilling of these requirements banks’ primary activity. Bankers who spend their time filling out government forms and worrying about being politically correct won’t have time for mischief making in the derivatives markets! Many of the requirements in Dodd Frank have nothing to do with banking but satisfy America’s insatiable need to protect women’s, consumer and minority groups via government regulation.
There’s an irony with Dodd-Frank. The larger banks can deal with regulations better than the smaller banks. There are economies of scale in hiring lawyers and accountants to deal with the unproductive task of complying with burdensome regulations. The too-big-to-fail big banks will benefit on a relative basis as compared to the “small-enough-to-die” small banks. In the future, talented young men and women aspiring to a career in banking should major in law and human relations, not finance. Actually, talented men and women may not aspire to a career in banking at all.
Congratulations to the SEC!
It is interesting that one of the most disastrous regulatory decisions of the last decade rarely gets mention. In 2004, the Securities and Exchange Commission vastly liberalized the limits on leverage for the major American investment banks. Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns and Lehman Brothers were allowed to increase their leverage by a quantum leap. And by 2008 they had done just that. Just in time to load up their balance sheets with complicated and soon to default mortgage derivative securities.
What so many observers don’t seem to care about was that the government in the form of the SEC had sufficient power to regulate investment banks. But, in the case of the major banks, the government failed to use the powers that it already had. What America needed to regulate its financial system was a government with integrity and brains and not corrupt politicians who then went on to pass the giant legislative atrocity called the Dodd-Frank bill.
Big Banks as Utilities?
Given the governments’ inability to back away from too-big-to-fail for the large banks, it seems to me that the large banks should be forced to become low risk, highly capitalized institutions. This coincides with the view of many that the big banks are too big. It is my view that their many riskier functions should be spun off to non-banks including hedge funds which definitely should be allowed to fail. In other words, the big banks would offer risk free financial services to the general retail and business markets. Their riskier functions would be performed by non-banks. Does this sound like the investment banking/commercial banking separation of olden times? It is not exactly that but in practice it might look not that different.
The LIBOR Issue—Another Reason to Go to Law School
I cannot claim any special expertise on this subject but it looks like the LIBOR “scandal” will turn into a global sinecure for lawyers. It is something the banks don’t need and something that makes bank stocks even less attractive. The banks apparently gamed the system. The London Interbank Offered Rate or LIBOR is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. It turns out weaker banks reported rates to LIBOR that were below that which they were actually paying. The idea was to conceal weakness. Apparently the professionals and the regulators knew what was going on. So from an economic point of view (as opposed to a legal), the wholesale market adjusted and no big deal.
But LIBOR has been used for pricing many loans around the world by borrowers that didn’t know the system was not what it appeared. For example mortgage loans in East Los Angeles or Fresno made to overleveraged minority borrowers who had no business borrowing in the first place. That was not a good idea. LIBOR wound up being used for purposes it was not intended.
A Note on Chinese Banks
Too-big-too-fail is the operational guideline for the large Chinese banks. These are majority government owned and totally government controlled. The bulk of their business is in China. They are not global like the Western mega banks. But the majority has equities trading in Hong Kong.
I’ll keep things simple. These banks carry out government policy. It is assumed the government will bail them out if required. Most of their lending in recent years has gone to State Owned Enterprises (SOEs) and entities related to local governments. The SOEs despite getting subsidized rates have low returns on equity and are destroyers of capital. The local government entities have misdirected large amounts of capital to real estate and unneeded infrastructure projects. When necessary, the accounting for these banks, especially dealing with non-performers, is manicured to create a more favorable picture.
Does this sound like an attractive investment story? Not to me. The Chinese mega banks – and mega they certainly are – are less interesting from an economic and investment standpoint than the too-big-to-fail Western mega banks.
|Peter T. Treadway______________________________________________________|
Dr. Peter T Treadway is principal of Historical Analytics LLC. Historical Analytics is a consulting/investment management firm dedicated to global portfolio management. Its investment approach is based on Dr. Treadway’s combined top-down and bottom-up Wall Street experience as economist, strategist and securities analyst.
Dr. Treadway also serves as Chief Economist, CTRISKS Rating, LTD, Hong Kong.