January 9, 2012 11:25 pm

Promises that proved ultimately empty

Unless banks can better demonstrate their usefulness to society, they face a debilitating battle against new regulation
UK Banks
City banks must draw up 'resolution plans' by mid-year

More than three years after taking the world to the brink of economic meltdown, banks remain heavily troubled. Instead of the rebound from losses that would normally have taken hold, they are now confronted with a rumbling debt crisis in Europe.

The crisis of legitimacy in capitalism has meanwhile spread since 2008, just as Occupy Wall Street has expanded from its original focus on bail-outs and bankers’ pay to a global reference point for the grievances of the “99 per cent”. Yet it was within banks where the crisis emerged and where its heart still lies.

Their troubles go beyond the financial. In the 1990s and 2000s, banks became a leading force in western economies. Their share of gross domestic product rose sharply; Wall Street banks such as Goldman Sachs extended their reach across Europe and Asia; the boundaries between commercial and investment banking were eroded, and bankers were highly rewarded and even regarded as glamorous.

Today, they are resented for holding taxpayers hostage by having becometoo big to fail”. Many argue that banks have drifted from their basic social function – to encourage growth by making loans, underwriting securities and advising companies – into a self-interested drive to make money by any means possible.

The hostile mood is exacerbated by the pay practices that grew up on Wall Street and in the City of London following deregulation in the 1970s and 1980s – the habit of half-mimicking the old partnership structures by paying investment bankers and traders large bonuses. Big financial institutions managed to absorb the gains from trading and risk-taking while socialising their losses. “There is a deep question of legitimacy that banks need to face up to,” says Ranu Dayal, senior partner at Boston Consulting Group. “The under­lying level of dislike of banks is compounded if they are not seen to have reformed and to be playing an important role in economic resurgence – or to have failed as a result of compensation structures or just naked greed.”

Unless they can find a way to demonstrate their usefulness clearly, and to curb the practices that most alienate outsiders, banks face a long, debilitating trench war against new regulation. For economies, this could limit the beneficial aspects of a thriving and focused financial sector.

Postponed and hidden risk

For a long time, banks coasted on a wave of growth in credit marketsdriven by the rise of derivatives, the loosening of regulation and capital standards, and a hubristic belief that they had somehow broken their old habit of losing billions of dollars in downturns. This turned out to be, as Andrew Haldane, an executive director of the Bank of England, concluded, “as much mirage as miracle”.

Instead, it transpired that most of the risks had simply been postponed and hidden, even from banks’ own directors. As Adair Turner, chairman of the Financial Services Authority, the main UK regulator, put it last year: “Some financial activities ... far from adding value in some complex though difficult to understand fashion, in fact created financial instability and produced economic harm.”

Such dangers went unseen. “There was a massive overconfidence that risk had been transformed and we were in a different banking paradigm,” says Philip Augar, a financial author and former analyst in the City. “It was all egged on by governments who listened to investment bankers and appointed them to high positions. They were told that all they had to do was to get out of the way.”

Banks that had relied on a variety of businesses to make money – from mergers and acquisitions advice to securities underwritingshifted overwhelmingly towards trading. Foreign exchange trading volumes rose 234-fold between 1977 and 2010, while trading – particularly in bonds and currencies made up 80 per cent of the biggest banks’ revenues in 2010, according to BCG.

Banking by numbers

Approximate rise in foreign exchange trading volumes, 1977-2010

Approximate level of return on equity for many banks in mid-2000s

Number of jobs lost in European banking sector in 2011

People migrated from traditional corporate banking and dealing in equities and bonds into exotic products that required the nuanced understanding of risk,” says Mr Dayal. “The industry pushed through the boundaries of what regulators could foresee.”

This brought high profits for a while, but it undermined the argument that they did something useful. “The investment banking industry has drifted from its original focus, which was raising capital for industry and providing advisory services,” says Bob Gach, the head of Accenture’s capital markets consultancy arm.

Thomas Philippon, a professor at New York University’s Stern School, estimates that the industry’s share of US gross domestic product rose from about 3 per cent in 1950 to more than 8 per cent in 2010. Instead of the intensified use of information technology increasing efficiency, as it did in retailing, banks simply got bigger.

Prof Philippon says that this growth in trading has not been accompanied either by sharper pricing in securities markets or by better financial insurance for industrial companies. Bankers such as J.P. Morgan were doing just as much as today’s industry in the past but they were more efficient. The more I look at the rise in trading, the more I conclude that society gets nothing from it. It is empty.”

A balance to restore

That has important implications for governments. Government and central banks were traditionally willing to back deposit-taking institutions in times of crisis – from the UK secondary banking crisis of the early 1970s to the 1980s US savings and loans shake-outs – because of the value of a sound banking system.

Even this was left deliberately ambiguous central bankers did not want to admit that any single institution was too big to fail. And it definitely was not intended to cover securities brokers and investment banks which, since the Glass-Steagall Act of 1934, were deliberately separated in the US from commercial banks.

The 2007-08 crisis destroyed that delicate balance, not only making European governments rescue large banks but leading to the US Federal Reserve extending the protection of its discount window to Goldman Sachs and Morgan Stanley. The old ambiguity disappeared and the protected club of “systemically important financial institutionswidened.

But just because a bank is systemically important meaning it would cause severe disruption across financial markets if it failed – that does not make it economically vital. The most important function of banks is also their least glamorous – taking deposits and making loans. This has been mingled with riskier, trading-related activities in ways that are difficult to disentangle.

The sharpest effort has emerged in the UK, where the government has backed the Vickers Commission’s proposal to ringfence retail banking deposits. Elsewhere, banks have fought regulations such as the Volcker rule curbing proprietary trading. “The regulatory agenda was too modest to start with, and the banks’ political power is incredible,” says Simon Johnson, a professor at MIT Sloan School.

A prolonged fight to keep doing the same thing while fighting regulation will do nothing for banks’ legitimacy, however, and little for the economies in which they operate. Nor will it address the need to restructure, which is being driven by a basic economic force – the financial pressure that banks now face. Institutions such as UBS and Citigroup are struggling to recover from their losses during the crisis and the European banking sector as a whole lost 40,000 jobs last year. After a post-2008 bounce, when central banks cut interest rates, trading revenues have fallen sharply.

Banks might be able to argue and delay their way out of their current troubles and wait for memories to fade. But that outcome is by no means assured, and would not be the best one for society as a whole. A healthy banking system – both in size and scope – is vital to a sound economy.

Nor is regulation the only challenge that banks face – the market is exerting even strong pressures for them to change their ways.

Meanwhile, corporate banking suffers from overcapacity that was left unaddressed in the growth years. “At heart, banking is a commodity business and a very mature one,” says Peter Hahn, a professor at City University’s Cass School. “Most industries deal with that through consolidation, but this was an industry that consolidated without taking out capacity. That’s a big problem.”

Banks had avoided having to face a low and shrinking return on assets by taking on more of themleveraging balance sheets in order to boost their return on equity to historically high levels. While many banks had only single-digit returns on equity in the 1990s, these rose to 20 per cent or more in the mid-2000s.

Reduced returns

Despite the regulatory pushback, central bankers are imposing higher capital and liquidity requirements, preventing them from using leverage as aggressively as before. The market has also imposed tougher discipline on institutions with highly leveraged balance sheets and fragile funding – as the collapse of MF Global, the bond broker, showed late last year.

This is causing big problems for banks, which were able to compensate for falling profitability in their core businesses by taking on more risks and increasing the size of their balance sheets. Now, any bank that tries to do so, even if its regulator allows it, risks its credit rating being cut and its access to funds evaporating.

If banks cannot find new revenues, the alternative is to cut costs, and to shrink and merge as those in other commoditised industries do. Governments, however, are wary of allowing them to become too big to fail, and the generation of executives at the senior levels of banks have never operated in a contracting industry.

“This industry is run by entirely the wrong people now,” says Prof Hahn. “It is not that they are idiots but, for three decades with only small intervals, you succeeded by growing your business and piling on risk. The new regime is about efficiency and cost and none of them knows about that.”

One investment banker says the mood in the industry is sober. Revenues and capital are both under pressure and that is affecting compensation and the employment outlook, which causes a fair degree of nervousness. There isn’t a depression but neither is there much ebullience.”

Large banks had a strong incentive in the past to invest heavily in new investment banking operations and to hire teams of bankers from others in order to push themselves into the “bulge bracket” of global banks. As Mr Turner notes, activities such as trading and securities underwriting are “natural oligopolies” in which those with a big market share take a large slice of the available profits.

But banks such as UBS have now pulled back from a growth-at-all-costs strategy. They are instead trying to focus on activities where they have an edge, such as domestic retail banking, wealth management and specialist areas such as securities custody.

The combination of lower leverage and curtailed ambition is likely to make banks much less profitable. Mr Dayal predicts that “from being a business of return on equity in the high [percentage] teens, it will go down to high single digits to low double digits”. It will revert to looking more like a utility industry.

If shareholders are willing to accept lower returns, banks may be able to regain some social legitimacy. Those that focus on deposit-taking and lending stand a better chance of being seen by governments as important to the economic system. Even investment banks that focus on securities underwriting and advisory work rather than trading will have a better story to tell.

The question is whether banks can and will transform themselves. Some are sceptical. “I don’t take the view that investment banking is finished,” says Mr Augar. “It will be less profitable and smaller for a period and it will be quite a while before we see so many would-be global banks trying to gain a seat at the top table. But not that long. Five years?”

Financial flashpoints: profits and pay

If there is one flashpoint in relations between investment banks and governments – and one reason bankers remain unpopular – it is pay.

The fact that banks that were given official support to avoid collapse in the 2007-08 crisis, but then proceeded to pay large bonuses to employees, caused widespread resentment.

The phenomenon was particularly pronounced in 2009, when low interest rates and a reduction in competition allowed banks to benefit from a benign trading environment.

Since then, profits have grown harder to come by. So, too, have bonuses; between 2009 and 2010, cash bonuses on Wall Street fell by 9 per cent.

Under pressure from governments, and domestic and international regulators, many lenders have restructured their pay arrangements. Before the crisis, aggressive bonus structures contributed to the proliferation of traders taking positions that were profitable in the short term but proved vulnerable to losses when markets became volatile. The most notorious example of theseshort volatilitytrades is the credit default swaps written on mortgage-backed securities by AIG, the American insurer bailed out in 2008 during the credit crisis.

Some banks now have introduced clawbacks, under which bonuses for trading are not paid in full for up to five years, and are ultimately denied if trades that initially appeared profitable turn out to lose money.

Lenders have also reduced the rising ratio of pay to net revenues, which surpassed 50 per cent at many institutions during the 2000s. Provisions for employee pay at Goldman Sachs, for example, fell by 59 per cent in the third quarter of 2011 year on year; for the first nine months of the year, the pay ratio stood at 44 per cent.

Copyright The Financial Times Limited 2012.

January 9, 2012 7:03 pm

A letter to capitalists from Adam Smith

To: Capitalists of the World

From: Adam Smith

What has become of my beloved capitalism? Countries teeter, protests rage, unemployed multiply, deficits abound the virtues of capitalism are questioned. Based on a few hundred years of observation, I have some fresh thoughts on how to sustain this system for a few hundred years more, or at least do better in 2012 than it did in 2011.

I am pleased to see that capitalism has triumphed over communism and socialism in virtually every part of the world – and many of the most skilled capitalists are, ironically, in the countries where communism and socialism once prevailed (now endearingly called emerging markets).

This triumph has occurred because capitalism’s greatest strengthproductive economic activity – has succeeded in creating more opportunities for more people than anyoneincluding me ever imagined. And with more wealth, billions of people now in the middle class can secure education for their progeny, purchase necessities and luxuries at once-unimagined levels, pursue leisure activities for a greater part of their lives and retire with higher levels of economic security.

All that is satisfying.

What is not satisfying is the view that capitalism has to work perfectly to justify its presence. I never said it would. I just said it was better than the alternatives, as Winston Churchill famously said about democracy.

I always felt there were two principal flaws – and we saw them come to a head over the past few years. The first is that unfettered exuberance about wealth creation will produce unsustainable booms and inevitable crashes. The great recession, fuelled by cheap credit, is a textbook example of this flaw.

The second is the inequality that results when the charge towards wealth creation leaves behind those less able (in most cases through no fault of their own) to adapt or to compete with the hard-chargers.

The income disparity in many wealthy countries is now at its greatest level since I left the scene – and it was not so wonderful then either.

While there is no simple cure to capitalism’s two big flaws, here is what I would do in 2012 to get the system back on its feet and to modulate income disparities.

1. Save the euro and the European Union. A functioning and vibrant EU – the world’s largest economic unit – is essential to global prosperity. The largest countries using the euro – and also those outside the eurozone or those dependent on a thriving EU must dig deeply into their pockets now to save the euro. If they do not, the pain and cost will be greater in the future. And those of more modest means will suffer the most if the euro is abandoned.

2. Fix the US debt and deficit. To my amazement, when the super committee failed to reach an agreement the markets yawned, undaunted by a $1.4tn deficit and accumulated debt in excess of $16tn. Beware, though. At some point during 2012 the markets will wake up and say: “No! We cannot wait until after the presidential election to fix this problem.” The Obama administration and Congress must quickly cobble a credible debt-reducing package. Otherwise, as in Europe, the markets’ harsh solutions will be borne disproportionately by the low income and disadvantaged. This is not acceptable, nor is it good for capitalism.

3. Integrate the emerged markets. The world needs to acknowledge that the centre of capitalism is shifting to the emerging markets – where most of the growth will occur in 2012. But having emerged, China, India and Brazil, among others, need to be fully integrated into the global economic decision-making process.

If they are not, the capital needed to solve many of the developed markets’ current problems, especially residual issues of the great recession, will not be available on tolerable terms. Again, this will hurt the poor more than the wealthy.

4. Educate. Educate. Educate. Perhaps the greatest cause of income inequality is the dismal state of primary and secondary education. The mismatch between job openings and qualified candidates is growing, which leads to reduced economic activity, a greater sense of disparity between the haves and the have-nots, and social unrest. To address these issues, governments need to embrace reform, ensure effective funding and allocate resources more efficiently. By educating all their children, reducing soaring high-school dropout rates, and re-educating and retraining adults, nations can more effectively prepare workers to embrace new technological realities.

Though much time has passed since I last put pen to paper, my faith in capitalism is steadfast. The problems you facesaving the EU, fixing the US budget, welcoming emerged nations as full partners and making education a real priority – are huge challenges that must be addressed now.

It is the only way to continue creating wealth for all nations and people, while giving capitalism the legitimacy it needs to thrive.

The writer is managing director and a co-founder of The Carlyle Group
Copyright The Financial Times Limited 2012

Germany should beware of celebrating negative yields

Mohamed El-Erian

January 10, 2012

Another day and another previously unthinkable development becomes reality in Europe. Yet what on the surface appears to be good news for Germany – the record low yield at its latest government debt auction – is actually an indication of growing stress elsewhere in the region.

At Monday’s regularly-scheduled auction, the German government sold six-month securities at a negative yield of 0.012 per cent. Investors who bought them made history. Rather than receive interest income for lending money, they were the first to pay the German government for the privilege of converting their cash into securities that, at the margin, are less liquid and subject to mark-to-market volatility.

The outcome should not have come as a great surprise. Negative yields had already occurred in secondary market trading for short-dated German government securities. Moreover, a similar phenomenon had taken place in the US at the height of the global financial crisis.

Some Germans may be tempted to welcome the cheap source of funding. But before celebrating too much, they would be well advised to consider both the causes and the implications.

Investors fleeing dislocated government debt markets elsewhere in Europe are attracted to Germany by its solid balance sheet and its fiscal discipline. Moreover, the fruits of years of structural reforms by Berlin are being harvested in the form of vibrant job creation and solid international competitiveness.

Part of this investor repositioning is funded by the sale of other European government debt. Another is being channelled through the banking system, with German banks gaining deposits at the expense of most other European banks.

Operational stress in Europe’s financial system is also a factor. Due to technical dislocations similar to what America experienced three years ago, some banks are forced to scramble in order to get their hands on high quality collateral, helping to push German yields to artificially low levels.

The longer these factors persist, the greater the likelihood that other private sector entities will also be pulled in the short-run into buying German securities. Over a longer time horizon, however, negative yields on the bills will reverse course, especially if conditions improve elsewhere in Europe. Yet, even then, there is a risk that a large portion of the new money pouring into German debt could prove more durable given that it is being hardcoded through investor- and depositor-driven changes to investment guidelines and benchmarks.

German rejoicing for borrowing money at negative rates should thus be tempered by the reality of Europe experiencing an accelerating disengagement of the private sector from the region’s economic integration project. This undermines growth and employment, shifts more of the load to taxpayers, and places even greater demands on creditor and debtor countries alikeall serving to aggravate an already-strained process for agreeing on the appropriate policy response and related burden sharing.

At a time of considerable domestic resistance, governments in surplus countries (essentially Germany, but also others such as Finland and the Netherlands), as well as the European Central Bank, will face even greater external pressure to substitute more of their solid balance sheets for the delevering private sector. Meanwhile, debtor countries will be expected to do even more on the austerity front, thereby aggravating internal tensions and sacrificing both actual and potential growth.

Rather than welcome negative yields, Germany should interpret the outcome of Monday’s auction as further indication of the gravity of the situation facing the eurozone as a whole. It is another alarm bell calling for more forceful steps to improve the region’s policy mix, counter banking fragility, and strengthen the institutional underpinning of a “refoundedEurope.

The writer is the chief executive and co-chief investment officer of Pimco