VULNERABLE U.S. BANKS AND THREATS TO GROW / THE FINANCIAL TIMES MARKETS ( VERY HIGHLY RECOMMENDED READING )

Vulnerable US banks and threats to growth

By Joseph Dear

Published: June 1 2011 13:03


A panel moderator asked me the other day, “What keeps you up at night?”


What popped into my mind was this: what if the global financial crisis isn’t over? Suppose we look back in three or five years and realise that the real underlying causes of the financial crisis weren’t addressed; they were only papered over or ignored, and as a consequence financial instability returned with a vengeance? What would we wish we had done now?


In one sense the financial crisis really is not over. The consequences of it are still reverberating through the economy. We have persistently high unemployment, slow job recovery and a continuing decline in housing prices. The fiscal position of US local, state and federal governments is precarious.


These consequences have spilled over to the work we do at Calpers and raised questions about the sustainability of public pensions. To some extent, even a slow recovery is helping us grow our way out of the problems.


But what if that doesn’t last – if self-sustaining growth fails to kick in? What if political systems don’t deliver on the excruciating policy choices they face? What if some completely unexpected chain reaction of implausible events destroys stability and confidence? How likely is that?


We seem to be on the verge of forgetting what brought on the global financial crisis, particularly our belief in market efficiency and our reliance on self-regulation to contain irrational behaviour and systemic risk.


Consider the vulnerability of US banks.


They are more concentrated today than before the financial crisis. Between 1994 and 2010, the combined market share of deposits held by the five largest US banks increased from 7.9 per cent to 34.3 per cent. Perhaps we’ll see that the real risk was that some banks became too big to be saved.


The regulatory reforms that we and others worked so hard for are under attack. The globally co-ordinated regulatory protections that we need aren’t happening. We could be headed to a suboptimal outcome – ineffective regulation and more risk out of view of regulators in the shadow banking system.


Governments still face daunting choices and are vulnerable to policy mistakes that could reignite the crisis. We have obvious problems in Europe with the potential contagion of the debt crisis threatening the European banking system. Even the economic recovery in the US is largely a product of, and dependent on, government intervention.


The federal government guarantees more than 90 per cent of all mortgages issued today for housing, and the Federal Reserve’s massively leveraged balance sheet supports extremely low interest rates.


I also worry about the persistent inequality and widening gap between the few who are doing well and the many who struggle.


A certain amount of inequality is expected in a system as dynamic as ours. However, as University of Chicago economist Raghuram Rajan writes in “Fault Lines”, many people, in a bid to maintain their standard of living as their real incomes fell back, took on increasing consumer debt and withdrew mortgage equity.


This behaviour undermines support for our political system and may contribute to the higher probability of policy mistakes. Governments find it difficult to deliver on the hard choices that must be made.


In view of these concerns, what should we be thinking about?


First, we have to recognise the perils. We must be alert to the warning signals without being paralysed by fright or despair. The work that we and other investors are doing to improve corporate governance, increase our risk intelligence, maintain our long-term perspective, build up a liquidity reserve and to prevent the Dodd-Frank reforms from being undermined or rolled back in the regulatory process is exactly what we should be doing.


Second, however daunting our challenges, they’re not potentially as bad as they seem.


That awful sensation of staring into the abyss is not gone, but the corrective steps taken by Congress, the Fed and two administrations did forestall the worst. We now know more than we did about the risk of fat tails and the false comfort of stable disequilibrium.


We must steer a course between excessive optimism and pessimism, seeking a realism that’s grounded on facts, unsentimental analysis and healthy debate. The worst could happen – but more likely and more typical of America is a muddling through, holding on with just enough of the right decisions, close enough to the right time to sustain the economic growth on which so much depends. Then human ingenuity and the remarkable resilience of the market system will work their wonders and we will recall a difficult period that survived through skill and determination.


Between now and then we face hard work, tough choices and sleepless nights.
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Joseph Dear is chief investment officer of the California Public Employees’ Retirement System (Calpers)


Copyright The Financial Times Limited 2011.