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Tuesday, 22 December 2009

UK Finance, Basel blame-game, Climate failure

I have been teaching Basel II regulation to African bankers, in emerging market countries that had a good first half to the world credit crunch recession before also falling off the cliff. Returning via Uganda where an oil boom is about to disrupt a poor country with a half its 30m population is under 15, and the total is expected to triple in size by 2050, and via Dubai where the local upper echelon enjoys a socialism of free houses, guaranteed jobs and income, while the remaining 80% labour in construction, retail, and professional services without rights of abode (no family allowed in and expelled once unemployed), least of all citizenship -and much else, all of this amazingly to build a Manhatten dedicated to urban luxury in a coastal desert (200 futuristic skyscrapers) that briefly shook world markets because someone went on holiday and sought a 3-month maturity delay on $4bn of bonds - chump change payment for Abu Dhabi.
UAE has an economy the size of Scotland, which also enjoys socialist policies but applied to the other end of the economic food chain. Arriving back in Scotland, I find home snowed-up transport chaos, climate agreement failure in Copenhagen, and usual seasonal media summing up our world of the past decade and to year's-end.
Three ideas appear to stick out of the Christmas stocking. One, various theories to blame credit crunch illness on the cure, regulation. Two, as USA severely reduces its trade deficit, where will growth come from if not from emerging market countries dramatically increasing their trade deficits, the same countries that pleaded unfairness and acute sensitivety in growth prospects to Copenhagen climate change agreement? Three, dependency on Finance sector to reduce and we must rely less on asset gain versus actual net earned-income, while others argue that without finance sector red in tooth & claw and recovery in property prices what terms of trade advantage has the UK left to rely upon to recover lost ground other than very slowly? These issues in our globalized world are of course interconnected.
One emerging fashionable consensus is that in the financial crisis, banks’ equity was insufficient and quasi-equity could not absorb the losses. Basel Committee on Banking Supervision appears to agree and has proposed a comprehensive shake-up. From a banker's perspective, the impression is of a punitive regime, including increasing capital reserves by half, of which most is for liquidity reserves, and all of which must be of higher quality. Investors then hearing this sold bank shares round the world on fears that banks will have to continue to deleverage and raise oodles of fresh capital before they can restore share premiums, on top of taking off-balance sheet assets back on balance sheet, dilutive capital raisings on both sides of the Atlantic (to avoid the costs of government schemes), bonus caps and 'living wills'. The credit rating agencies, notwithstanding their own problems of mass-action compensation claims, are prowling like wolves round the winter campfires howling to downgrade any banks with living wills and any countries with rising deficits and debts. Also, matters are either so bad or so good that junk bonds look attractive and the dollar is rebounding as a safe haven, yet world economic growth continues looking liverish blotchy or blood-poison septicaemic!
It is a bit silly to focus on the idea that more reserves would have evaded the credit crunch problem. Bank writedowns and the lesser credit default losses have wiped out bank capital 100% and threatens to do so by another 100% before the crisis can have a final line drawn under it. What would have our economies and banks been like with 20-25% capital reserves ratio to asset exposures compared to 10%? For one thing losses would have been on a smaller scale anyway, but housing and office price bubbles and credit booms would have to have been severely curtailed with more bank lending to industry and far less to construction and property, but in a lower consumer spending environment with more savings diverted into longer term insurance and investment. The emerging markets poor countries would have been denied their boom of the past decade or so. We should not neglect what a boon that was to the world in shifting wealth and income from richest countries to poor countries. Now, it seems the idea (as set out by the Brookings Institute, for example) is that we should go back to a world economy driven by poor countries running rising deficits financed by aid. The FT says investors should welcome the Basel committee’s emphasis on beefing up banks' capital ratios so that "Funny money hybrids will be phased out". This is a blow to how hedge funds and private equity firms leverage their investors' capital via prime brokers and leveraged buy-ins etc. Banks will deleverage and should rebalance their lending away from finance (as they have been doing so enormously already that this triggered the credit crunch by denying banks' ability to roll-over funding gaps by borrowing from each other) and away from property towards industries that make tradable goods. The BCBS capital proposals are appropriately targeted: banks trading in derivatives, for example, will have to hold extra capital against counterparty risk. Furthermore, as the FT describes it, "a leverage ratio – the preferred measure in the US – will be introduced as a supplementary dial on the regulatory dashboard. While many European banks already report such a ratio, it will be harmonised internationally to cater for differing accounting treatments around the world". BCBS also wants to curb pro-cyclicality, requiring banks to bolster capital in good times. A minimum liquidity standard for internationally-active banks provides further protection, which will require a liquidity reserve equal to about one third more in capital reserves.
What is missing here is that governments stepped in to refresh banks' funding gaps (gap between loans and deposits previously filled by private sector intra-finance sector lending) equivalent to 100% of banks' capital reserves. Although governments have also widened their budget deficits to cope with falling tax revenues, the cause of much political hand-wringing, in fact this is more than covered by buying in government debt (nearly $2 trillions by UK and USA alone under Quantitative Easing financed by surplus margins between assets pledged by banks and government paper swapped in return). The profits that were previously private and are now public will in the recovery pay down at least half of governments' budget deficits. Governments (especially USA and UK) are showing that they can be and are being financial engines for growth. This is deeply unsettling for fundamentalists who believe in all government revenue and all growth only coming from private sector pockets and private sector's productivety efforts. The same fundamentalism lies behind emerging countries led by China sabotaging the Copenhagen Climate deal. They refuse to see green policies as just another business, and a growth business that they should be part of. The poorest countries see it as a reason for seeking more aid, more than the $100bn on offer by OECD countries led by UK & USA, while the richer emerging markets such as China especially merely see it as a cost like a green tax that will hold back economic growth and therefore China arm-wrestled 26 or so other poor countries to trade objection to Copenhagen for more investment and trade from China! This is 2-dimensional thinking. China ought to see green policies as another new business sector in which China should seek a large share. De-polluting and cutting global warming gases is no more a cost to industrial growth in general (regardless of whether climate warming science is right or wrong) than if 30 years ago the world had had resisted computerisation because it would add massively to business costs. Computerisation was, of course, sold as cost-saving. Computing became one of the biggest of all industry sectors. In hindsight we can see that the cost-saving argument was not true, but industrial groiwth did not thereby suffer. Instead a new industry formed. As experts will know, it is rare for new computer systems to generate cost savings before they have to be replaced again by a replacement technology.
The difference of environmental cost compared to computing is that climate warming counter-measures, emission-reduction targets and technology are not sold as cost-saving, only as 'saving the planet' when actually hey have more genuine chance of being a growth benefit in the long and medium term as was the case with computing. The argument can be extended to other industries such as health and education that were resisted by taxpayers and continue to be so resisted even if they have long since become self-financing parts of the whole economy. It is too easily presumed that moral reasons for doing anything must involve higher cost burdens while narrow business case reasons are assumed to be profitable efficiency gains. My own experience of over 30 years has taught me that such assumptions are generally wrong - that often the opposite is true.
Adam Smith's Invisible Hand should be understood by reversing the equation to recognise that by beginning with moral benefits economic benefits will usually follow. I don't doubt the same will be true of changing the culture in investment banking.