Too big to fail is over…Discuss:

Or more precisely: “Too big to fail has been solved”, said by Jamie Dimon, CEO, JPMorgan Chase — 2017. This may or may not be a watershed moment in terms of global, financial stability systemically. BASEL 3.0 could stand for:

Big

American

Sop, for

European

Lethargy

The financial and ‘banking related’ appointments of Donald Trump, The Consumer Finance Protection Board and the Federal Deposit Insurance Corporation are the four crucial strings that attach to (arguably) the western world’s and America’s systemic stability.

Almost all of the big banks in the West have their fortunes now inextricably tied to the confidence, reputation and now technical ability of the governments of the individual nation states. The technical ability in the US is in doubt, especially as Donald Trump is yet to make senior financial, technical appointments to his tope team(s).

This rather leaves a hole in financial stability mechanisms and mitigations of risk, select experts believe until “the mid 2020s”. This troubles me as it emphasises that the whirring wheels of (b)€ureaucracy are nearly TWO DECADES shy of the necessary speed and efficiency.

THE BANKERS’ SIDE

A thought provoking Special Report in the reputable Economist newspaper takes us on a journey through the landscape of why we should remain cautious about banks — it doesn’t go Asian [1]but the report does emphasise American, UK and European banks, in that order. Perhaps, its author suggests there are seven core consequences of the 2007/8 “apocalypse”:

· Over-regulation: there are over 43,000 jobs at JPMorgan Chase vs 24,000 in 2011

· More and higher capital requirements across the board

· Returns on equity (RoE) have fallen away dramatically;

· Sluggish industry revenue growth[2]

· Banks are much less attractive as employers

· Banks’, insurers’ and even re-insurers’ reputations are in proverbial tatters

· Fintech is becoming ever-more important — Bitcoin and “self-asset-management”

The world’s largest bank by assets around 2007, after it purchased ABN Amro, was, wait for it, Royal Bank of Scotland. The Royal piece has a certain ring of irony to it as Sir Fred Goodwin, Fred the Shred, was stripped of his knighthood for sub-prime atrocities which inflated egos, reputations and of course, bonuses.

Stripped yes, by the Queen. How times have changed. Regulation, regulation and more regulations the bankers are crying aggressively again rather than assertively that “Too big to fail has been solved”. Nonsense.

JPMorgan Chase, for whom, agitator in chief Mr Dimon works, was, in an eerie echo of for example, the MPs expenses scandal in Westminster, bailed out in 2008 to the tune of $12bn. That’s $12,000,000,000.

THE OTHER SIDE

One of my first questions after the quagmire of material, (delivered a little tongue in cheek) in the first third of this special report is: “Is it possible or even probable whether the financial services industry can go properly and totally, b2c; business to consumer — i.e. Fintech will out?

From my own risk management-driven perspective, reputation is all, and, broadly the banks trashed themselves a decade ago. As a consequence youngsters don’t want to work at these places any more. Yet now there are tens of thousands of new graduates working in risk and compliance alone[3]. Their reluctance is justified, please trust what I say.

TARP, or ‘the Toxic Asset Relief Programme’ came in very soon after the advent of (the relatively passive) Barak Obama. The speed was what certain factions believe got America back to “growth” sooner, but with interest rates still very low[4] the “recovery” remains debt fuelled.

The key to appreciating just how “deep” the government had to go is the fact that Fannie, Freddie and Auntie AIG were bailed out too. The $700bn largesse of TARP overall stabilised things and did only need $475bn in the end. $245bn of it did go directly to the banks.

The article also discloses how General Motors (cars!) must have been caught up in leveraged property bets too: Google “Ally Financial”.

$21bn has needed to be raised by Deutsche and UniCredit banks ten years after the crisis hit — there must be creative accounting occurring regularly over the last ten years. Nobody can accuse the European psyche of being overtly proactive.

Between 2007 and 2015 the European banks’ mantra has been “retain profits and reward shareholders.

Rather than rebuilding their balance sheets. That’s $571bn that has neither topped up balance sheets nor indeed OUR ailing pension funds.

CORPORATE STRATEGY POST-CRISIS

My last point in the previous paragraph signals a very significant strategic risk as well as a creeping strategic shift. Companies and more recently quite a few governments are not even close to funding their medium-term pension liabilities.

Post 2007/8 as detailed above, they have continued to retain earnings and pay half-yearly dividends; fully serving their short-term stakeholders needs. This they would argue is prudent medium term planning. This would have been and indeed was true back in the 1960s, before the IMF loan. Alas, due to the “eat what you kill” ethos of any investment bank or even lending organisation, it’s just not true anymore. To use the same turn of phrase as the aforementioned Dimon — “We’ve had our lunch; it’s over”.

EUROPE IN CONTEXT #brexit IN FOCUS

What I hear you ask does SSM stand for? No? Well, it’s something that the European Central Bank has created. In keeping with its lethargic modus operandi the Single Supervisory Mechanism was only created two and a half years ago.

In terms of productivity and some prudent realism, Europe’s banking union can only be seen as horribly incomplete. For completion it clearly would require insurance and underwriting by Germany of all deposits across the Eurozone, which the German public and German politicians would not sanction. The SSM itself, through Daniele Nouy the chief executive, diplomatically claims that it needs regulations rather than directives.

Directives do not compel compliance, regulations would — period. And she is correct. But the British public on 23/6/16 decreed the €uro and the European “project” a busted flush. Equity cushions, the article decrees could have been a massive 64% higher had prudence been in evidence. Alas it has not been.

Having just attended an evening with the European continent’s most controversial short-term politician, the self-confessed whistle blower Yanis Varoufakis, I take issue with the Economist’s view that Italy is the continent’s current chief concern. Greece was one of the countries that received the Investment banking “treatment” [5] It’s controversial to say so but with a French leader already displaying “L plates”, the entire European ‘dream’ now comes under scrutiny, at least in this piece; 34% of the French voters ticked LePen.

Eighty per cent of bans in 2016 believed that they would cover their (conservatively calculated) cost of capital; only twenty per cent do now — alarming. Confidence seems to have capitulated in just a little over twelve months. Debt fuel must be intoxicating some protagonists, but which ones?[6]

John Cryan, Deutsche Bank’s CEO does, in contrast to many other banks) have a strategy. The sale of part of Deutsche Bank Asset Management and the retention of Postbank and the halving of a hefty $14bn Department of Justice fine, this is all good. Mr Thiam — Credit Suisse’s chief (of Prudential Insurance notoriety) also displays strategic nous. Eyes East towards China and raising equity capital. John Cryan, like Thiam, had a reputation that preceded him. At UBS — A bailout recipient from the (sage) Swiss government, he cut back investment banking and zeroed in on wealth management long term, another wise call.

STRESS TESTING

Both Jamie Dimon and Lloyd Blankfein energetically cry “we hold too much capital” but it is crucial at the 2017 juncture (the tenth anniversary of the start of the meltdown) that the regulators (and the elite power brokers) hold firm over this.

A man called Daniel Tarullo had a strained life. It was he who designed current stress test models. He spoke at his farewell of the tests having to adapt to new risks[7] He is not wrong. Twenty-first century bankers like Blankfein NEED TO BE HELD BACK by stronger leashes of constraint. Only 279 OUT OF 390 test requirements have been met thus far. My reservations only apply to the bigger banks[8]. Small banks the tendency goes will squeal at over-regulation. It is those 100 or so that have assets of over $10bn that have the power (and egos) to hold the system to ransom. With the coming of fintech[i], so online banks threaten community banks; a further erosion of important social capital I would suggest and caution strongly against. The bank must not be allowed to step away from community participation and genuine social responsibility. Using a term borrowed from Nassim Nicholas Taleb of Antifragile and Randomness fame, onliners lack enough “skin in the game” there is no footing to their game-plan.

Like many an Economist article, this one was America-centric. As it drills down into gritty details on all the 5,000 (smaller banks) holding less than $1bn in the US; we need to properly compare this to what’s actually happening in Eastern countries and Europe in its entirety, plus of course Australia and New Zealand.

Essentially, officials such as Gary Cohn (another ex-Goldman Sachser)musing about a 21st century Glass Stiegel do not know what to. The word filibuster is used: a tendency that leads to a bill being debated for so long that it runs out of time. Another tactic has been to deliberately frustrate funding for the CFPB — nasty.

Dodd Frank — Donald Trump has vowed to “do a big number” on this, i.e. torpedo it, replace it. Can we have one rule for big banks now and another for the relative minnow banks?

The logic of certain situations is a little lost by the Economist’s author[ii]. He raises the question of the Volcker Rule — investors’ deposits cannot and should not be used as a foundation to fund proprietary trading-, saying that it can be relaxed as it was not this type of trading that caused the 2008 crisis — SO WHAT? — We are trying to put an end to bankers’ sharp practice — period!.[9]

It is also worth noting that the GAAP legislation on accountancy practices allows banks to offset derivatives exposures on the asset/ liabilities sides of their balance sheets. THIS, to safeguard European banks exposures MUST be repealed.

Huw van Steenis, emphasising the financial sectors’ collective parochialism[10] has been on the merry-go-round since he left Oxford, Trinity College to be precise. He showed up at Schroders Asset Management in 2016 after a spell at Morgan Stanley. He has highlighted the consensus trend towards more international legislation weakening.

The fact that there is even an acronym (G-Sib) for the global strategically important banks indicates how ‘too big to fail’ must be enshrined into both legislators’ thinking, banks’ psyche and (arguably) even the academic discourse.

TLAC — total loss-absorbing capacity must amount to 16% by 2019 and 18% by 2022, as some sensible and sensitive analysts bray for more legislation rather than “executive orders” or loose directives.

One question that has not been raised is whether risk weights of Sovereign bonds must be elevated. There may be a CETI differential of up to 400 basis points here — 4%. American banks have front run such a move! But European and UK banks have not and with #brexit on the agenda it promises to be an uncertain ride for bank equities and debt alike, Barclays Bank’s equity plunged as a true story about the CEO having a private investigator put upon a potential whistle-blower whom he had hired particularly stuck in my proverbial craw. RBS too while Fred the Shred has his day in court at long last, saw a little volatility, this time (rarely) in an upward direction as the government was considering the sale of its gigantic 83% stake.

Some in the know, and I agree with them, are saying that if there is a correction in assets markets and bond yields start going up as well, it will be rather a severe one. Why ten I enquire does Basel III ask for just one month for withdrawals under a stress induced outflow rather than a quarter or even a half-year of grace? Dangerous.

One statement struck a huge chard:

“It is unacceptable that the US Federal Reserve continues to negotiate International regulatory standards for financial institutions among global bureaucrats in foreign lands, without transparency, accountability or (even) the authority to do so. ”

Patrick McHenry: Vice Chairman, House Financial Services Committee.

Fleetingly “Big Chinese banks in any case neglect consumers and small businesses so customers feel NO loyalty towards incumbent lenders. Then, tellingly: Regulators have also been willing to let online companies shift into finance. I’d say that this may be dangerous but the system so badly needs competition and competitors that it is probably a risk worth taking; the top 100’s oligopoly has to be broken.

FINTECH ADVANTAGES

1. Nimble code (re)writing and unlimited flexibility towards customer needs; one New York broker claims to update their mortgage offer some 20 times a day (?!)

2. They’re attractive to young, socially and professionally mobile graduates (banks are “over”)

SAFETY FIRST

In the worlds of socially democratic integrity and social responsibility Canada aside, only Scandinavia stands out, in the case of Sweden, beacon-like. The rapidly conceived merger and nationalization of Gota and Nordbanken should be examined in detail — it happened back in 1992.[11]

First, Nordbanken was already majority owned by the government in Stockholm. Nine years later in 2001 Norwegian, Finnish and Danish lenders were added to the mix to form the generically christened Nordea.

Kenneth Rogoff and Carmen Reinhart’s study all the way back to the 1890s proved that the income[12]recovery period is 8 years or thereabouts, so methinks US and Europe, including UK are not out of the woods just yet.

Seven out of twelve countries, post 2007 have thus far “clambered back to their starting points” — America reputedly had by 2013 — but just look at the deficit and the debt-fuel. Central banks’ balance sheets bear the imprints of the crisis — still now.

MILLENIAL PROBLEM

Recruitment and sustainably attracting young, bright graduates into (investment) banking

An example is given of Bank of America Merrill Lynch greenwashing graduate open days with half an hour of Q&A on the organisation’s CSR programme. There is a problem with attracting and skilling-up graduates and it will endure.

Banks and fintechs in the light of all this should be and are cooperating. But as ever the banks are defensive; they do not want to morph into “shells” that bind — for fintech entrepreneurs, but this I would say, is almost a given inevitability. “Mountains of data sharing” is mentioned — viruses and hackers spring to mind. This is where the Economist; Special Report goes in on itself, temporarily honing in on San Francisco.

Chinese firms have started buying into outfits like ZestFinance (an example of a fintech). It remains to be seen whether the spending spree gathers momentum; it could.

As the newspaper’s author explores fintech companies he mentions are “cutting losses” rather than turning profits.

Top down fintech (a term coined by Adam Lutwin of Chain) “They do it, the same thing as financial services companies but faster. Blockchain = a distributed ledger = an immutable shared record.

But, terms and practices like “blockchain” just reemphasises to me the vulnerability of fintech to cyber-attacks like the one we saw on Friday 12th May 2017 on the NHS, 200,000 people in 150 countries which was stymied by a 22 year old in his bedroom in North Devon! Spurned employees from places like Microsoft, The Linux Foundation, and the US’s National Security Agency and moreover, GCHQ — Codes and practices can be stolen, revamped, passwords can be abused, systems and efficiencies can be dismantled in seconds these days.

The Enterprise Ethereum Alliance “a blockchain challenger” is working on an all-singing-all dancing version of blockchain — I do hope that encoders are busy looking at far more sophisticated ways of encrypting data in order to avoid hacking and viruses becoming rife.

CONCLUDING REMARKS

· Although this article borrows much from Patrick Lane’s material it is worth the reiteration

· Credit is too lax and asset bubbles and consumer spending are debt-fuelled

· Capital adequacy and tier one capital rules must continue to be tightened and subject to stringent regulation. Basel 3.0 needs to be rapidly backed up with a strong global Volker rule and probably a Basel 4.0

· Allow banks to fold if they encounter insolvency; it should have been so back in 2008, many a bailout was a remarkable mistake.

Robert Peach

16th May 2017

[1] “Go Asian” — from experts I have read Chinese facts may mirror these in the global North — there is vulnerability over there too.

[2] I think this is called greed

[3] When I was in financial services, we all used to call them “business prevention officers” — One at my company was even called Blood!!

[4] A key indicator of whether Mr Trump’s bravado is not fake news, will be whether interest rates are going to rise three times more this year as certain experts are predicting.

[5] The balance sheet was dressed up in order to allow admission to the €uro

[6] Doubtless a community hub of the future

[7] NHS and International cyber-attack May, 2017.

[8] The “Challenger banks like Yes and Metro need to be given encouragement to take more deposits and rise up. Virgin Money Direct is also an admirable business model.

[9] It WAS proprietary trading that caused the 2007 bust, this is why the banks’ balance sheets were loaded up with toxic assets to the tune of $100s of billions — See Tett G: Fools Gold, 2010

[10] His wife Camilla, Baroness Cavendish of Little Venice, was an adviser to no other than David Cameron

[11] This merger was driven by a property crash similar to America 2007

[12] Gross Domestic Product (GDP)

[i] FINTECH = financial technology entities that are displacing banks’ and asset managers’ business models.

[ii] Thanks to the Economist author Patrick Lane for an engaging analysis that enabled this one!

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