Mint – Blain’s Morning Porridge

And still those voices are calling from far away, wake you up in the middle of the night.. 

What have we got this morning? Everyone is smiling about the Greek package being approved. Happy happy markets –for a brief while anyway.. The market has chosen to read Yellen’s testimony as dovish, while I wonder if she actually means “we won’t raise rates any time soon… until we change our minds”. 

A news story drifted across the wires yesterday and set me thinking. JP Morgan is going to cut about US$100 billion of large customer deposits to limit the amount of capital it requires to meet the US Fed’s onerous additional capital requirements relating to capital buffers and the assets they need to meet a crisis. Customer deposits don’t count – they might run for the door in a crisis. So JPM is trying to direct that money into products like money market funds, or it will cut deposits and the size of its trading book. So regulation means the bank offers less to clients? Makes loads of sense. Interesting that JPM and HSBC are the planet’s two most important Systemically Important Financial Institutions (SIFIs)..

And I got loads of feedback after yesterday’s comment on HSBC’s current travails. A number of folk commented HSBC’s ROE slide proves the banking mantra: “the only thing worse than too little capital is too much”. However, most reckon HSBC’s dire results earlier this week beg serious questions and discussions about the regulatory/capitalisation maelstrom, the future allure of banking as an investible sector, and banking’s diminishing role as an allocator of capital across the global economy.

Many believe HSBC is being singled out simply because it’s the biggest – and is nowhere near the most guilty. The bigger they are, after all, the harder they fall.

On the one hand we have those who believe regulation and proscriptive capital rules are absolutely necessary to prevent a repeat of the 2008 Global Financial Crash. The “too-big-to-fail” mentality kept undeserving bankers in jobs and socialized banking losses. Totally unacceptable and nobody is denying it was a wrong outcome. (But it’s also worth noting that HSBC was one of the very few major institutions that didn’t take large swathes of government money through the crisis.)

But, no matter how unacceptable, too-big-to-fail became the default regulatory response to the last crisis. (Maybe because it was as much regulatory failure as banking failure that allowed the last crisis to occur?) The ultra-conservative approach to capital that has followed is now a simple mindset – avoid TBTF - meaning the new rules are responses to the last crisis, not the next one.

The cumulative result of the emergency regulation and new capitalisation rules is raft upon raft of complexity, making it almost impossible for investors to understand the nuances as capital levels are surreptitiously tweaked by regulators. (For instance, HSBC’s Pillar 2a level was changed - we suspect at the suggestion of a concerned HKMA to the UK’s PRA – how should a potential investor who spotted it weight that news?)

Meanwhile, bankers are hamstrung by regulation and capitalisation constraints. It is not efficient. Risk-taking has been replaced by risk assessment as a banking skill – an important but subtle difference. The only growth in banking has been in compliance, regulation and control functions. Banking has become ossified.

Don’t forget that poor regulatory responses at the outset made the last crisis worse. The nanny state of over-regulation might appear to have made banks safer – which is one reason hedge funds were so quick to binge on CoCos when yields were much higher (arbitraging over regulation) - but with multiple consequences.

Firstly, the banks are now so de-risked they add little except as batch processors. The EU hopes its much heralded Capital Markets Union will go some way to replacing banks with new direct lenders. They look to crowd-funding and peer-to-peer lending to take up some of the slack, but you know these sectors will be regulated to near death the moment we get our first big alternative lending scandal. Niskanen’s Rule Of Bureaucracy: regulators maximize their economic utility by maximising their regulatory purview.

The second issue is bank profitability – as HSBC is discovering. The layers and layers of SIFI, Pillar 2 and Leverage ratios the regulators demand eat into returns. Banks are no longer making sufficient returns to justify even the limited risks they take. And governments have realized banks can be raided again and again with fines. Who is going to invest in banks as they become less and less attractive? The layers and layers of additional compliance staff simply destroy that most important banking ratio – the cost/income ratio that represents banker efficiency. I read somewhere that HSBC’s has collapsed from mid-50s to mid-60s. Do I want to own that?

The third issue is unwise capital. The upside down concept of bailing-in debt holders before equity is a difficult concept for investors to grasp. Contingent capital is now AT1 – but in a global systemic banking crisis a hundred banks triggering AT1 deals could collapse the whole global financial system as effectively as a wave of bankruptcies. Banks are already playing games optimising CET1 and AT1 ratios.. why wouldn’t they? What’s the alternative?

Of course we could go back to simpler days. What about really basic, difficult to arbitrage leverage ratios or capital rules that effectively let banks set the amount of capital they believe are correct for their business. If it’s right, they will attract investors and depositors, and the capital levels will reflect their business. Let the market judge capital ratios by the price it sets on capital cover. Simples?

What about letting banks, even the biggest, fail. Why not? If every bank has a “living will” and an effective resolution plan in place, and all banks are aware of the need to make sure they understand all their counterparty risks, then the Lehman aftermath could be made much less messy. Constructive destruction in the banking sector may be no bad thing…

Perhaps I’m just a dreamer, but I’m not the only one..

Meanwhile.. I read that Europe faces a power outage crisis on March 20 when a solar eclipse will create about 60% totality for a few minutes. Apparently all the solar power (and wind, because the wind typically drops during totality) will switch off and trip all European power… Arrg.. Can I just ask...what happens at night in Europe?

Finally.. no Porridge till Tuesday.. the Gentlemen’s Ski-Touring Club of La Thuile is in session the next few days.

 

Bill Blain

44 207 786 3877

44 7770 881033

[email protected]

[email protected]