Saturday, December 3, 2011

Are We On the Cusp of Another Financial Crisis?

In The Rising Fear in Bank Stock Prices, Andrew Atkeson and William Simon, both professor at the UCLA School of Law, argue that "markets are signalling investors' worries about the soundness of bank balance sheets and the adequacy of bank capital".

Similarly, in a Bloomberg piece, Deutsche Bank Could Transfer Financial Contagion, Simon Johnson, former chief economist at the IMF and a professor at MIT claims that we have our heads in the sand about the soundness of the banking system. The financial situation of the large western world economies may appear stable and under control on the surface but it is only an illusion. According to Simon Johnson, many very large banks are as thinly capitalized as they were before the crisis and a significant proportion of their assets are rubbish.

In both articles, the authors expressed the fear that another credit crisis may very soon be coming our way. The first set of authors are making their arguments from their reading of the market tea leaves which seem to indicate that bank stock volatility is in a danger territory (see the graph above) while Simon Johnson bases his own evaluation of the situation on a direct analysis of banks' balance sheets; in particular, the little-known American subsidiary of Deutche Bank, Taunus Corp. which is incidently the U.S.’s eighth-largest bank holding company.

Both articles recommand that banks build much stronger capital positions soon. Atkeson and Simon also argue that "banks should be required to have much higher levels of common equity to reduce their leverage and their incentives to take risks". Simon Johnson also suggests that "this would be a good time for Congress to dig more deeply into the risks that Deutsche Bank poses to financial stability in the U.S. and around the world."

However, as Dan Aronoff, who writes regularly for The Sceptical Market Observer, argued earlier this week in How NOT to Deleverage Banks - The Eurozone Bank Capital Target Risks Disaster, the danger lies in the likelihood that the affected banks will achieve the new capital target by, in large part, reducing lending, which will almost certainly tip Europe into a recession and quite possibly trigger more serious social and political turmoil.

Yet, as Charbel Cordari argued on two LinkedIn Groups (Global Economist Network and Economists Professional Network) in response to Dan's piece:

"Indeed, in the current situation, banks looking to fulfill the new Basel capital requirement will find it difficult to raise capital and, since profits are weak, ... banks will reduce lending. On the other side, ... better adequacy ratios strengthen confidence in the banking sector and facilitate later capital raising (meaning more future lending). In the meantime, ... lending will shrink, asset prices will go down, and European economies may enter into a prolonged recession. Otherwise, ... confidence will deteriorate further, leading all the same to assets’ price deterioration and additional economic problems. Both situations are painful. But since in both cases economic growth will suffer, the implementation of the new requirements seems to be the best alternative. The writer’s recommendation to cap assets at their current level is a good proposal, but I am not sure it can be implemented properly, unless regulators and auditors find a way to segregate asset volumes (over which banks have control) from assets prices (over which banks have no control)."

In conclusion, it might be a matter of "damned if we do and damned if we don't." We might very well be stuck between a "bank" and a hard place. I will let you decide. Here are the two articles.

First, the article by Atkeson and Simon published in The Wall Street Journal last week:

The consensus among public officials and financial experts that the U.S. economy is gradually recovering may be too optimistic. There are emerging signs in the stock market that the U.S. economy is about to face financial headwinds that may lead to another credit crisis and recession next year. The recent volatility in bank stocks is a signal that U.S. banks, large and small, are not as healthy as many analysts assume.

Banking is a game of confidence. So if the investing public is uncertain about the health of bank balance sheets, its uncertainty can turn into fear, setting the stage for a banking panic.

This dynamic has played out twice before over the past 85 years—in the Great Depression and the panic of 2008-09—with devastating consequences for the broader economy. Over the past three months, investor uncertainty about the soundness of bank balance sheets, manifested in the daily volatility of stock prices, is back up to levels seen historically only in advance of these two great crises.

The volatility of bank stock prices from one day to the next depends on investor perceptions of the riskiness of the assets held by banks. In tranquil times, when investors feel that bank portfolios are reasonably safe and not excessively leveraged, daily volatility is low. When investors are uncertain about the soundness of bank balance sheets and about the adequacy of bank capital, then daily volatility rises in bank stock prices to double or triple their normal levels.

When uncertainty turns to panic, as it did in 1929-33 and again in 2008-09, the volatility in the daily movements of bank stock prices can shoot up to seven or eight times their normal levels. When this occurs, the damage radiates quickly from the banks to the broader economy.

These dynamics are illustrated in the nearby chart, which shows the volatility of daily movements in an index of all publicly traded bank stocks from 1926 to the present. In normal times, volatility hovers below 1%, occasionally rising as high as 2%, and rarely rising above 3% unless a serious crisis is at hand.

Volatility spiked to an unprecedented level (nearly 9%) with the market crash of October 1929, indicating widespread panic among investors. The panic moderated after the initial crash, but then built again steadily, rising to 4% in 1932 and to 5% on a sustained basis in early 1933. By this time, the banking system had essentially collapsed, causing newly elected President Franklin Roosevelt to declare a nationwide bank holiday in an attempt to stem the panic. Afterward, the volatility in bank stocks steadily declined to more or less normal levels by 1935, then spiking upward again in the recession of 1937-38.

After World War II, bank stock prices were stable for decades, and their volatility never approached the telltale 3% until the stock market crash of Oct. 19, 1987. On that occasion, the measure spiked to Depression-era levels, giving investors a fleeting scare.

Over the last 20 years, however, with deregulation of financial institutions, the daily movements in bank stocks have become more volatile and, interestingly, are now more closely correlated with economic downturns. This volatility increased in 1990 with the recession that began in midyear, spiked again in late 1998 with the Russian default, and once again shortly thereafter with the bursting of the "tech bubble" and recession in 2000-02.

Bank stock volatility increased again in 2007 in much the same pattern as it did in the late 1920s. It rose to extreme levels in 2008 and 2009 as uncertainty gave way to panic in the midst of the financial crisis.

From mid-August through last week, bank volatility has been over 3%. The market for bank stocks is now sending a bright red warning signal that conditions are ripe for another potentially disastrous financial panic.

This extraordinary volatility is not limited to the stocks of large banks but extends to small and midsize banks as well. For example, the volatilities of the daily stock returns of indices of regional and smaller bank stocks have also been hovering around 3% since mid-August, including the KBW Regional Bank Index (KRX), S&P's bank index (BIX), the Nasdaq bank stock index (IXBK), and the ABA Community Bank index (ABAQ).

What can be done? Throughout history, forceful leadership has been the key to restoring public confidence in the banking system. Without it, there is the risk that mounting uncertainty will lead irresistibly to fear and panic, with well-known consequences for the broader economy. This leadership now can only come from the Federal Reserve and the U.S. Treasury.

Given the extraordinary danger, regulators should take immediate steps to restore the investing public's confidence in our banking system—without waiting for European officials to deal with their crisis or for Dodd-Frank provisions and revisions to Basel capital standards to be fully articulated and implemented.

The Fed took a useful first step last week in announcing a tough new stress test. This time around, a larger number of banks will be required to prepare plans for adequate capital under severely stressed macroeconomic and market scenarios, and the results will be made public.

There is no silver bullet for calming the volatility in the market for bank stocks over the past three months. But the Fed's best shot is to apply this latest stress test broadly across banks both large and small and to insist that banks put forward clear plans to build up much stronger capital positions soon.

In addition—and perhaps more importantly—banks should be required to have much higher levels of common equity to reduce their leverage and their incentives to take risks. The recent spike in the volatility of bank stocks is telling us that the banking system is still too highly leveraged and that investors are fearful for the soundness of our banks.

The time to restore confidence is now.

Here is also the article by Simon Johnson published in Bloomberg a couple of weeks ago:

(I suggest that you go to the article to be able to click on the multiple and relevant links within the piece.)

You’ve probably never heard of Taunus Corp., but according to the Federal Reserve, it’s the U.S.’s eighth-largest bank holding company. Taunus, it turns out, is the North American subsidiary of Germany’s Deutsche Bank AG, with assets of just over $380 billion.

Deutsche Bank holds a large amount of European government and bank debt; it also has considerable exposure to lingering real estate problems in the U.S. The bank, therefore, could become a conduit for risk between the two economies. But which way is Deutsche Bank more likely to transmit danger -- to or from the U.S.?

By any measure, Deutsche Bank is a giant. Its assets at the end of September totaled 2.28 trillion euros (according to the bank’s own website), or $3.08 trillion. In the latest ranking from The Banker, which uses 2010 data, Deutsche was the second- largest bank in the world by assets, behind only BNP Paribas SA.

The German bank, however, is thinly capitalized. Its total equity at the end of the third quarter was only 51.9 billion euros, implying a leverage ratio (total assets divided by equity) of almost 44. This is up from the second quarter, when leverage was about 36 (assets were 1.849 trillion euros and capital was 51.678 euros.)

Even by modern standards, this is very high leverage. JPMorgan Chase & Co. has a balance sheet about 20 percent smaller than Deutsche Bank’s, but more than twice as much Tier 1 capital, an important indicator of a bank’s financial strength. Bank of America Corp., whose weakness is a serious worry in the U.S. today, has twice Deutsche’s capital. (These comparisons use The Banker’s ranking of the top 25 banks.)

Healthy Capital Ratio

Globally, Deutsche’s capital ratios are relatively healthy, judging by the banking industry’s standard measures. At the end of the third quarter, its Tier 1 capital ratio was 13.8 percent (up from 12.3 percent at the end of 2010) and its core Tier 1, which excludes hybrid debt that can convert into equity, was 10.1 percent.

How does such a highly leveraged bank become “well- capitalized”? The answer is that “risk-weighted assets” were 337.6 billion euros as of Sept. 30. But what is a low risk- weight asset in the European context today? Incredibly, it is sovereign debt, which of course is far from riskless at the moment.

Perhaps Deutsche Bank holds mostly German government debt, which still has safe-haven value. But it’s likely that Deutsche also holds a significant amount of Italian and French government bonds.

Still, the bigger risks are probably in the U.S. Deutsche Bank is a significant trustee for mortgages, having been heavily involved in the issuance and distribution of mortgage-backed securities during the housing bubble. Yves Smith, writing on the blog, says Deutsche Bank is one of the U.S.’s four biggest securitization trustees. Many questions on whether paperwork was done properly and whether the rights of investors have been protected hang over these trusts.

Let’s take a look just at Taunus Corp., named after a range of mountains outside the parent bank’s Frankfurt headquarters. The latest figures (from the Fed data, using the consolidated financial statement at the end of the third quarter) show Taunus with total equity capital of just $4.876 billion. This implies an eye-popping leverage ratio of around 78.

Why would the Federal Reserve and the new council of regulators known as the Financial Stability Oversight Council allow Deutsche Bank to operate in the U.S. with sky-high leverage -- with its huge implied risk to the rest of the financial system? Presumably, in the past, U.S. authorities have taken the view that Deutsche Bank had a strong enough balance sheet worldwide that more capital could be provided to its American subsidiary, if needed.

Troubling Questions

Such a presumption now seems questionable, at best. Earlier this year, Bloomberg News reported that Taunus needed almost $20 billion of additional funds to meet U.S. capital standards, and that Deutsche Bank was trying to declassify Taunus as a bank- holding company to avoid capital requirements entirely. It’s unclear where this process now stands, but it’s also not obvious how declassification would help U.S. or global financial stability. Financial reform advocates hopefully will press hard on this issue.

All of this raises troubling questions. Have U.S. bank supervisors really satisfied themselves, through onsite inspections, that Deutsche Bank’s risk weights accurately reflect market conditions and the increasing structural weakness of the euro area? Can U.S. regulators document their satisfaction beyond the materials produced for the European Banking Authority, which earlier this year oversaw stress tests that pronounced now-collapsed Dexia as well-capitalized? (Actually, Dexia had stronger capital ratios than Deutsche Bank.)

In their prescient, pre-crisis book, “Too Big To Fail” (not to be confused with the more recent Andrew Ross Sorkin book of the same title), Gary H. Stern and Ron J. Feldman, in 2004 nailed the incentive distortions that encouraged risk-taking and brought the financial sector to its knees. No one else came close to them in getting this right. Included in their analysis are examples of banks that could have been regarded as having moral hazard issues because of their size. Deutsche Bank is No. 4 on their list of large, complex banking organizations by asset size.

This dog did not bark during the 2008 crisis, partly because most foreign governments were seen as having strong enough balance sheets to back their banks’ worldwide operations. But this is no longer necessarily true for euro-area governments.

Even in 2008-2009, this may have been illusory. According to published reports, Deutsche Bank received considerable assistance from the Federal Reserve, including $11.8 billion through the American International Group bailout and $2 billion through the Fed’s discount window. Deutsche was the second- largest discount-window borrower and the largest user of the Fed’s Term Asset-Backed Securities Lending Facility during the crisis.

Asking for Trouble

Deutsche Bank and, if necessary, the German government should be required to inject substantially more capital into Taunus. Allowing business as usual is asking for trouble, particularly as Deutsche wants to remain focused on relatively risky investment banking. Recently it named as chairman Paul Achleitner, the finance director at Allianz SE, the German insurance company, and an ex-Goldman Sachs executive, worrying even some of its shareholders.

This would be a good time for Congress to dig more deeply into the risks that Deutsche Bank poses to financial stability in the U.S. and around the world.

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