1/6/20: COVID19 and European Banking

McKinsey research note on European banks' potential losses due to COVID19 is quite on the money:

With more than 1/3rd of European executives expecting "a muted recovery that would lead to sharp drops in banks’ revenue, a squeeze on their capital, and a hit on return on equity", European banks can expect revenues to drop by 40 percent plus, and ROE drop 11 percentage points in 2021.

And the problems are strategic. COVID19 is actually accelerating changes in customers' demand for services. "McKinsey’s European customer survey shows how customer behavior and needs have changed over the past month: digital engagement levels have climbed up to 20 percent, the use of cash has halved, 30 to 40 percent of customers have expressed a greater need for advice, while 20 to 40 percent want products to help them through the crisis.4 Pension shortfalls are a particular challenge with those close to retirement facing a very immediate problem."

Alas, European banks, especially those operating in the 2008-2014 crises-hit economies, such as Ireland, Italy, Spain and Portugal, are utterly unprepared for these shifting trends. I wrote about these problems in a series of two article for The Currency here: https://www.thecurrency.news/articles/4810/a-catalyst-for-underperformance-how-systemic-risk-and-strategic-failures-are-eroding-the-performance-of-the-irish-banks and https://www.thecurrency.news/articles/3833/culture-wars-and-poor-financial-performance-just-what-is-going-on-within-irelands-beleaguered-banks.

17/2/17: European Non-Performing Banks' Loans 2016

Latest Fitch data shows some significant progress achieved by Ireland in dealing with non-performing loans on banks' balancesheets:

According to Fitch, Irish banking system ranked 6th worst in terms of NPLs in the EU at the end of 2016. This is a significant improvement on second and third places for Ireland during the height of the Greek and Cypriot crisis. However, the above data requires some serious caveats:

1. Ireland has been the earlier starter in the game of repairing banks' balancesheets than any other country in the Fitch's Top10 Worst systems table above;
2. Ireland's performance crucially depends on the assumed quality of mortgages debt restructurings undertaken by the banks over recent years - an assumption that is hardly un-contestable, given that the vast majority of mortgages arrears resolutions involve extend and pretend types of measures, such as extending mortgages maturity, rolling up arrears into a new (for now cheaper) debt and so on; and
3. Ireland is compared here to a number of countries where the banks bailouts have either been much shallower or completely absent.

Still, for all the caveats, it is good to see that after 9 years of a crisis, Irish banking system is no longer in top-5 basket cases league table in Europe. At this speed, by 2026, me might be even outside the top-10 table... 

23/10/16: Too-Big-To-Fail Banks: The Financial World 'Undead'

This is an un-edited version of my latest column for the Village magazine


Since the start of the Global Financial Crisis back in 2008, European and U.S. policymakers and regulators have consistently pointed their fingers at the international banking system as a key source of systemic risks and abuses. Equally consistently, international and domestic regulatory and supervisory authorities have embarked on designing and implementing system-wide responses to the causes of the crisis. What emerged from these efforts can be described as a boom-town explosion of regulatory authorities. Regulatory,  supervisory and compliance jobs mushroomed, turning legal and compliance departments into a new Klondike, mining the rich veins of various regulations, frameworks and institutions. All of this activity, the promise held, was being built to address the causes of the recent crisis and create systems that can robustly prevent future financial meltdowns.

At the forefront of these global reforms are the EU and the U.S. These jurisdictions took two distinctly different approaches to beefing up their respective responses to the systemic crises. Yet, the outrun of the reforms is the same, no matter what strategy was selected to structure them.

The U.S. has adopted a reforms path focused on re-structuring of the banks – with 2010 Dodd-Frank Act being the cornerstone of these changes. The capital adequacy rules closely followed the Basel Committee which sets these for the global banking sector. The U.S. regulators have been pushing Basel to create a common "floor" or level of capital a bank cannot go below. Under the U.S. proposals, the “floor” will apply irrespective of its internal risk calculations, reducing banks’ and national regulators’ ability to game the system, while still claiming the banks remain well-capitalised. Beyond that, the U.S. regulatory reforms primarily aimed to strengthen the enforcement arm of the banking supervision regime. Enforcement actions have been coming quick and dense ever since the ‘recovery’ set in in 2010.

Meanwhile, the EU has gone about the business of rebuilding its financial markets in a traditional, European, way. Any reform momentum became an excuse to create more bureaucratese and to engineer ever more elaborate, Byzantine, technocratic schemes in hope that somehow, the uncertainties created by the skewed business models of banks get entangled in a web of paperwork, making the crises if not impossible, at least impenetrable to the ordinary punters. Over the last 8 years, Europe created a truly shocking patchwork of various ‘unions’, directives, authorities and boards – all designed to make the already heavily centralised system of banking regulations even more complex.

The ‘alphabet soup’ of European reforms includes:

• the EBU and the CMU (the European Banking and Capital Markets Unions, respectively);
• the SSM (the Single Supervisory Mechanism) and the SRM (the Single Resolution Mechanism), under a broader BRRD (Bank Recovery and Resolution Directive) with the DGS (Deposit Guarantee Schemes Directive);
• the CRD IV (Remuneration & prudential requirements) and the CRR (Single Rule Book);
• the MIFID/R and the MAD/R (enhanced frameworks for securities markets and to prevent market abuse);
• the ESRB (the European Systemic Risk Board);
• the SEPA (the Single Euro Payments Area);
• the ESA (the European Supervisory Authorities) that includes the EBA (the European Banking Authority);
• the MCD (the Mortgage Credit Directive) within a Single European Mortgage Market; the former is also known officially as CARRP and includes introduction of something known as the ESIS;
• the Regulation of Financial Benchmarks (such as LIBOR & EURIBOR) under the umbrella of the ESMA (the European Securities and Markets Authority), and more.

The sheer absurdity of the European regulatory epicycles is daunting.

Eight years of solemn promises by bureaucrats and governments on both sides of the Atlantic to end the egregious abuses of risk management, business practices and customer trust in the American and European banking should have produced at least some results when it comes to cutting the flow of banking scandals and mini-crises. Alas, as the recent events illustrate, nothing can be further from the truth than such a hypothesis.


America’s Rotten Apples

In the Land of the Free [from individual responsibility], American bankers are wrecking havoc on customers and investors. The latest instalment in the saga is the largest retail bank in the North America, Wells Fargo.

Last month, the U.S. Consumer Financial Protection Bureau (CFPB) announced a $185 million settlement with the bank. It turns out, the customer-focused Wells Fargo created over two million fake accounts without customers’ knowledge or permission, generating millions in fraudulent fees.

But Wells Fargo is just the tip of an iceberg.

In July 2015, Citibank settled with CFPB over charges it deceptively mis-sold credit products to 2.2 million of its own customers. The settlement was magnitudes greater than that of the Wells Fargo, at $700 million. And in May 2015, Citicorp, the parent company that controls Citibank, pleaded guilty to a felony manipulation of foreign currency markets – a charge brought against it by the Justice Department. Citicorp was accompanied in the plea by another U.S. banking behemoth, JPMorgan Chase. You heard it right: two of the largest U.S. banks are felons.

And there is a third one about to join them. This month, news broke that Morgan Stanley was charged with "dishonest and unethical conduct" in Massachusetts' securities “for urging brokers to sell loans to their clients”.

Based on just a snapshot of the larger cases involving Citi, the bank and its parent company have faced fines and settlements costs in excess of $19 billion between the start of 2002 and the end of 2015. Today, the CFPB has over 29,000 consumer complaints against Citi, and 37,000 complaints against JP Morgan Chase outstanding.

To remind you, Citi was the largest recipient of the U.S. Fed bailout package in the wake of the 2008 Global Financial Crisis, with heavily subsidised loans to the bank totalling $2.7 trillion or roughly 16 percent of the entire bailout programme in the U.S.

But there have been no prosecutions of the Citi, JP Morgan Chase or Wells Fargo executives in the works.


Europe’s Ailing Dinosaurs

The lavishness of the state protection extended to some of the most egregiously abusive banking institutions is matched by another serial abuser of rules of the markets: the Deutsche Bank. Like Citi, the German giant received heaps of cash from the U.S. authorities.

Based on U.S. Government Accountability Office (GAO) data, during the 2008-2010 crisis, Deutsche was provided with $354 billion worth of emergency financial assistance from the U.S. authorities. In contrast, Lehman Brothers got only $183 billion.

Last month, Deutsche entered into the talks with the U.S. Department of Justice over the settlement for mis-selling mortgage backed securities. The original fine was set at $14 billion – a levy that would effectively wipe out capital reserves cushion in Europe’s largest bank. The latest financial markets rumours are putting the final settlement closer to $5.4-6 billion, still close to one third of the bank’s equity value. To put these figures into perspective, Europe’s Single Resolution Board fund, designed to be the last line of defence against taxpayers bailouts, currently holds only $11 billion in reserves.

The Department of Justice demand blew wide open Deutsche troubled operations. In highly simplified terms, the entire business model of the bank resembles a house of cards. Deutsche problems can be divided into 3 categories: legal, capital, and leverage risks.

On legal fronts, the bank has already paid out some $9 billion worth of fines and settlements between 2008 and 2015. At the start of this year, the bank was yet to achieve resolution of the probe into currency markets manipulation with the Department of Justice. Deutsche is also defending itself (along with 16 other financial institutions) in a massive law suit by pension funds and other investors. There are on-going probes in the U.S. and the UK concerning its role in channelling some USD10 billion of potentially illegal Russian money into the West. Department of Justice is also after the bank in relation to the alleged malfeasance in trading in the U.S. Treasury market.

And in April 2016, the German TBTF (Too-Big-To-Fail) goliath settled a series of U.S. lawsuits over allegations it manipulated gold and silver prices. The settlement amount was not disclosed, but manipulations involved tens of billions of dollars.

Courtesy of the numerous global scandals, two years ago, Deutsche was placed on the “enhanced supervision” list by the UK regulators – a list, reserved for banks that have either gone through a systemic failure or are at a risk of such. This list includes no other large banking institution, save for Deutsche. As reported by Reuters, citing the Financial Times, in May this year, UK’s financial regulatory authority stated, as recently as this year, that “Deutsche Bank has "serious" and "systemic" failings in its controls against money laundering, terrorist financing and sanctions”.

As if this was not enough, last month, a group of senior Deutsche ex-employees were charged in Milan “for colluding to falsify the accounts of Italy’s third-biggest bank, Banca Monte dei Paschi di Siena SpA” (BMPS) as reported by Bloomberg. Of course, BMPS is itself in the need of a government bailout, with bank haemorrhaging capital over recent years and nursing a mountain of bad loans. One of the world’s oldest banks, the Italian ‘systemically important’ lender has been teetering on the verge of insolvency since 2008-2009.

All in, at the end of August 2016, Deutsche Bank had some 7,000 law suits to deal with, according to the Financial Times.

Beyond legal problems, Deutsche is sitting on a capital structure that includes billions of notorious CoCos – Contingent Convertible Capital Instruments. These are a hybrid form of capital instruments designed and structured to absorb losses in times of stress by automatically converting into equity. In short, CoCos are bizarre hybrids favoured by European banks, including Irish ‘pillar’ banks, as a dressing for capital buffers. They appease European regulators and, in theory, provide a cushion of protection for depositors. In reality, CoCos hide complex risks and can act as destabilising elements of banks balancesheets.

And Deutsche’s balancesheet is loaded with trillions worth of opaque and hard-to-value derivatives. At of the end of 2015, the bank held estimated EUR1.4 trillion exposure to these instruments in official accounts. A full third of bank’s assets is composed of derivatives and ‘other’ exposures, with ‘other’ serving as a financial euphemism for anything other than blue chip safe investments.

The Financial Undead

Eight years after the blow up of the global financial system we have hundreds of tomes of reforms legislation and rule books thrown onto the crumbling façade of the global banking system. Tens of trillions of dollars in liquidity and lending supports have been pumped into the banks and financial markets. And there are never-ending calls from the Left and the Right of the political spectrum for more Government solutions to the banking problems.

Still, the American and European banking models show little real change brought about by the crisis. Both, the discipline of the banks boards and the strategy pursued by the banks toward rebuilding their profits remain unaltered by the lessons from the crisis. The fireworks of political demagoguery over the need to change the banking to fit the demands of the 21st century roll on. Election after election, candidates compete against each other in promising a regulatory nirvana of de-risked banking. And time after time, as smoke of elections clears away, we witness the same system producing gross neglect for risks, disregard for its customers under the implicit assumption that, if things get shaky again, taxpayers’ cash will come raining on the fires threatening the too-big-to-reform banking giants.


Note: edited version is available here: http://villagemagazine.ie/index.php/2016/10/too-big-to-fail-or-even-be-reformed/.

2/9/16: Remember Banks Stress Tests: Tripple Farce and Still No Joy for Ireland

Couple of older, but still relevant notes have stacked up on my virtual desktop over the last few weeks. Catching up with these, here is a post on the banking sector 'bill of un-health' produced this summer by the EBA.


European banks street tests conducted by EBA last month combined the usual old farce with the novel new farce. Just to make sure the punters were not too scared of the European economy’s champions.

Based on Basel III criteria - CT1 ratio of 7% post shock - all but two banks (Italy’s Banca Monte dei Paschi di SAiena Spa and Austria’s Raiffeisen Zentralbank) have managed to escape the tests with CT1 ratios post-shock within the Basel III parameters. Or in other words, everyone passed, save for two who didn’t. Systemically, therefore, EBA can assure us all that euro area banking is just fine. Nothing to see, nothing to worry about.

However, the farce of the tests goes deep than this predicable and historically conditioned outcome. Because this time around, EBA no longer even bothered with determining who ‘failed’ and who did not. Like in Breznev’s USSR, in the EBUSSR, ‘friendship wins’ and ‘no one loses’.

There was another predictable trend in the EBA results. No matter how ‘flexible’ the models fort testing get, no matter how being the ‘stress assumptions’ get, Irish and Italian banks remain the sickest puppies in the entire ward of already not too healthy ones:

But, hey, despite much of the stock markets hullaballoo over recent months, the bidding of banks’ equity has not really done much in terms of beefing sufficiently their capital buffers. So here are some comparatives on 2014 stress tests against current ones.

Note: 2014 stress tests estimated impact of a shock out to 2016, while this year tests are estimating impact out to 2018.

So behold (via @FT):

Italy:

• 2016 state: Transitional CET1 ratio of 6.14 per cent v 8.42 per cent average - under performing the average by 228 bps
• 2018 state: Fully loaded CET1 ratio of 7.62 per cent v 9.2 per cent average - under performing the average by 158 bps
• Signals improvement, on the surface, but this is a cross comparative over tow somewhat different benchmarks

Ireland:

• 2016 state: Transitional CET1 ratio of 7.05 per cent v 8.42 per cent average, undershooting the average by 137 bps
• 2018 state: Fully loaded CET1 ratio of 5.21 per cent v 9.2 per cent average, underperforming by 399 bps
• Signalling, even if we are to totally disregard differential quality, this does not bode too well for Irish financial ‘giants’

FT did provide a handy chart showing changes in stress test shock-level CET1 ratios for Adverse Stress Scenarios in 2014 tests and 2016 tests (never mind the ‘actual’ levels as of 2015, as these are subject to market valuations etc).

What the above shows?

For a tiny banking system, Ireland’s one is sicker than any other. And this comes on foot of years of repairs, recapitalisations, arrears resolutions etc etc etc. Green Jerseying ain’t working, folks. All Spanish banks are performing better than the two Irish flagships. Majority of Italian banks (save for one) are better than the two Irish ‘giants’. All Portuguese banks are stronger than the Irish systemically-important institutions. And none have spent anything close to Ireland on ‘repairing’ their lenders.

Maybe, if we wait long enough, EBA will include a bunch of Greek and Cypriot banks next… to make ours look better…

10/7/16: Europe's Banks: Dinosaurs On Their Last Legs?

Europe's banks have been back in the crosshair of the markets in recent weeks, with new attention to their multiple problems catalysed by the Brexit vote.

I spoke on the matter in a brief interview with UTV here: http://utv.ie/playlists/default.aspx?bcid=5026776052001.

Now, Bloomberg have put together a (very concise) summary of some of the key problems the banks face: "Europe's banks have been a focal point of investor skittishness since Britons voted to leave the European Union, but reasons to be worried about financial firms pre-date the referendum. Whether it be the mountain of non-performing loans, the challenge from fintech firms and alternative lenders encroaching on what was once their turf, or rock bottom interest rates eroding margins, the problems facing Europe's lenders are mammoth."

To summarise the whole rotten lot: European banks (as a sector)

• Cannot properly lend and price risk (hence, a gargantuan mountain of Non-Performing Loans sitting on their books that they can't deleverage out, exemplified by Italian, Slovenian, Spanish, Portuguese, Cypriot, Greek, Irish, and even, albeit to a lesser extent, German, Dutch, Belgian and Austrian banks);
• Cannot make profit even in this extremely low funding cost environment (because they cannot lend properly, while controlling their operating costs, and instead resort to 'lending' money to governments at negative yields);
• Cannot structure their capital (CoCos madness anyone?);
• Cannot compete with more agile fintech challengers (because the dinosaur mentality and hierarchical structures of traditional banking prevents real innovation permeating banks' strategies and operations);
• Cannot reform their business models to reflect changing nature of their customers demands (because they simply no longer can think of their customers needs); and
• Cannot succeed in their traditional markets and services (despite being heavily shielded from competition by regulators and subsidised by the governments).

Instead of whingeing about the banks' plight, we should focus on the banks' resound failures and stop giving custom to the patrician incumbents. Let competition restructure Europe's banking sector. The only thing that sustains Europe's banks today is national- and ECB-level regulatory protectionism that contains competition within the core set of banking services. It is only a matter of time before M&As and organic build up of fintech players will blow this cozy cartel up from the inside. So regulators today have two options: keep pretending that this won't happen and keep granting banks a license to milk their customers and monetary systems; or open the hatches and let the fresh air in.

4/3/16: Can Cryan halt Deutsche Bank's decline? Euromoney

Recently, I wrote about the multiple problems faced by the Deutsche Bank (see post here http://trueeconomics.blogspot.com/2016/02/12216-deutsche-bank-crystallising.html).

Subsequently, Euromoney published a well-researched and wide-ranging article on the same subjects that is also worth reading, even though there are quite significant overlaps with my earlier post: http://www.euromoney.com/Article/3534126/Can-Cryan-halt-Deutsche-Banks-decline.html?single=true.

12/2/16: Deutsche Bank: Crystallising Europe’s TBTF Problems

This week was quite a tumultuous one for banks, and especially Europe’s champion of the ‘best in class’ TBTF institutions, Deutsche Bank. Here’s what happened in a nutshell.

Deutsche’s 6 percent perpetual bonds, CoCos (more on this below), with expected maturity in 2022, used to yield around 7 percent back in January. Having announced massive losses for fiscal year 2015 (first time full year losses were posted by the DB since 2008), Deutsche was under pressure in the equity markets. Rather gradual sell-off of shares in the bank from the start of 2015 was slowly, but noticeably eroding bank’s equity risk cushion. So markets started to get nervous of the second tier of ‘capital’ held by the bank - second in terms of priority of it being bailed in in the case of an adverse shock. This second tier is known as AT1 and it includes those CoCos.

Yields on CoCos rose and their value (price) fell. This further reduced Deutsche’s capital cushion and, more materially, triggered concerns that Deutsche will not be calling in 2022 bonds on time, thus rolling them over into longer maturity. Again, this increased losses on the bonds. These losses were further compounded by the market concerns that due to a host of legal and profit margins problems, Deutsche can suspend payments on CoCos coupons, if not in 2016, then in 2017 (again, more details on this below). Which meant that in markets view, shorter-term 2022 CoCos were at a risk of being converted into a longer-dated and zero coupon instrument. End of the game was: Coco’s prices fell from 93 cents to the Euro at the beginning of January, to 71-72 cents on the Euro on Monday this week.

When prices fall as much as Deutsche’s CoCos, investors panic and run for exit. Alas, dumping CoCos into the markets became a problem, exposing liquidity risks imbedded into CoCos structure. There are two reasons for the liquidity risk here: one is general market aversion to these instruments (a reversal of preferences yield-chasing strategies had for them before); and lack of market makers in CoCos (thin markets) because banks don’t like dealing in distressed assets of other banks. Worse, Asian markets were largely shut this week, limiting potential pool of buyers.

Spooked by shrinking valuations and falling liquidity of the Deutsche’s AT1 instruments, investors rushed into buying insurance against Deutsche’s default on senior bonds - the Credit Default Swaps or CDS. This propelled Deutsche’s CDS to their highest levels since the Global Financial Crisis. Deutsche’s CDS shot straight up and with their prices rising, implied probability of Deutsche’s default went through the roof, compounding markets panic.


Summing Up the Mess: Three Pillars of European Risks

Deutsche Bank AG is a massive, repeat - massive - banking behemoth. And the beast is in trouble.

Let’s do some numbers first. Take a rather technical test of systemic risk exposures by the banks, run by NYU Stern VLab. First number of interest: Systemic Risk calculation - the value of bank equity at risk in a case of systemic crisis (basically - a metric of how much losses a bank can generate to its equity holders under a systemic risk scenario).

Deutsche clocks USD91.623 billion hole relating to estimated capital shortfall after the existent capital cushion is exhausted. A wallop that is the third largest in the world and accounts for 7.23% of the entire global banking system losses in a systemic crisis.

Now, for volatility that Deutsche can transmit to the markets were things to go pear shaped. How much of a daily drop in equity value of the Deutsche will occur if the aggregate market falls more than 2%. The metric for this is called Marginal Expected Shortfall or MES and Deutsche clocks in respectable 4.59, ranking it 8th in the world by impact. In a sense, MSE is a ‘tail event’ beta - stock beta for times of significant markets distress.

How closely does Deutsche move with the market over time, without focusing just on periods of significant markets turmoil? That would be bank’s beta, which is the covariance of its stock returns with the market return divided by variance of the market return. Deutsche’s beta is 1.61, which is high - it is 7th highest in the world and fourth highest amongst larger banks and financial institutions, and it basically means that for 1% move in the market, on average, Deutsche moves 1.6%.

But worse: Deutsche leverage is extreme. Save for Dexia and Banca Monte dei Paschi di Siena SpA, the two patently sick entities (one in a shutdown mode another hooked to a respirator), Deutsche is top of charts with leverage of 79.5:1.

Incidentally, this week, Deutsche credit risk surpassed that of another Italian behemoth, UniCredit:

So Deutsche is loaded with the worst form of disease - leverage and it is caused by the worst sort of underlying assets: the impenetrable derivatives (see below on that).


Overall, Deutsche problems can be divided into 3 categories:

1. Legal
2. Capital, and
3. Leverage and quality of assets.

These problems plague all European TBTF banks ever since the onset of the Global Financial Crisis. The legacy of horrific misspelling of products, mis-pricing of risks and markets distortions by which European banks stand is contrasted by the rhetoric emanating from European regulators about ‘reforms’, ‘repairs’ and ‘renewed regulatory vigilance’ in the sector. In truth, as Deutsche’s saga shows, capital buffers fixes, applied by European regulators, have yielded nothing more than an attempt to powder over the miasma of complex, derivatives-laden asset books and equally complex, risk-obscuring structure of new capital buffers. It also highlights just how big of a legal mess European banks are, courtesy of decades of their maltreatment of their clients and markets participants.

So let’s start churning through them one-by-one.


The Saudi Arabia of Legal Problems

Deutsche has been slow to wake up and smell the roses on all various legal settlements other banks signed up to in years past. Deutsche has settled or paid fines of some USD9.3 billion to-date (from the start of the Global Financial Crisis in 2008), covering:

• Charges of violations of the U.S. sanctions;
• Interest rates fixing charges; and
• Mortgages-Backed Securities (alleged) fraud with respect to the U.S. state-sponsored lenders: Fannie Mae and Freddie Mac.

And at the end of 2015, Deutsche has provided a set-aside funding for settling more of the same, to the tune of USD6 billion. So far, it faces:

1. U.S. probe into Mortgages-Backed Securities it wrote and sold pre-crisis. If one goes by the Deutsche peers, the USD15.3 billion paid and set aside to-date is not going to be enough. For example, JP Morgan total cost of all settlements in the U.S. alone is in excess of USD23 billion. But Deutsche is a legal basket case compared to JPM-Chase. JPM, Bank of America and Citigroup paid around USD36 billion on their joint end. In January 2016, Goldman Sachs reached an agreement (in principle) with DofJustice to pay USD5.1 billion for same. Just this week (http://www.businessinsider.com/morgan-stanley-mortgage-backed-securities-settlement-2016-2) Morgan Stanley agreed to pay USD3.2 billion on the RMBS case. Some more details on this here: http://www.reuters.com/article/us-deutsche-bank-lawsuit-idUSKCN0VC2NY.
2. Probes into currency manipulations and collusion on its trading desk (DB is the biggest global currency trader that is yet to settle with the U.S. DoJustice. In currency markets rigging settlement earlier, JPMorgan, Citicorp and four other financial institutions paid USD5.8 billion and entered guilty pleas already.
3. Related to currency manipulations probe, DB is defending itself (along with 16 other financial institutions) in a massive law suit by pension funds and other investors. Deutsche says ‘nothing happened’. Nine out of the remaining 15 institutions are pushing to settle the civil suit for (at their end of things) USD2 billion. Keep in mind of all civil suit defendants - Deutsche is by far the largest dealer in currency markets.
4. Probes in the U.S. and UK on its alleged or suspected role in channeling some USD10 billion of Russian money into the West;
5. Worse, UK regulators are having a close watch on Deutsche Bank - in 2014, they placed it on the their "enhanced supervision" list, reserved for banks that have either gone through a systemic failure or are at a risk of such; a list that includes no other large banking institution on it, save for Deutsche.
6. This is hardly an end to the Deutsche woes. Currently, it is among a group of financial institutions under the U.S. investigation into trading in the U.S. Treasury market, carried out by the Justice Department. 
7. The bank is also under inquiries covering alleged fixings of precious metals benchmarks.
8. The bank is even facing some legal problems relating to its operations (in particular hiring practices) in Asia. And it is facing some trading-related legal challenges across a number of smaller markets, as exemplified by a recent case in Korea (http://business.asiaone.com/news/deutsche-bank-trader-sentenced-jail).

You really can’t make a case any stronger: Deutsche is a walking legal nightmare with unknown potential downside when it comes to legal charges, costs and settlements. More importantly, however, it is a legal nightmare not because regulators are becoming too zealous, but because, like other European banks, adjusting for its size, it has its paws in virtually every market-fixing scandal. The history of European banking to-date should teach us one lesson and one lesson only: in Europe, honest, functioning and efficient markets have been seconded to manipulated, dominated by TBTF institutions and outright rigged structures more reminiscent of business environment of the Italian South, than of Nordic ‘regulatory havens’.

CoCo Loco

CoCos, Contingent Convertible Capital Instruments, are a hybrid form of capital instruments that are designed and structured to absorb losses in times of stress by automatically converting into equity should a bank experience a decline in its capital ratios below a certain threshold. Because they are a form of convertible debt, they are counted as Tier 1 capital instrument ‘additional’ Tier 1 instruments or AT1.

CoCos are also perpetual bonds with no set maturity date. Banks can be redeemed them on option, usually after 5 years, but banks can also be prevented by the regulators from doing so. The expectation that banks will redeem these bonds creates expectation of their maturity for investors and this expectation is driven by the fact that CoCos are more expensive to issue for the banks, creating an incentive for them to redeem these instruments. European banks love CoCos, in contrast to the U.S. banks that issue preferred shares as their Tier 1 capital boosters, because Europeans simply love debt. Debt in any form. It gives banks funding without giving it a headache of accounting to larger pools of equity holders, and it gives them priority over other liabilities. AT1 is loved by European regulators, because it sits right below T1 (Tier 1) and provides more safety to senior bondholders on whose shoulders the entire scheme of European Ponzi finance (using Minsky’s terminology) rests.

In recent years, Deutsche, alongside other banks was raising capital. Last year, Credit Suisse, went to the markets to raise some CHF6 billion (USD6.1 billion), Standard Chartered Plc raised about $5.1 billion. Bank of America got USD5 billion from Warren Buffett in August 2014. So in May 2014, Deutsche was raising money, USD 1.5 billion worth, for the second time (it tapped markets in 2013 too). The fad of the day was to issue CoCos - Tier 1 securities, known as Contingent Convertible Bonds. All in, European banks have issued some EUR91 billion worth of this AT1 capital starting from 2013 on.

Things were hot in the markets then. Enticed by a 6% original coupon, investors gobbled up these CoCos to the tune of EUR3.5 billion (the issue cover was actually EUR25 billion, so the CoCos were in a roaring demand). Not surprising: in the world of low interest rates, say thanks to the Central Banks, banks were driving investors to take more and more risk in order to get paid.

There was, as always there is, a pesky little wrinkle. CoCos are convertible to equity (bad news in the case of a bank running into trouble), but they are also carrying a little clause in their prospectus. Under Compulsory Cancelation of Interest heading, paragraphs (a) and (b) of Prospectus imposed deferral of interest payments on CoCos whenever CoCos payment of interest “together with any additional Distributions… that are simultaneously planned or made or that have been made by the issuer on the other Tier 1 instruments… would exceed the Available Distributable Items…” and/or “if and to the extent that the competent supervisory authority orders that all or part of the relevant payment of interest be cancelled…”

That is Prospectus-Speak for saying that CoCos can suspend interest payments per clauses, before the capital adequacy problems arise. The risks of such an event are not covered by Credit Default Swaps (CDS) which cover default risk for senior bonds.

The reason for this clause is that European regulators impose on the banks what is known as CRD (Combined Buffer Requirement and Maximum Distributable Amount) limits: If the bank total buffers fall below the Combined Buffer Requirement, then CoCos and other similar instruments do not pay in full. That is normal and the risk of this should be fully priced in all banks’ CoCos. But for Deutsche, there is also a German legal requirement to impose an additional break on bank’s capital buffers depletion: a link between specified account (Available Distributable Items) balance and CoCos pay-out suspension. This ADI account condition is even more restrictive than what is allowed under CRD.

This week, DB said they have some EUR1 billion available in 2016 to pay on EUR350 million interest coupon due per CoCos (due date in April). But few are listening to DB’s pleas - CoCos were trading at around 75 cents in the euro mark this week. The problem is that the markets are panicked not just by the prospect of the accounting-linked suspension of coupon payments, but also by the rising probability of non-redemption of CoCos in the near future - a problem plaguing all financials.

DB is at the forefront of these latter concerns, because of its legal problems and also because the bank is attempting to reshape its own business (the former problem covered above, the latter relates to the discussion below). DB just announced a massive EUR6.8 billion net loss for 2015 which is not doing any good to alleviate concerns about it’s ability to continue funding coupon payments into 2017. Unknown legal costs exposure of DB mean that DB-estimated expected funding capacity of some EUR4.3 billion in 2017 available to cover AT1 payments is based on its rather conservative expectation for 2016 legal costs and rather rosy expectations for 2016 income, including the one-off income from the 2015-agreed sale of its Chinese bank holdings.

Earlier this week, Standard & Poor’s, cut DB’s capital ratings on “concerns that Germany’s biggest lender could report a loss that would restrict its ability to pay on the obligations”. S&P cut DB’s Tier 1 securities from BB- to B+ from BB- and slashed perpetual Tier 2 instruments from BB to BB-.

Beyond all of this mess, Deutsche is subject to the heightened uncertainty as to the requirements for capital buffers forward - something that European banks co-share. AT 1 stuff, as highlighted above, is one thing. But broader core Tier 1 ratio in 4Q 2015 was 11.1%, which is down on 11.5% in 4Q 2014. In its note cutting CoCos rating, S&P said that “The bank's final Tier 1 interest payment capacity for 2017 will depend on its actual net earnings in 2016 as well as movements in other reserves.” Which is like saying: “Look, things might work out just fine. But we have no visibility of how probable this outcome is.” Not assuring…

DB is also suffering the knock-on effect of the general gloom in the European debt markets. Based on Bloomberg data, high yield corporate bonds issuance in Europe is down some 78 percent in recent months, judging by underwriters fees. These woes relate to European banks outlook for 2016, which links to growth concerns, net interest margin concerns and quality of assets concerns.


Badsky Loansky: A Eurotown’s Bad Bear?

Equity and debt markets repricing of Deutsche paper is in line with a generally gloomy sentiment when it comes to European banks.

The core reason is that aided by the ECB’s QE, the banks have been slow cleaning their acts when it comes to bad loans and poor quality assets. European Banking Authority estimates that European banks hold some USD 1.12 trillion worth of bad loans on their books. These primarily relate to the pre-crisis lending. But, beyond this mountain of bad debt, we have no idea how many loans are marginal, including newly issued loans and rolled over credit. How much of the current credit pool is sustained by low interest rates and is only awaiting some adverse shock to send the whole system into a tailspin? Such a shock might be borrowers’ exposures to the US dollar credit, or it might be companies exposure to global growth environment, or it might be China unwinding, or all three. Not knowing is not helpful. Oil price collapse, for example, is hitting hard crude producers. Guess who were the banks’ favourite customers for jumbo-sized corporate loans in recent years (when oil was above USD50pb)? And guess why would any one be surprised that with global credit markets being in a turmoil, Deutsche’s fixed income (debt) business would be performing badly?

Deutsche and other european banks are caught in a dilemma. Low rates on loans and negative yields on Government bonds are hammering their profit margins (based on net interest margin - the difference between their lending rate and their cost of raising funds). Solution would be to raise rates on loans. But doing so risks sending into insolvency and default their marginal borrowers. Meanwhile, the pool of such marginal borrowers is expanding with every drop in oil prices and every adverse news from economic growth front. So the magic potion of QE is now delivering more toxicity to the system than good, and yet, the system requires the potion to flow on to sustain itself.

Again, this calls in Minsky: his Ponzi finance thesis that postulates that viability of leveraged financial system can only be sustained by rising capital valuations. When capital valuations stop growing faster than the cost of funding, the system collapses.

In part to address the market sentiment, Deutsche is talking about deploying the oldest trick in the book: buying out some of its liabilities - err… senior bonds (not CoCos) - at a discount in the markets to the tune of EUR5 billion across two programmes. If it does, it will hit own liquidity in the short run, but it will also (probably or possibly) book a profit and improve its balance sheet in the longer term. The benefits are in the future, and the only dividend hoped-for today is a signalling value of a bank using cash to buy out debt. Which hinges on the return of the markets to some sort of the ‘normal’ (read: renewed optimism). Update: here's the latest on the subject via Bloomberg http://www.bloomberg.com/news/articles/2016-02-12/deutsche-bank-to-buy-back-5-4-billion-bonds-in-euros-dollars

Back to the performance to-date, however.

Deutsche Bank's share price literally fell off the cliff at the start of this week, falling 10 percent on Monday and hitting its lowest level since 1984.

On bank’s performance side, concerns are justified. As I noted earlier, Deutsche posted a massive EUR6.89 billion loss for the year, with EUR2 billion of this booked in 4Q alone. Compared to 2014, Deutsche ended 2015 with its core equity Tier 1 capital (the main buffer against shocks) down from EUR60 billion to EUR52 billion.

Still, panic selling pushed DB equity valuation to EUR19 billion, in effect implying that some 2/3rds of the book of its assets are impaired. Which is nonsense. Things might be not too good, but they aren’t that bad today. The real worry with assets side of the DB is not so much current performance, but forward outlook. And here we have little visibility, precisely because of the utterly abnormal conditions the banks are operating in, courtesy of the global economy and central banks.

So markets are exaggerating the risks, for now. Psychologically, this is just a case of panic.

But panic today might be a precursor to the future. More of a longer term concern is DB’s exposure to the opaque world of derivatives that left markets analysts a bit worried (to put things mildly). Deutsche has taken on some pretty complex derivative plays in recent years in order to offset some of its losses relating to legal troubles. These instruments can be quite sensitive to falling interest rates. Smelling the rat, current leadership attempted to reduce bank’s risk loads from derivatives trade, but at of the end of 2015, the bank still has an estimated EUR1.4 trillion exposure to these instruments. Only about a third of the DB’s balance sheet is held in German mortgages and corporate loans (relatively safer assets), with another third composed of derivatives and ‘other’ exposures (where ‘other’ really signals ‘we don’t quite feel like telling you’ rather than ‘alternative assets classes’). For these, the bank has some EUR215 billion worth of ‘officially’ liquid assets - a cushion that might look solid, but has not been tested in a sell-off.


In summary: 

Deutsche’s immediate problems are manageable and the bank will most likely pull out of the current mess, bruised, but alive. But the two horsemen of a financial apocalypse that became visible in the Deutsche’s performance in recent weeks are worrying:
1) We have a serious problem with leverage remaining in the system, underlying dubious quality of assets and capital held and non-transparent balance sheets when it comes to derivatives exposures; and
2) We have a massive problem of residual, unresolved issues arising from incomplete response to markets abuses that took place before, during and after the crisis.

And there are plenty potential triggers ahead to derail the whole system. Which means that whilst Deutsche is not Europe’s Lehman, it might become Europe’s Bear Sterns, unless some other TBTF preempts its run for the title… And there is no shortage of candidates in waiting…



Links: 
DB’s 2015 report presentation deck: https://www.db.com/ir/en/download/Deutsche_Bank_4Q2015_results.pdf
DB’s internal memo to employees on how “ok” things are: https://www.db.com/newsroom_news/2016/ghp/a-message-from-john-cryan-to-deutsche-bank-employees-0902-en-11392.htm

24/1/16: European Financial Networks: Prepare for Bloodletting to Commence

A recent paper, titled "Transmission Channels of Systemic Risk and Contagion in the European Financial Network" co-authored by Nikos Paltalidis, Dimitrios Gounopoulos, Renatas Kizys, Yiannis Koutelidakis (Journal of Banking and Finance, gated) tackles a very interesting problem relating to the systemic stability of the European banking system and the bi-directional contagion channels shifting/transmitting systemic shocks between the banks and the sovereigns.

Following the euro area banking crisis of 2008-2012 (with residual effects of this crisis still strongly present in the so-called euro area 'periphery'), financial systems analysts and modellers came to the realisation that a number of key questions relating to overall system stability remain un-answered to-date. These include:

• What determines the intensity with which exogenous shocks propagate in the financial system as a whole (and how this intensity carries across banking systems)?
• How do we "identify, measure and understand the nature and the source of systemic risk in order to improve the underlying risks that banks face, to avert banks’ liquidation ex ante and to promote macro-prudential policy tools"? 
• How do systemic risks arise in the cases where such risks are endogenous to the banking system itself?
• How resilient is the euro area banking system (under improved regulatory and supervisory regimes) to systemic risk?
• How "…shocks in economic and financial channels propagate in the banking sector"? 
• And related to the above: "In the presence of a distress situation how the financial system performs? Have the new capital rules rendered the European banking industry safer? What is the primary source of systemic risk? How financial contagion propagates within the Eurozone?"

As the authors correctly note, "These fundamental themes remain unanswered, and hence obtaining the answers is critical and at the heart of most of the recent research on systemic risk."

Lacking empirical evidence (due to proximate timing of events and their extreme-tail nature) the authors create “a unique interconnected, dynamic and continuous-time model of financial networks with complete market structure (i.e. interbank loan market) and two additional independent channels of systemic risk (i.e. sovereign credit risk and asset price risk).”

Summary of the findings relating to sources of shocks:

1. “…A shock in the interbank loan market causes the higher amount of losses in the banking network”;
2. “…Losses generated by the sovereign credit risk channel transmit faster through the contagion channel, triggering a cascade of bank failures. This shock can cause banks to stop using the interbank market to trade with each other and can also lead banks to liquidate their asset holdings in order to meet their short-term funding demands.”
3. “Moreover, we evaluate the impact of reduced collateral values and provide novel evidence that asset price contagion can also trigger severe direct losses and defaults in the banking system.”

So the model does support the view that “the Sovereign Credit Risk channel dominates systemic risks amplified in the euro area banking systems and hence, it is the primary source of systemic risk.” Which is quite interesting from a number of perspectives:

• Firstly, we tend to think about the Global Financial Crisis as a mother of all systemic crises and we tend to attribute the degree of disruption in the crisis to the origins of the crisis shocks: the financialisation of the ‘bubbles’ in real assets (e.g. real estate), leading to liquidity crunch and then to solvency crunch. We think of the sovereign shock channel as being in play only because of banks-sovereign link. And we think that the second order contagion from the sovereign to the banks is secondary in magnitude to the GFC. It appears that things are much more complex and inter-connected both in terms of direction of contagion and orders of disruption caused.
• Secondly, we tend to ignore the relationship between the banks bailouts, QE programmes and equity markets. We think of them as related, but separate acts, e.g.: banks bailouts require funds which are supplied via sovereigns which need to obtain financial resources, which they do via QE, which simultaneously lowers the cost of investment and increases valuations of equities. But the problem is that we also have direct QE —> Equity valuations —> Banks balance sheet pathways. Just as asset prices collapse or illiquidity can trigger a liquidity run by the banks and defaults and losses within the banking system, so are asset prices increases can lead to improved liquidity conditions for the banks and improved banks balance sheets.
• Thirdly, the study provides “…novel evidence that systemic risk in the euro area banking system didn’t meaningfully decrease as it is evident that shocks in the three independent channels -interbank market, sovereign credit risk, asset price risk- trigger domino effects in the banking system.” Which sort of tells us what we suspected all along: the entire ‘firewalls have been built’ brigade of European politicos is eating hopium by truckloads. There are no ‘firewalls’. There are bits of wet cardboard stuck into the cracks and a perennial hope they stay well moisturised by occasional rains. 

Now, let’s give it a thought: since the end of the crisis, we’ve been told that solution to the problem of preventing future crises and alleviating the costs of those that still might happen is more coordination, harmonisation and integration of banking systems under the watchful eye of ECB. In other words, more internationalisation of domestic banks - more linking between them and banks operating in other economies within the Euro area. What does evidence have to say on that? “…we find that the cross-border transmission of systemic shocks depends on the size and the degree of exposure of the banking sector in a foreign financial system. Particularly, the more exposed domestic banks are to the foreign banking systems, the greater are the systemic risks and the spillover effects from foreign financial shocks to the domestic banking sector.”

Ya wouldn’t! No, ya couldn’t! But… baby… we had firewalls and we had EBU and more interconnected system of Euro area-wide banking supervision… and we now have?.. err… Yep, in the words of the authors: “Finally, the results imply that the European banking industry amid the post-crisis deleverage, recapitalisation and the new regulatory rules, continues to be markedly vulnerable and conducive to systemic risks and financial contagion.”

21/6/15: ECB ELA for Greece: Welcome to a Daily Drip of 'Solvency'

Two days ago, I speculated on ECB's motives for drip-feeding ELA liquidity provisions to Greek banks (http://trueeconomics.blogspot.ie/2015/06/1962015-greek-ela-and-ecb-whats.html). And I have noted consistently that ELA is now running against available liquidity cushion, meaning Greek banks are now simultaneously, skirting close to ELA limits in terms of

• Eligible collateral, and
• ELA funds available to cover deposits outflows.

So, not surprisingly, two links come up today:

1. Ekathimerini reports that Greek banks have enough ELA-supported liquidity to sustain capital outflows through Monday only: http://www.ekathimerini.com/4dcgi/_w_articles_wsite2_1_20/06/2015_551285 as on the day of EUR1.8 bn ELA extension approved by the ECB< Greek banks bled EUR1.7 billion in deposits, bringing week's total to EUR4.2 billion in outflows, and
2. Reuters report that the ECB has been all along planning to review/upgrade ELA after Monday emergency summit: http://www.reuters.com/article/2015/06/19/us-eurozone-greece-pm-idUSKBN0OZ0DP20150619

Thing is, Greek banks are now solvent solely down to an almost daily drip-feeding of liquidity by the ECB. Which, sort of, shows up the entire charade of the dysfunctional euro system: the pretence of monetary and financial systems stability is being sustained by not just extraordinary measures, but by an ICU-like mechanics of assuring that a patient is not pronounced dead too soon...

14/1/2015: European Banks: Permanently in the International Isolation Ward

My blog post on the declining fortunes of European banking for Learn Signal blog is available here: http://blog.learnsignal.com/?p=143

17/11/2014: All the years draining into banking cesspool...

So the tale of European banks deleveraging... record provisions, zero supply of credit for years, scores of devastated borrowers (corporate and personal), record subsidies, record drop in competition, rounds and rounds of 'stress testing' - all passed by virtually all, the Banking Union, the ESM break, forced writedowns in some countries, nationalisations, various LTROs, TLTROs, MROs, ABS, promises, threats, regulatory squeezes ... and the end game 6 years into the crisis?..

Per Bloomberg Brief, the sickest banking system on Planet Earth is... drum roll... Wester European one.

It is only made uglier by all the efforts wasted.

H/T for the chart to Jonathan. 

9/8/2014: Europe's bank risks back under the spotlight: ECR

Euromoney Country Risk report this week is covering rising risks in the European banking systems, with a brief comment from myself:

And unloved European banks chart, showing risk scores (higher score, lower risk):

19/7/2014: Trueconomics Cited in FT

Delighted and proud that FT is quoting the blog on European banks woes: http://www.ft.com/intl/cms/s/0/de39b744-0e61-11e4-a1ae-00144feabdc0.html#axzz37pQsLLmF

July 18, 2014 1:03 pm

Reality check for European banks

By Christopher Thompson and Andrew Bolger

Constantin Gurdgiev at True Economics says while current monetary and investment climates remain supportive of lower yields, markets are starting to show an increasing propensity to react strongly to negative newsflows. Investors’ view of the peripheral states as being strongly correlated in their performance remains in place, especially for Spanish, Portuguese and Greek sovereigns and corporate issuers.

“The markets are jittery and are getting trigger-happy on sell signals as strong rises in bond prices in recent months have resulted in sovereign and corporate debt being overbought by investors,” says Mr Gurdgiev.

Nice birthday present for myself. Thanks, FT!

16/1/2014: Fresh Signs of Euro Area Banks Deleveraging Out of Global Growth

For some time now I have been pointing at the ongoing exits by the European banks from the rest of the world (obviously there are some exceptions)... Here's a reminder http://trueeconomics.blogspot.ie/2012/10/13102012-europes-banks-are-now-global.html

Now, more evidence trickling in:

And the process ain't over yet...

15/9/2013: BIS Quarterly: a tale of two banking systems

Two hugely revealing charts from the BIS Quarterly Review, September 2013 (http://www.bis.org/publ/qtrpdf/r_qt1309e.pdf) show exactly the remaining adjustments yet to be undertaken by the banking sector in Europe, compared to the US.

Here they are:

 and

 
note how European banks lag US banks in assets deleveraging, and in raising capital, and are slightly lagging in terms of changes in the ratio of risk-weighted assets. In risk-weighted capital ratios, the european banks are about 1/3rd of the way shy of the US, and in terms of capital, roughly 1/2 of the adjustment to the US levels is still required.

And per operational weaknesses of the European banking system? Next we have a table:

Although different across periods, the divergences between the European and US banks are still qualitatively the same for pre-crisis and crisis periods. In particular, US banks operate at higher cost than European ones, but generate more interest income and other income.

16/12/2012: A Bucket of the Bad with a Pinch of the Ugly

I wanted to post this chart for some time now, but kept forgetting about it. The chart comes from RBS research on banks from November 2012 and is based on data through Q3 2012.

The interesting bits - beyond the overall apparent weakness of the European banks, as highlighted in the headline, is which banks are the weakest. Basically: Mediobanca leads, with Danske and Banco Popolare in second. Which brings us to the irony of Danske's latest marketing push for becoming a bank for the 'New Normal' (see here). Oh, the irony...

1/12/2012: Irish banking Reforms: are things getting better?

In the previous post, I discussed changes in irish banking system systemic stability in 2012 (January-November). But here's a longer range view - from September 2010 on through November 2012.

Now, keep in mind: since September 2010, Irish banks had

1. Massive recaps (2011-2012)
2. Full reform and deleveraging programmes, approved by the EU and Irish authorities
3. Rounds of increases in charges on customers to beef their own interest margins
4. Vast subsidies from the ECB and CBofI
5. Subsidies from the Government via deposits (see here)
6. According to the Government, BofI (largest bank) has completed its deleveraging programme, while AIB (second largest bank) is ahead of target
7. Massive sales of riskiest assets to Nama that crystalized losses and led to recaps, which are now completed
8. According to the Government have bee operating in more benign environment of property prices stabilization
9. Benefited from a 88% rally in Government bonds which they stuffed onto their balancesheet over 2010-present like there is no tomorrow

and so on. In other words, there are tomes and tomes of Government sponsored propaganda to suggest that things are going honky-dory in the banking sector in Ireland. Here's what Head of the Department of Finance had to say this week about the banking sector 'progress' (emphasis is mine):

"With PCAR capital investments and the Bank of Ireland sale, confidence started to return to the banking sector. [this refers to 2011]"

"In 2012 we have witnessed further tangible signs of stability. …Even though non-performing loans continue to grow; here again there are tentative signs that in the mortgage arrears area the growth in new arrears has been arrested. 

The banks still have a lot of work to do to roll out sustainable mortgage solutions, but this process is underway.

Importantly, confidence is returning to our banking system following its recapitalisation.  Deposits across the Irish system are up 2.5% with stronger growth recorded by AIB, BOI and PTSB (which are up 5.3%).

We are in a situation now where the domestic banking system is getting stronger, albeit from a very weak starting point.

• The large scale balance sheet restructuring has been completed;
• BOI have completed the disposal of non-core portfolios
• AIB have substantially completed their disposals. 
• The funding gap has been significantly reduced and the drawing on Eurosystem funding by our government supported going-concern banks continues to decline, and is now less than €60 billion (excluding IBRC).
• Importantly, as I said earlier deposits are growing and the banks are back in the funding markets."

So, in other words, we should expect Ireland's banking system to have performed well in progressing since 2009-2010 lows?

Here's the chart:

In reality, courtesy of Euromoney surveys, we know that Irish banking system stability has deteriorated, not improved, between September 2010 and November 2012, and this deterioration was the second largest amongst 37 European countries.

1/12/2012: Ireland - still the second worst banking sector in EA

Another Euromoney risk survey on and the results for the banking sector are out:

Ireland's banking sector zombies are ranked as 4th least safe in the entire Europe of 37 countries. Next to Greece (3rd least safe), and Macedonia (1 place ahead of Ireland - 5th least safe). Iceland, having defaulted and demolished its banks, ranks 7th least safe. Note, Ireland remains the second weakest banking sector in the EA17.

Of course, our 'leaders' would say that yes, things are bad, but they are improving... hmm...

Are they? Well, sort of. Ireland's score (higher score, greater systemic stability) have risen in 11 months of 2012, but the rise was far from spectacular. Ireland's improvement in the score is 7th largest in the sample, behind that for Iceland.

Ireland's gap to the peers (Advanced Small Open Economies) in overall score is about 4.4 points. 11 months of heroic Government reforms have yielded a gain of 0.2 points in Irish position, and the deterioration in the overall euro area climate has resulted in a decline in the average ASOE score of 0.07 points. This means the spread improved in favour of Ireland by less than 0.3 points in 11 months - a rate of 'reforms' that can close the current gap, assuming continued deterioration in ASOE average, over  161 months. In other words, unless the 'reforms' in Ireland's banks start bearing fruit much faster than they have done in 11 months of 2012 so far, it will take us 13.4 years to reach ASOE average levels of banking system stability.

15/06/2011: Few points of the future of FS

This is the presentation I gave at the Roundtable (thanks to all 150+ academic & industry practitioners who came and engaged) on the Future of Financial Services at the Infinity 2011 Conference on International Finance. Slides and few points:
Since I was chairing the event, I had to limit severely my presentation and the core of the event was based on 3 presentations by industry experts and the discussion with the audience - less Q&A, more open discussion.
Consistent with my view, the global financial crisis continues to threaten macroeconomic stability of the global financial and economic systems.

• The core component of the crisis - the crisis across global financial markets has abated due to the efforts of the Central Banks and Governments around the world. But it has not gone away. The system overall remains fragile on the side of liquidity (with quantitative easing rounds now being scaled back and no liquidity traps remaining, holding liquidity already supplied in the system locked away from the process of real lending).
• The crisis continues largely unabated in the sub-geographies of advanced economies and in particular within the banking sector in Europe, Japan and to a much lesser extent - the US. In the US, where balancesheet repairs on the capital side took stronger forms, the crisis in now manifested on the demand side for lending as well as in continued stagnation in the core household asset markets (property in particular).
• The main focus of the crisis has shifted onto debt - with deleveraging of balance sheets being secondary to the need to continue deleveraging households - something that continues to evade the focus of the policymakers.
• A number of large economies are now also experiencing a full-blown or forthcoming sovereign debt crises.

Overall, the duration, the breadth and the depth of the current crisis are so profound that in my view they signal a structural nature of the crisis, leading to a permanent (or long run) shift in:

• Regulatory environments (tightening of regulatory and supervisory systems, higher demand for capital, higher demand for quality capital, etc) all of which, unfortunately, so far, represent no qualitative departure from the already failed model of regulation that led to the current crisis in the first place. In other words, there's 'more of the same' type of a response on the regulatory side that is emerging so far, which does not hold any real promise of change, but suggest dramatic increases in the cost of capital provision, especially via debt instruments.
• The process of re-banking advanced economies - yet to start - will be taking Europe, North America and other advanced economies to a New Normal which will require cardinal rebalancing of the markets for financial services provision. This, in my opinion, will see consolidation of global banking institutions and a decline in their combined market shares, and the emergence of highly competitive and innovative specialization-driven service providers. The latter will be drawing increasingly greater shares of the markets for FS globally and will be largely free from the legacy of the crisis. In this context, the legacy of the crisis that will remain with the sector is the legacy of massive destruction of wealth inflicted onto the clients by the minimal compliance (prudential or suitability tests-based standards) ethos of the pre-crisis investment and wealth management services providers. In their place, the new providers will be adopting (driven by market demand, not regulatory systems) a fiduciary principle-based services ethos, which will put client needs as the main driver of revenues for the sector. Up-selling complexity and risk is out as a business strategy for margins support. Client relationship-building and product-backed client support will emerge as the core replacement strategy.
  
• In terms of re-equilibrating demand and supply of credit, the problem of shrinking pool of savings (due to fiscal austerity-driven tax increases, and demographic aging in the West contrasted with consumption expansion in the New Advanced Economies - NAE) will have to alleviated through new instruments. Debt will remain constrained as long-term process of deleveraging unfolds, equity will be the king, but hybrid instruments (on corporate finance side, less so onr etail side) and some new instruments for investment will have to emerge.
  
• Lastly, the New Normal will be characterized by a drastic scaling back of real off-balancesheet public liabilities (pensions, health and social welfare nets). The age of reduced local (within advanced economies) savings, falling debt levels and tighter global supply of savings (consumption effects in the emerging and NAE economies) will result in reduced ability to finance sustained deficits. This will precipitate emergence of new financing mechanisms (more closely aligned pay and benefits) for public investment, further reducing private investment supply.

The New Normal is already emerging via the divergence of financial services environments across two geographies: the Advance Economies (the "North") and the NAE economies (the "South").
In addition to regulatory pressures of 'Do More of the Same' approach in the advanced economies, and on top of a persistent gap in growth between the advanced economies and NAEs regions, there are emerging gaps in Investment volumes heavily skewed in favor of NAEs, a margin gap and a capital gap (both in terms of quantity and quality of capital, with many NAE banking systems explicitly or implicitly underwritten by solvent and liquid SWFs).

This geographic bifurcation of the FS models will fully emerge, in my view, around 2015-2020 and by 2020-2025 we are likely to see the drive toward convergence of FS across two geographies:
This convergence will be driven, in addition to the above factors, by the rising pressure of competition with 'North' service providers pushing into NAEs to capture higher margins and new markets, and with 'South' service providers pushing aggressively into the advanced economies markets to capture know-how, exercise competitive advantage of relatively cheaper capital available in the 'South' and retaliate against 'North's' competitive drive into their own markets. The end result will be globally lower Returns to Equity (ROE) squeezed on both sides by higher capital requirements and compliance and risk management costs (E-up) and lower margins (R-down) due to lower availability of savings, regulatory costs increases outside capital costs alone and a long-term shift of demand away from high risk high margin products (the shift toward fiduciary standards). Overall risk (sigma) will abate, as global economy settles on a lower structural growth level, further reducing risk premia-driven margin and ability to upsell risk.

In this process of transition to the New Normal, it is, IMO, of interest to have expanded academic and practitioner debate and research relating to the following questions:

Economics 6/11/10: Regulation in Financial Services Sector

This an unedited version of my column in the current issue of Business & Finance magazine.

The New Regulatory Normal: banking and financial services future

The latest poll of public opinion on the issues of domestic and cross-border competition, released in late October, has found that citizens across the EU identified energy (44%), the pharmaceutical products (25%) and telecommunication (21%) as the main sectors where they perceive lack of competition to remain a major problem. Irony has it, banking and financial services (18% concerned) came out closer to the bottom of the list in terms of perceived competition deficit.

Even though more than a quarter of Greek (31%), Irish (28%) and British (27%) residents said that, based on their own experiences, a lack of competition was causing problems for consumers in the financial services sector, these proportions are still below those for other sectors. For example 30% of Irish respondents are concerned with lack of competition in transport sector, and 41% in pharmaceutical sector.

This is despite the fact that across the EU, and indeed the entire developed world, banks are being supported directly (via taxpayers’ financed measures) and indirectly (via the Central Banks supply of liquidity) to the extent well in excess of the combined subsidies delivered to all of the aforementioned sectors of concern. Writedowns of banks assets remain a top priority for policymakers and the adverse newsflow from the sector is abating extremely slowly (chart below).

Total asset write downs by category, October 2009–April 2010
$ billions, Revisions to estimates
Source: IMF GFSR database, 2010

In addition, banks and financial services companies are facing a tsunami of regulatory reforms, which dominate the newsflow and will likely result in more restricted competition and lending in the sector in years ahead.

Banks and financial services companies across the EU play by far much more dominant role in financing economic activity of firms and households than they do elsewhere in the world, as was highlighted in the latest Global Financial Stability Report from the IMF. In contrast with consumers, business leaders worldwide perceive the financial services to be the current hot spot for adverse pressures on the economy. Banks and financial services providers are expected to be more significantly impacted by the uncertainty induced by the policymakers responses to the crisis. For example, Global CEO Study, 2010 conducted by the Institute for Business Value, IBM shows that a large number of CEOs worldwide expect the Banking and Financial Services sector to be subject to greater structural change and volatility over time than the public sector, despite the fact that public sector itself is experiencing unprecedented debt and deficit pressures.

So the latest public opinion polls seem to be at odds with the reality of the potential crisis-and reforms-induced distortions to competition in the banking sector.

This is an unfortunate oversight, for today, more than ever before financial services need a serious debate about the role for and the future direction of regulatory and supervisory regimes in the sector.

Regulatory structures in the traditional banking and financial services sector have failed to keep up with the increasing complexity, demand for services and interdependence of products and service providers. At the heart of the current crisis, by all accounts, were the imbedded conflicts of interest and outdated regulatory regimes.

For example, the overreliance on prescriptive regulation, an approach that is now being promoted as the panacea to the future crises, is itself partially to be blamed for the meltdown in the rated instruments. Per IBM research paper “The yin yang of financial reform: Embracing maxims to enable financial stability and healthy financial innovation”, when regulations mandated that institutions use of the credit rating agencies to assess risks inherent in MBSs and CDOs, “internal credit research essentially died. Had institutions done their own credit analyses, perhaps the ultimate outcome would have been different or, at the very least, less severe.”

This points to a major potential pitfall in the ongoing process of increasing regulatory systems reliance on prescriptive rules as a protection against future crises.

Since the Lehman collapse, governments in the US and Europe have been addressing the imbalances in their national financial systems by passing both structural and operational reforms. These focus on size, scope, societal costs and “too big to fail” institutions (i.e., cross-firm reforms). Operational reforms, typically implemented by regulators or multilateral international organizations, focus on capital, liquidity, incentives and taxation (i.e., what firms need to do within their own organizations).

As our research at the IBM’s Global Centre for Economic Development (GCED) highlights, on a nutshell, the direction of reforms adopted by the US and EU legislators to-date can be described by a stylized formula measuring the returns on equity (ROE) in the banking sector. So far, new regulatory regimes being introduced imply that in the future banking sector will see “Lower R + Higher E = Lower ROE”. This is a structural threat to the viability of the sector, and many new regulations coming on-line globally are the main culprit.

From the international Basel III framework to the Dodd-Frank Act in the US, increased quality and quantity of capital reserves on the financial services companies is likely to drive down global credit supply both in the short term (as banks engage in rebuilding their balancesheets) and in the long run (as financial services providers compete for a severely reduced capital pool).Per Josef Ackermann, the Deutsche Bank CEO, “There can be no doubt that [Basel III] will produce a drag on economic recovery.”

This statement relates to the core headlines coming out of Basel III and to the auxiliary parts of the framework. Specifically, higher capital reserves under Basel III, increasing common equity capital to 4.5% of risk-weighted assets by 2015 and to 7% by 2019, are expected to cost global economy some 3.1% of overall worldwide income over 2011-2015, implying a loss of almost 10 million jobs worldwide.

Ratio of capital to risk weighted assets held on balance sheet
% of Assets
Source: World Bank Financial Stability Indicators

In addition to the cost of rising capital reserves, Basel reforms include the idea of imposing a tax on the systemically important (aka larger) institutions, known as SIFIs. In addition to amounting to a tax on consumers (especially in the markets where a small number of larger banks controls the market for services, such as the Euro zone), such a charge will not address the issues of product (rather than institutions) specific risks.

Finally, Basel III introduction of the new liquidity and funding rules offers another example of a potentially market-restricting intervention that can end up costing the sector dearly, while producing little real benefit in alleviating systemic risks. The idea behind these measures is to ensure that financial institutions hold sufficient liquid reserves buffers to withstand a bank run, as well as to reduce the banks over-reliance (especially in Europe) on short-term wholesale funding. At the very best, these measures will lead to a significant cut in the banks’ ability to generate credit in the future.

At the same time, it is highly doubtful that any level and quality of reserves can ever guarantee a sufficient insurance against significant asset busts or even large liquidity events. Past history, as for example, analysed by a recent research paper from the University of Pennsylvania, clearly shows that regulatory tightening following previous episodes of major financial markets corrections had inevitably failed to prevent or even to significantly alleviate future financial busts. Instead, every episode of deep markets corrections was followed by severe tightening of financial regulation, prompting lenders to increase their reliance on more complex financial products. The levels of reserves never once were found sufficient to cover the sector.

More specific potential adverse effects of Basel III and Dodd-Frank Wall Street Reform and Consumer Protection Act changes relate to all three core sides of financial services business models: the trading side, the capital side and the funding side. On the trading side, increased capital reserves will likely constrain trading exposures, and cover for securitization and counterparties. The positive here will be a shift from narrowly traded derivatives to exchange-traded and centrally cleared derivatives. The net effect, however, will be smaller new products base in the sector and tighter margins, leading to a pressure on the returns.

Another study, titled “Global financial services: a New Regulatory Normal” prepared by the GCED identified a series of other potential risks in the latest regulatory reforms processes worldwide. In addition to the main headlines on capital side of the reforms outlined earlier, ongoing regulatory changes imply introduction of pro-cyclical capital bases, tighter restriction of capital allowances to paid up capital and retained earnings, elimination of hybrid products from capital base, as well as deferred taxes and intangibles. Restriction of minority equity and leverage ratios alongside with aforementioned capital rules changes will also likely lead to higher cost of banks capital and origination bases, implying restricted lending and associated jobs and income losses in the real economy. Lastly, stressed liability-linked liquidity provisions and efforts to reduce maturity mismatch via reduced reliance on short-term funding will further depress lending.

All of this suggests that going forward, banking sector in Europe and the US will face significant difficulties in generating new lending. In line with this, financial services growth is likely to shift away from traditional banking and brokerage, and toward less regulated and liquidity-rich sovereign wealth players and alternative lenders and investors.

This, in turn, will have profound effects on economic development, as the aforementioned GCED research highlights. In addition to tighter credit markets for companies and households, new rules are likely to lead to significant increases in costs and access barriers to capital for long term assets, such as infrastructure and plant investment. This development can also amplify, not reduce, the links between the exchequers and the banks. As banks will play an increasingly important role as the holders of public debt and as the source of tax revenue, current liquidity traps will be deepened. Liquidity supply and velocity of money will be reduced and M2 and broader money supply metrics will continue to lag liquidity injections from the central banks.

The resulting risk of closer political and economic integration between the financial services providers and the states can create simultaneously a new layer of inefficiency in financing of economic growth. It can also amplify shared risks, setting up the next crisis, this time around – with potential for a full contagion from the financial services to the sovereigns.

In the light of these regulatory changes and the convergence of regulatory regimes, banking and other financial services institutions face the need to provide sufficient internal buffers against the rising regulatory risk. These buffers require service providers to:

1. Rethink their business models to simplify operations and enhance ability to deal with systems and models complexity
2. Rebuild their balance sheet and focus on the new capital and leverage requirements
3. Actively pursue opportunities for mergers and divestitures
4. Improve their understanding of clients’ behaviors and preferences
5. Reconnect with their clients by investing in client analytics to gain insights
6. Provide clients with more and more complex and better responding services and data
   

In short, addressing business challenges presented by the ongoing processes of regulatory reforms worldwide, the banking and financial services sector will have to get much smarter in structuring future strategies for growth and operational processes.