25/2/19: Europe's TBTF Banks are only Bigger-to-Fail...

Since the start of the Global Financial Crisis (GFC) and through subsequent Euro area crises, the EU frameworks for reforming financial services have invariably been anchored to the need for reducing the extent of systemic risks in European banking. While it is patently clear that Euro area's participation in the GFC has been based on the same meme of 'too big to fail' TBTF banks creating a toxic contagion channel from banks balance sheets to the real economy and the sovereigns, what has been less discussed in the context of the subsequent reforms is the degree of competition within European banking sector. So much so, that the Euro area statistical boffins even stopped reporting banking sector concentration indices for the entire Euro area (although they did continue reporting the same for individual member states).

Chart below plots weighted average Herfindahl Index for the EA12 original Euro area states, with each country nominal GDP being used as a weight.

The picture presents a dire state of the Euro area reforms aimed at derisking the bank channel within the Eurozone's capital markets:

• In terms of total assets, concentration of market power within the hands of larger TBFT banks has stayed virtually unchanged across the EA12 between 2009 and 2017. Herfindahl Index for total assets was 0.3249 in 2009 and it is was at 0.3239 in 2017. Statistically-speaking, there has been no meaningful changes in assets concentration in TBTF banks across the EA12 since 2003. 
• In terms of total credit issued within the EA12, Herfindahl Index shows a rather pronounced trend up. In 2010 (the first year for which consistent data is provided), Herfindahl Index for total credit shows 0.0602 reading, which rose to 0.0662 in 2017.

Put simply, TBTF banks are getting ever bigger. With them, the risks of contagion from the banking sector to the real economy and the sovereigns remain unabated, no matter how many 'green papers' on reforms the EU issues, and no matter how many systemic risk agencies Brussels creates.

30/11/17: Efficiency of Enforcement vs Volume of Regulation

Yesterday, in our class on Economics, we talked about the distinction between regulation (volume of rules) and efficient enforcement (monitoring, investigatory, enforcement and pre-emptive functions of regulatory authorities). As an example, we referenced the repeated chain of customer-level scandals at the Wells Fargo Bank.

Here is the latest scandal, unveiled earlier this week that I mentioned: http://www.zerohedge.com/news/2017-11-28/it-tuesday-time-another-banking-scandal.

From our stand point, this case is really pushing the gap between regulation and enforcement out into new widths. Previous scandals, e.g. false accounts being created by bank employees, were harder to detect, pre-emptively, from regulatory point of view. The latest one was out in plain view for any supervisor/regulator to spot.

The bank signed a contract with its customers (standard terms of contract applying to all specified groups of customers) for ca 0.15% commission on foreign currency exchanges. The bank charged its customers (in 88% of all cases analyzed) higher fees, ranging to as much as 4%.

As ZeroHedge notes, this is absurd level of charges. And this charge comes on already absurd banks' spreads on buying and selling currency (so it is not the only charge customers pay). And yes, as ZeroHedge also notes, there are multiple service providers who do the same for much much lower fees. I use a service that charges me a flat rate fee of $1 for transaction, including transfers of money from one bank to another, plus exchange from one currency into another and trades currency at quoted market rates (average over 2 hours prior to transaction timing). So, in effect, I pay zero spread margin and my total cost of exchanging anything between $10 and $1 million is $1.00.  Were I to have used Wells Fargo services to do my last transaction, I would have paid somewhere around $29 more for the honor of wiring money into my Wells Fargo account than I did, judging by rates quoted to me for the date by Wells Fargo, as opposed to the rate I obtained from my service provider.

The only way the banks sustain the business model that provides them with such an opportunity to earn a huge profit off simple transactions is the model of monopolistic competition with price discrimination: the banks price their services at the high end of transaction cost in full knowledge that those of us who need the service often enough (like myself) will use other service providers, while those who use this service only infrequently will opt to pay higher price to avoid the cost of searching for better alternative.

But that absurd inefficiency of the services provided by the banks is a secondary point from our point of view. The primary one is the regulation in relation to consumer protection.

Let's face the music: the financial regulators receive data from the banks regarding their volumes of transactions carried out for customers in foreign exchange on a regular basis. They also receive the breakdown of costs and margins these transactions generated. It is a matter of excel-level algorithm to detect the discrepancy between the contractual 0.15% charge and the effective charge that - on the aggregate for Wells Fargo - would have been well in excess of 0.15%.

A red flag would have gone up at that stage. The timing to that would have been within one month (per reporting lags).

A sample of actual transactions could have been requested as soon as the flag was up and the actual fees charged could have been identified against the contractual fees. Assume that would have taken a lag of, say, another month.

Within two months from the start of the scam, Wells Fargo would have been under investigation. Damages to customers would have been limited, costs to the bank of complying with the regulations and consumer protection laws would have been limited, the enforcement system would have worked.

Is any of this feasible in the current regulatory and monitoring environment? You bet. Why was it not done? Because there is no pro-active analytics of reported data when it comes to smaller scale transactions. And because the culture of regulation is based on the assumption that too-big-to-fail banks are too-big-to-mistrust.

Either way, Wells Fargo governance and strategy misfires continue to deliver new lessons for us all. The lesson this week is that when the regulators talk the fine talk about protecting the small folks, it is actually whistleblowers or the media or competitors who most often do the heavy lifting on this front - they do the enforcement bit of job that the regulators are de facto walking away from. Efficiency of enforcement, when neglected, undermines the promise of regulation, even when the latter is backed by volumes of rules.

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…

8/915: Five Years of Dodd-Frank Act: Two Posts on Reforms Impact

Five years ago, on July 19, 2010, President Barak Obama signed the most far-reaching regulatory reform of the U.S. financial system since the end of the Great Depression – Dodd-Frank Wall Street Reform and Consumer Protection Act.

The Act has three core pillars:

• enhanced protection of consumers;
• expanded regulatory reach over risk management (including the markets for derivatives), and
• the Too-Big-To-Fail (TBTF) safeguards.

Given its ambitious scope, the Act was designed to shape American response to the Global Financial Crisis, both in terms of addressing some of the underlying causes, and mitigating future systemic risks. Not surprisingly, the passage of the Act was lauded at the time as a historic moment

My first post, covering Consumer Protection and Derivatives regulations under the Dodd-Frank Wall Street Reform and Consumer Protection Act is available here.

My second post on Dodd-Frank Act, covering regulation of TBTF banking and financial institutions is available here.

21/2/2014: Fed Transcripts, 2008: Icebergs, Titanic, Violins...

Marketwatch are running a live blog on Fed's release of 2008 transcripts

http://blogs.marketwatch.com/capitolreport/2014/02/21/the-feds-crisis-era-transcripts-of-its-2008-meetings-live-blog/

My comment: Fed transcripts from 2008 show a circus hit by a hurricane drowning in a surge of self-delusion.

Bernanke waffling on, in September 2008, about 'moral hazard' in a virtually academic exercise that is more about him being 'decidedly confused and muddled' shows the extent to which the Fed (and do keep in mind - this is the most competent Central Bank out there) was left completely unprepared for a systemic crisis. Forget the nature of the crisis or specific causes of it. The point is that some 14 months into huge pressure pilling up in the markets, the Fed was utterly unprepared to face a crisis.

Now, observe that having done the deed of acting outside any confidence about the impact of his actions, Bernanke subsequently defends his choices by saying that "I just don't believe that you can allow systemically critical institutions to fail in the middle of financial crises and expect it to be not a problem." Which, of course begs the question: does he believe that he should fail these institutions ex post after the crisis is over? And how the hell does he propose we go about that restoration of 'zero moral hazard' state? By sending in the FBI?..

In short, the man is still out of touch with reality. First, with the one he was thrown into in September 2008, second, with the one he constructed in response to September 2008 events.

Poor Ben... he goes on: "“We did not have—as the Europeans have or as we have FDICIA for banks—a system that was set up to allow a reasonable and responsible orderly resolution of nonbank systemically critical institutions. I think we now have made a lot of progress there. The TARP will provide a good interim solution.”"

Come again? What is that that 'the Europeans' have? "a system ...to allow a reasonable and responsible orderly resolution of nonbank systemically critical institutions"? Dear, oh dear... he needed retirement rest and relaxation back in 2008.

Still, the Fed transcripts show how the Central Bank did move to face the reality, unlike 'the Europeans' who basically used the Mongols' tactic for capturing Beijing - throw bodies against the walls. Even though Fed's 'data' included Yellen's quotes about plastic surgeons reporting customers delaying elective procedures... and she subsequently followed up on this pearl by expressing (in December 2008) concern about rising labour force participation...


In short, the transcripts make us, macroeconomists, look decidedly scientific and impossibly human, compared to the Central Bankers... And this before we get any transcripts from that bastion of surreality in Frankfurt, called the ECB...

27/9/2013: Consolidating Irish Banking Sector is a Bit of a Efficiency Dodo?

A new paper by Anolli, Mario, Beccalli, Elena and Borello, Giuliana, titled "Are European Banks Too Big? Evidence on Economies of Scale" (August 6, 2013: http://ssrn.com/abstract=2306771) "…investigates the level of economies of scale, as well as their determinants, for 103 European listed banks over the period 2000-2011…"

H/T to @brianmlucey for spotting the paper. Brian blogged on this today here: http://www.irishbusinessblog.com/2013/09/26/are-irish-banks-too-big-seems-so/


According to the abstract [emphasis is mine]: "The results reveal that economies of scale are widespread and move together for all size classes, although small and medium-sized banks experience the lowest economies of scale and even diseconomies of scale in some of the years under analysis."

The economies of scale concept as applied here is whether banks become more cost efficient when their size increases. In other words, the issue is are TBTF banks more efficient and are smaller banks, perhaps created by a regulatory breaking up of larger institutions in the wake of the crisis less efficient?

According to the authors, in the wake of the crisis: "An intense debate on the “make-them-smaller” is ongoing, and we aim to contribute from a quantitative perspective."

To do so, and "to fill the gap of evidence on European banks over the most recent years, this paper aims to investigate whether, among EU listed banks, there is evidence of economies of scale also for the largest banks in terms of total asset. Moreover it aims to isolate the effects of risk-taking, diversification in the business model and profitability on economies of scale."

"We find that economies of scale are widespread across different size classes of banks, and that they are especially wide for the largest banks. Moreover, there is a scale effect of the financial system, the smallest financial systems (Iceland, Belgium and Finland) and the countries most affected by the financial crisis (Ireland, Iceland, Belgium, Portugal and Spain) experience the lowest economies of scale (if not even diseconomies of scale) probably due to the small/reduced use of their production capacity."

Put differently, in countries like Ireland, the study finds that there is small or negative effect of larger size on greater efficiency of the banking system. Now, wait, but what about Government/Central Bank plans for consolidating the banking system into 3-pillar banks? Ooops...

"As for the effects of risk-taking, diversification in the business model and profitability on economies of scale, higher economies of scale are documented for banks more oriented towards investment banking (in all periods), banks with a higher liquidity but only up to a liquidity ratio of about 5.3 percent (convex curve during the crisis only), banks with a smaller amount of Tier 1 capital (concave, although almost flat, curve during the crisis only), and banks contributing less to systemic risk. The Granger causality tests suggest the existence of unidirectional causality for liquidity, Tier 1 and systemic risk."

So in plain English, this means that authors found that larger banks are more efficient when they are more liquid, take on more risky assets (investment banking), hold less capital (i.e. run greater risk of potential need for larger bailouts) and for banks that are less wired into the economy (contribute lower systemic risks). Oh, and the casualty for the economies of scale efficiencies goes from riskier behaviour and less connection to the economy to greater efficiency related to scale. Which part of these conclusions supports the irish Government/CB plans for 3-pillar banking system? Err… none!

Now onto country-level results: "Table 4 reports the average economies of scale for each country and for the different size classes of banks during the entire period 2000-2011."

"…Three countries (Belgium, Finland and Iceland) show overall diseconomies of scale. Meanwhile in the other European countries…, large significant economies of scale are reported (in particular for banks in the Netherlands and Switzerland). When we combine country and bank size, we observe that diseconomies of scale are experienced by the smallest banks in Finland, Germany, Ireland and Spain, the small banks in Finland, Germany, UK, Iceland and Portugal, and the medium banks in Belgium and the UK. Large banks exhibit diseconomies of scale in Ireland only, whereas largest banks show diseconomies of scale in Belgium only."

Oh, wait, so the 3 Pillars are getting worse (at being efficient) as they get bigger? You betcha… And the solution is… per Irish Government plans... to grow them even more mighty by consolidating the entire banking space in their hands. But more to come on these giants of greatness in the next table.

"Table 5 shows the average values of economies of scale for each country and in each year under analysis."

"Diseconomies of scale are more pronounced during the global financial crisis. In 2007 the number of countries that experience constant economies and diseconomies of scale (Finland, Ireland, Iceland and Spain) increases, but it is especially in 2008 that the number of countries that encountered diseconomies of scale (Belgium, Finland, Greece, Ireland, Portugal and Spain) increases. This evidence confirms, as expected, that the scale of European banks, when volumes declines due to the crisis, resulted to be excessive and inefficient due to excess capacity."

Wait a second, folks… between 2010 and 2011 Irish 'banks have: (a) shed much of their bad assets into Nama; (b) got recapitalised, and (c.) spent the last few years trimming down their operations to deliver on efficiencies demanded from them by the Central Bank… And yet - the economies of scale declined for them between 2010 and 2011.

Crazy stuff, until you realise that none of the 'reforms' we put forward to our banks have anything to do with increasing their efficiency or their capacity to function like proper banks. All our 'reforms' have been designed to suppress the explosion of bad risks on their balanceshets. Extend-and-pretend across the banking system doesn't add up to gains in efficiencies in the banking system? Who could have thought that up to be the case?

Now, how about a novel approach to repairing Irish banking system? How about getting real competition going by encouraging new entrants and freeing up (regulatory) credit unions and post offices to move into banking and consolidate within their sub-sector to form medium-sized banks? That might reduce market concentration and increase the numbers of banks with economies of scale?..

8/6/2013: Shortages of Safe Assets & Banks Recaps - troubled waters of Basel III

Here's an interesting view on European banks: http://www.voxeu.org/article/urgent-need-recapitalise-europe-s-banks . The core point is here:

Chart: Market-to-book value of European banks:

Quote: " On average, the market-to-book value of European banks now is about 0.50 (see Figure 1). This indicates that accountants’ estimates of bank capital are far too rosy, and that banks have substantial hidden losses on their books."

But there's more. "Until now, Europe’s banking sector has been kept afloat by implicit state guarantees of virtually all liabilities. …in 2012 these guarantees provided banks in Europe with an annual average funding advantage amounting to 0.3% of total assets. …An annual funding advantage of 0.3% of assets can be capitalised to be equivalent to 2% of total assets, on the assumption of a discount rate of 15% commensurate with banks’ uncertain earnings prospects. Given total banking assets of €33 trillion in the Eurozone, we are talking about an implicit guarantee of about €650 billion."

In short, through the crisis, European banking system was pumped with implicit supports to the tune of EUR2.6 trillion.

More than that. EBA is delaying stress tests into 2014, so we won't even in theory be able to know what is going on in the banks. Except, one has to doubt that the theory is a good instrument for the reality, as EBA has managed to bungle all stress tests it carried out to-date. In other words, EBA is acting de facto to increase implied supports as it delays and evades recognition of losses.


Look at the following paper: http://www.cpb.nl/en/publication/private-value-too-big-fail-guarantees (alternative link via ssrn: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2271326) which concluded that: "over the period 1-1-2008 until 15-6-2012" for only 151 European banks, "the size of the funding advantage' granted by various state supports "is large and fluctuates substantially over time. For most countries it rises from 0.1% of GDP in the first half of 2008 to more than 1% of GDP mid 2011. Our results are comparable to findings in previous studies. We find that larger banks enjoy on average higher rating uplifts, but the effect of size does not increase anymore for banks with total assets above 1,000 billion Euro compared to banks with assets between 250 and 1,000 billion Euro. In addition, a higher sovereign rating of a bank‟s home country leads on average to a higher rating uplift for that bank."

In other words, remove the protectionist supports and the system will crumble.

Note, the paper also cites the case of Ireland. "When we take a closer look at the funding advantages of banks from Spain, Italy, and Portugal in Figure 7, we see that the advantages enjoyed by banks are relatively small in these countries. This can be explained by the smaller rating uplifts that the banks from these countries enjoy. The fact that rating uplifts are relatively small in these countries is likely to be related to lower sovereign creditworthiness. The banking sector in, for example, Spain is not necessarily smaller when compared to GDP than the banking sector in France and Germany. So this is unlikely to explain the results we find. In Ireland, funding advantages are relatively large compared to the other three countries. The funding advantage enjoyed by Irish banks is somewhat higher than the advantage enjoyed by French and German banks."

Figure 7: funding advantage per country (Spain, Ireland*, Italy, and Portugal) (*note that the figure for Ireland is drawn on a different scale)

Now, when you just thought that the resolution path (as suggested by the article linked above) is well-known: assess, expose, recap, things are getting slightly out of hand. BIS has warned that simply pumping more capital into banks might be a wrong thing to do. Here's the BIS paper: http://www.bis.org/publ/cgfs49.pdf.

In the nutshell, BIS is saying that core tools for dealing with banks insolvency so far are… possibly… making these banks less safe, not more. The problem is that under Basel III, safety of bank capital is determined by safety of underlying assets held as capital (so far - fine). These 'safe' assets are… err… Government bonds and Government-guaranteed commercial paper (e.g. MBS). The idea is that 1) these assets are more secure, thus provide better cushion in the case of distress, and 2) these assets can be sold (are liquid) easily to cover any losses.

Problem is: there is a shortage of 'safe' assets as defined by Basel. The shortages are riven by 1) higher demand for these assets, 2) smaller number of 'safe' (highly-rated) sovereigns, 3) reduced issuance by highly-rated sovereigns ('austerity') and 4) central banks and non-banking financial institutions (e.g pensions funds) hoovering up these assets. BIS is not worried about the shortages of safe assets, but here are some links on this:

• from the Economist: http://www.economist.com/blogs/freeexchange/2013/02/safe-asset-shortage
• and from BIS own researchers: http://www.bis.org/events/conf120621/gourinchas_paper.pdf
• from Bruegel: http://www.bruegel.org/nc/blog/detail/article/1023-blogs-review-the-safe-asset-shortage/
• from FT Alphaville: http://ftalphaville.ft.com/tag/shortage-of-safe-assets/ with a chart:

In turn, shortages of safe assets, even if nascent, can drive ups emend for riskier assets and thus increase riskier assets allocations by the financial intermediaries (think insurance and pensions funds on drugs).

Here's a very interesting discussion of what can happen next from @simonefoxman: http://qz.com/88585/new-fears-of-financial-interconnectedness-highlight-the-delusion-of-bank-capital/?oref=dbamerica

"And therein lies the risk. The assets don’t change hands permanently: It’s just one institution lending junk bonds to another and borrowing higher-quality ones in return. So a default on one side could translate into problems for the other. In such cases, the “high-quality capital” is only as reliable as the low-quality capital it was exchanged for. Moreover, if assets on either end of such a deal are mispriced, it could have knock-on effects across the financial system.

As a result, warns the BIS, the financial system is becoming more interconnected—and thus more susceptible to system-wide problems of the kind we saw in the financial crisis a few years ago."

Once again, Basel III might be off the target by a mile when it comes to improving quality of risk buffers in the banks… Just as with liquidity buffers: http://trueeconomics.blogspot.ie/2013/05/352013-basel-25-can-lead-to-increased.html