16/7/2013: Sovereign --> Private Risk Transmission

Is ECB policy too tight, about right or too loose? Well, the answer depends on many factors and metrics of choice. One metric is the cost of credit to the private sector - influenced in part by the ECB benchmark rates and in part by lending conditions and environments. The two forces are not independent of each other, however. More specifically, markets conditions (e.g. raging sovereign debt crisis in the euro area in the 2010-2011) can have impact on how monetary policy is transmitted. Put differently, in addition to banks --> sovereign transmission of risks, there is also sovereign --> private sector credit transmission mechanism.

"The Impact of the Sovereign Debt Crisis on Bank Lending Rates in the Euro Area" by Stefano Neri, June 20, 2013, Bank of Italy Occasional Paper No. 170  argues that "since the early part of 2010 tensions in the sovereign debt markets of some euro-area countries have progressively distorted monetary and credit conditions". This resulted in constriction of "the ECB monetary policy transmission mechanism and raising the cost of loans to non-financial corporations and households." The study looks at the role that the sovereign markets tensions played in determining bank lending rates in the main euro-area countries. The author finds that sovereign debt markets tensions "have had a significant impact on the cost of [private sector] credit in the peripheral countries". More specifically, "if the spreads had remained constant at the average levels recorded in April 2010, the interest rates on new loans to non-financial corporations and on residential mortgage loans to households in the peripheral countries would have been, on average, lower by 130 and 60 basis points, respectively, at the end of 2011."

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2284804

Few charts, showing simulated interest rates against actual rates. Note: red lines: actual data; blue dotted lines: simulated data starting from May 2010; blue dashed lines: simulated data starting from July 2011. Percentage points.

Interest rates on new loans to non-financial corporations: counterfactual simulations - peripheral countries:

20/6/2013: Stalled Irish Banks Reforms: Sunday Times, June 16, 2013

This is an unedited version of the Sunday Times article from June 16, 2013


The latest data from the Central Bank shows that in two years since the current government took office, Irish banking sector is not much closer to a return to health than in the first months of 2011.

Objectively, no one can claim that the task of reforming Irish banking sector is an easy one. However, credit and deposits dynamics in the sector point to the dysfunctional stasis still holding the banks hostage. Despite ever-shrinking competition and vast subsidies extended to them, Irish banks are not investing in new technologies, systems and models. Banks’ customers, including businesses and households, are thus being denied access to services and cost efficiencies available elsewhere. In short, the Government-supported model of Irish banking is failing both the sector and the economy at large.


In April this year, total inflation-adjusted credit advanced to the real domestic economy, as measured by loans to Irish households and non-financial corporations, stood at EUR175,419 million. Since Q1 2011, when the current Government came to power, real credit is down EUR32,302 million. This figure is equivalent to roughly twice the annual rate of gross investment in the economy in 2012. Total credit to non-financial corporations has now been in a continuous decline for 48 months.

Half of this contraction came from loans over 5 years in duration. These loans are more closely linked to newer vintage capital investment in the economy, generation of new jobs, R&D and innovation activities, as well as new exports, than loans with shorter duration. Let’s take this in a perspective. The fall in total longer duration lending since mid-2009 is equivalent to losing 70,000-90,000 direct jobs. Factoring in interest income plus employment-related taxes, the foregone credit activity has cost us close to the equivalent of the tax increases generated in Budgets 2012-2013.

It would be fallacious to attribute credit supply declines solely to the property related lending. Based on the new data reported this Thursday by the Central Bank, loans levels advanced to private enterprises have fallen, between Q1 2011 and Q1 2013 in all sub-sectors of the economy, with largest loans supply declines recorded in domestic, as opposed to exports-oriented, sub-sectors.  All loans are down 6%, while loans to companies excluding financial intermediation and property related sectors are down 5.8%.

However, on the SMEs lending side, some of the steepest loans declines came from the exports-focused enterprises, such as ICT sector, where credit has fallen 9.7% on Q1 2011, or in computer, electronic and optical products manufacturing where loans are down 6.5%. Even booming agriculture saw credit to SMEs falling 5.7% over the last two years, while credit for scientific research and development is down 13.3%.

The picture is, in general, more complex for the levels of credit outstanding in the SMEs sector. On the demand side, in Ireland and across the euro area, there has been a noticeable worsening in the quality of loans applications filed with the banks during the crisis. In a research paper based on the ECB SAFE enterprise level survey data for euro area SMEs, myself and several co-authors have identified the problem of selection biases in companies’ willingness to apply for credit. In simple terms, SMEs more desperate for funding due to deteriorating balancesheets are more likely to apply for credit today. In contrast, healthier firms are more likely to avoid applying for bank credit.

ECB data also shows that Ireland’s problem of discouraged borrowers is much worse, than the euro area average. For example, in Ireland, 21% of all SMEs that did not apply for credit stated that they did so for fear of rejection, almost 3 times the rate of the euro area average and nearly double the second worst performing economy – Greece.


On the funding side, Irish banks have been and remain the beneficiaries of an unprecedented level of funding support compared to their euro area counterparts.

A recent research paper from the Dutch think tank CPB, titled "The private value of too-big-to-fail guarantees" showed that through mid-2012, the pillar banks in Ireland have availed of the largest subsidy transfers from the sovereign and Eurosystem of all banking systems in Europe. Funding advantages, accorded to the largest Irish banks, alone amounted, back in June 2012, to more than double the share of the country GDP compared to Portugal, and more than seven times those in Spain and Italy.

Removal of the explicit Guarantees was supposed to serve as a major step in the right direction. Alas, Irish pillar banks continue to depend for some EUR39.5 billion worth of funding on Eurosystem.  The latest Fitch report on the pillar banks shows that this reliance is likely to persist as loan/deposit ratios remain relatively high. Latest figures put Bank of Ireland, AIB and PTSB loan/deposit ratios at around 120%, 130%, and over 200%, respectively.

And there are further issues with funding in the system. By mid-2014, AIB is required to raise EUR3.5 billion to redeem the preference shares held by the National Pension Reserve Fund. Bank of Ireland will have to find EUR1.8 billion for the same purposes. In both cases there are questions as to how these funds can be secured in the current markets without either further reducing money available for lending or tapping into taxpayers’ funds.


Subsidies to the ‘reformed’ Irish pillar banks go hand-in-had with the regulatory protectionism, which completes the picture of massive transfers of income from the productive economy to the zombified banking sector.

Since 2008, Irish financial services continue to experience ongoing process of consolidation and, underlying this, the reduction in overall competition. Data from the ECB shows that the number of financial institutions operating in the country has fallen in 2012 to the levels below those recorded in 2000-2008. Dramatic declines in the fortunes of the third and the first largest lenders – Anglo and AIB - should have led to a drop in the combined market share held by the top 5 banks. Instead, the market share of top 5 credit institutions rose over the years of the crisis.

To a large extent, this reflects exits of a number of foreign lenders from the market. However, unlike in the case of the US and the UK, there are no new challengers to the incumbent players in the Irish asset management, investment, corporate and merchant banking, and credit unions sector. Neither the regulators, nor the banks have any incentives to encourage new players' entry.

And this has direct adverse impact on the overall health of the economy. When we studied the effects of banking sector concentration on firms’ willingness to engage with lenders, we have found that higher concentration of big banks’ power in a market is associated with lower applications for credit and higher discouragement.

As the result of the reforms undertaken in the Irish banking sector, our banking services are left to stagnate in the technological and strategic no-man's land.

Mobile and on-line banking systems remain nothing more than appendages to the existent services, with only innovation happening in the banks attempting to force more customers to on-line banking to cut internal costs.

Currently, worldwide, banking services are migrating to systems that can facilitate lower cost customer-to-customer transactions, such as direct payments, e-payments, peer-to-peer lending, and mixed types of investment based on combinations of equity and debt. All of this aims to reduce cost of capital to companies willing to invest. Irish financial services still operate on the basis of high-cost traditional intermediation and the Government policy is to keep hiking these costs up. Instead of moving up to reflect the true levels of risks inherent in Irish banks, deposit rates for non-financial corporations and households are falling. Interest on new business loans for non-financial corporations is up 105 to 197 basis points in April 2013, depending on loan size, compared to the average rates charged in Q1 2011. Over the same time, ECB policy rates have fallen by 75 basis points. This widening interest margin is funding banks deleveraging at the expense of investment and jobs.


Combination of the lack of trust in the banking system, alongside the lack of access to direct payments platforms means that many businesses in Ireland are switching into cash-only transactions to reduce risk of non-payments and invoicing delays. Currency in circulation in Ireland is up 10.3% on Q1 2011 average, while termed deposits are down 6.3%.

With big Pillar Banks unable to lend and incapable of incentivizing deposits growth, we should be witnessing and supporting the emergence of cooperative and local lending institutions. None have materialized so far. If anything, the latest noises from the Central Bank suggest that the credit unions can potentially expect to take a greater beating on the loans than the banks will take on mortgages and credit cards.

All-in, Irish banking system is far from being on a road to recovery so often spotted in the speeches of our overly-optimistic politicians and bankers. The credit squeeze on small businesses and sole traders is likely to continue unabated, and with it, the rates of business loans arrears are bound to rise.

Box-out:
In this month’s survey of economists by the Blackrock Institute some 64% of the respondents stated they expected euro area economy to get e little stronger over the next 12 months and none expected the recovery to be strong. In contrast, 74% of respondents thought German economy will get better and 81% forecast the same for the UK. In the case of Ireland, however, only 57% of respondents expected Irish economy to become a little stronger in a year through June 2014 (down on 75% in May 2013 survey). None expected this recovery to be strong. Interestingly, 69% of respondents describe Irish economy's current conditions as being consistent with an early or mid-cycle expansion - both normally consistent with above-trend rapid growth as economy recovers from a traditional recession. Thus, the survey indicates that majority of economists potentially see longer-term prospects for the Irish economy in the light of slower trend growth rates. Back in 2004-2005, I suggested that the Irish economy will, eventually, slowdown to an average rate of growth comparable to that of a mature small euro area economy. This would imply an annual real GDP growth reduction from the 1990-2012 average of 4.9% recorded by Ireland, to, say, 1.8% clocked by Belgium. Not exactly a boom-town prospect and certainly not the velocity that is required to get us to the sustainable Government debt dynamics.

13/5/2013: Banks Reputation Matters... for Borrowers too

Why banks reputations matter outside the interbank funding markets and regulatory offices? A question that is, perhaps, somewhat distant for Irish bank zombies, but ultimately the answer is not. It turns out, bank's reputation matters to the corporate borrower. And it matters materially.

Here's an interesting paper on this from Ongena, Steven R. G. and Roscovan, Viorel (see link below). As usual, italics are my own.

The authors argue that "banks play a special role as providers of informative signals about the quality and value of their borrowers. [Which is sort of trivial, when considered on 'accept' vs 'reject' or 0:1 basis. A '0' or 'reject' loan application signal provides information to the firm and to investors when the latter can observe the outcome of an application that the firm might be not as credit worthy as previously believed.]

Such signals, however, may have a quality of their own as the banks' selection and monitoring abilities may differ. [In other words, here's the core hypothesis: take two banks. Bank A has a lower capacity to price risk inherent in the firm than bank B. Over time, bank A repetitional capital should be lower than bank B. Now, firm 1 applies for a loan with A and B and gets rejected by B and accepted by A. Another firm, call it firm 2, applies for same loan and get accepted by B. Clearly, if the quality differential between A and B are known to the market, information about firms 1 and 2 experiences in applying for loans should matter in valuing firms 1 and 2.]

Using an event study methodology, we study the importance of the geographical origin and organization of the banks for the investors' assessments of firms' credit quality and economic worth following loan announcements. Our sample comprises 986 announcements of bank loans to US firms over the period of 1980–2003.

We find that investors react positively to such announcements if the loans are made by foreign or local banks, but not if the loans are made by banks that are located outside the firm's headquarters state. Investor reaction is, in fact, the largest when the bank is foreign.

Our evidence suggest that investors value relationships with more competitive and skilled banks rather than banks that have easier access to private information about the firms. [Confirming the core hypothesis above]"

Which is yet more bad news for Irish banks and the corporates stuck with them... and another reason why the banks reforms should deal with reputational fallout of this crisis as much as with macroprudential risks and regulatory capital cushions.


Ongena, Steven R. G. and Roscovan, Viorel, Bank Loan Announcements and Borrower Stock Returns: Does Bank Origin Matter? (June 2013). International Review of Finance, Vol. 13, Issue 2, pp. 137-159, 2013. http://ssrn.com/abstract=2262145

17/11/2012: A tradeoff Ireland does not have an option of facing

"Banking Competition, Housing Prices and Macroeconomic Stability" by Oscar Arce and Javier Andres (The Economic Journal, Vol. 122, Issue 565, pp. 1346-1372, 2012 | http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2174836):

The paper develops a macroeconomic model "with an imperfectly competitive bank‐loans market and collateral constraints that tie investors’ credit capacity to the value of their real estate holdings".

The model shows that "lending margins are optimally set by banks and have a significant effect on aggregate variables." [Something that can be potentially magnified by the market structure, such as, for example duopolization of the market, as in the case of Ireland today].

"Fostering banking competition increases total consumption and output by triggering a reallocation of available collateral towards investors." In other words, that 'creative destruction' works - flows of collateral are made more efficient by a competitive banking system.

"Also, stronger banking competition implies higher (lower) persistency of credit and output after a monetary (credit crunch) shock."

"In the short‐run, output, credit and housing prices are more responsive on impact to shocks in an environment of highly competitive banks." "…Key to this last result is the reaction of housing prices and their effect on borrowers' net worth. The response of housing prices is more pronounced when competition among banks is stronger, thus making borrowers' net worth
more vulnerable to adverse shocks and, specially, to monetary contractions."

"Thus, regarding changes in the degree of banking competition, the model generates a trade-off between the long run level of economic activity and its stability at the business cycle frequency."

Of course, the problem for Ireland in the current crisis is that
1) we have an ongoing monetary crisis (with interest rates and FX rates policies out of synch with the economy needs);
2) a solvency crisis (debt overhang); and
3) a liquidity crisis

We are also experiencing a dramatic collapse of competitive forces in the banking sector just when we would hope for the competition in banking to start generating those efficiencies in funding allocations and thus sustaining recovery.

In other words, we have - per paper above - the worst of both worlds, we neither had a cushion of the rigid downward shocks responses in the economy going into the crisis, nor do we have the salvation option of using a competitive banking system to drive up recovery. All that, plus no controls over monetary policy.

And we are still hearing the drivel about a 'Lost Decade' for Ireland? Try decades...

15/9/2012: Brazil soaks bank bondholders

H/T to Ed - here's Brazil shutting down one medium-sized insolvent bank (link) and triggering the largets corporate bonds default in Latin America since 2002.

According to the report, ATMs still are functioning in Brazil. 

And a lovely quote from the Irish Government advising HSBC (alas via their Brazil division):

“It is quite healthy to have this kind of reminder every once in awhile that doesn’t pose a systemic threat,” said Pedro Bastos, chief executive officer of HSBC Global Asset Management in Brazil, in a phone interview from Sao Paulo. “It’s an important reminder that risk and return need to be in line with the investor’s profile.”

And lest we think Brazil's CB is not 'reckless' enough (in Irish counterparts parlance), Brazilian authorities are investigating fraud allegations - something that Irish authorities are not too keen on doing.

Obviously, there will be likely costs associated with the decision, namely, funding costs for the country medium sized banks might rise (they will most certainly rise in the short term, but it is the medium term that anyone should be concerned with as Central Banks can provide the bridge for the shorter term funding).

7/7/2012: Banking union - a bit of a folly

Daniel Gros makes a cogent argument on banking union at vox.eu : http://bit.ly/L0tmUR

However... his argument is partially self-defeating.

Unified banking operations for an Italian bank with german subsidiary he uses as an example, by allowing transfer of liquidity (funds / deposits) from German subsidiary to cover Italian parent's liquidity demand that arises from Italian bank's overall elevated riskiness would be, in effect, a case of mis-pricing risk for German customers of the Italian bank. Should these customers re-price risk post-banking union, the customers will walk out of the subsidiary and the Italian parent bank will still be short of liquidity.

Thus, unless Italian bank is made a German bank (or until), the problem will remain. The only way for the supervisory authority to avoid the problem arising in the short run is by deceiving German customers of the Italian bank.

In addition, in order to make an Italian bank into a German bank, common supervision will require full convergence of all banking models to a common denominator. Whether such a convergence yields a better Italian bank (by the standards of the day) and / or a less safe German bank is a matter of more than supervision, but of a full regulatory convergence.

9/6/2012: Why IMF 'vision' on EA crisis is missing major points

An interesting speech given by the IMF Managing Director, Ms Christine Lagarde to the Annual Leaders’ Dialogue Hosted by Süddeutsche Zeitung last night. Here are some extensive exerts from it and my thoughts - sketched out, rather than focused - about her ideas.


Part 2 of the speech focused on the need for breaking the cycles of the crisis(that amplify risks to the economy, including global economy). Do note - coincidentally, the theme is exactly identical to my forthcoming Sunday Times article and to the research note currently awaiting legal clearance (both will be posted here early next week).


Per Ms Lagarde:
"One is an economic cycle. The feedback loop between weak sovereigns, weak banks and weak growth that continually undermine each other.

"...Another cycle on my mind: the political economy. It is a cycle that has become too familiar since the start of the crisis, like a movie we have watched one too many times. It looks something like this. Tensions escalate and, out of necessity, policymakers take action. But, just enough for the danger to subside. Then the urgency is lost, momentum wanes, and the policy discourse begins to fracture, too focused on their own backyards and not enough on the big picture. And so tensions start to rise again.
But, with the passing of each cycle, we reach a higher and higher level of uncertainty, and the stakes rise.

"In the case of Europe, the cycles are now threatening the very existence of the European project. We must break both of these cycles if we are to break the back of this crisis. And one cannot happen without the other."

So far, on the money, although Ms Lagarde seems to be unwilling to recognize that we also have a structural growth problem in Europe, a problem linked with the above cycles, but also independently grave enough to warrant concern.

To break these cycles, "...the policy debate needs to move beyond the false dichotomies of growth versus austerity, stability versus opportunity, national versus international interests. We need to agree on a comprehensive strategy that is good for stability and good for growth."

So, per Ms Lagarde, the core pillars of such a strategy are: "First, macroeconomic policies should help support the recovery and also tackle the underlying causes of the crisis.

• Monetary policy should continue to be very supportive. Central banks, in particular the ECB, should further loosen monetary conditions, and remain ready to use unconventional tools to ease tensions and provide funding to address liquidity constraints. [In other words, Ms Lagarde is wisely going well beyond the rates policy alone. Good news, but no specifics.]
• Public debt remains too high and countries need credible and ambitious roadmaps to bring it down over the medium term. For the most part, that adjustment should be gradual and steady, unless countries are forced by markets to move more aggressively—which is, of course, the case for several countries in the Eurozone. If growth becomes weaker than expected, countries should stick to announced fiscal measures, rather than announced fiscal targets—as economists say, they should let the automatic stabilizers to operate. [Basically: do austerity policies, but don't chase targets too much. Unless you have to. In which case... well, nothing really new. Just do something?]

"Second, more effective crisis management. This is very urgent and mainly an issue for the euro area. But, a broader element is the collective effort to reinforce the global financial safety net. In this context, I welcome the increase in the IMF’s resources by $430 billion." [A complete 'Fail' for Ms Lagarde here. Increasing 'global safety net' is hardly the only factor in carrying out effective crisis management. How about recognizing that all problems are inter-linked with each other, and thus effective crisis management should be not about creating another pot from which lending can occur to the sovereigns, but actually creating a system that can permanently and swiftly resolve the singular core pressure cause that might be specific for each country? E.g. for Ireland - a system that can address the banking sector debts loaded into the real economy, for Greece - a system that can write off a large portion of the country sovereign debt without restructuring it into new debt, and so on]

"Third, we need more determined progress on structural reforms. For example, labor market and product market reforms that can carry the torch of growth beyond the immediate support from macroeconomic policies.' [Again, Ms Lagarde is exceptionally weak on specifics, in part because structural reforms are country-specific, but in part despite the fact that structural reforms for the euro area must include some - e.g. markets structure changes, moving economy away from state-dominated management and investment etc.]


In part 3 of her speech, Ms Lagarde focused on financial sector reforms.


"Let me be clear: the heart of European bank repair lies in Europe. That means more Europe, not less. ... To break the vicious cycle of financial-sovereign risks, there simply must be more risk-sharing across borders in the banking system. ...In the near term, this should include a pan-euro area facility that has the capacity to take direct stakes in banks. Looking a little further ahead, monetary union needs to be supported by building a true financial union that includes unified supervision; a single bank resolution authority with a common backstop; and a single deposit insurance fund."

[Aside from the 'true financial union', the common deposits insurance system is exactly what I suggest as well, although my proposals go further to include a common resolution mechanism for banks insolvencies that is systemic, not debt-based, unlike Ms Lagarde's approach that will simply pool bad debts into a larger warehousing facility, other than national one. Sadly, the logic of failed banking resolution policies to-date escapes Ms Lagarde. Pooling bad debts into a pan-European system instead of current national systems is equivalent to suggesting that putting all sick and healthy patients in one ward will somehow prevent contagion.]

"Moves toward deeper fiscal integration should go hand-in-hand with these efforts. In particular, the area needs to take the further step of some form of fiscal risk-sharing. Options here include some form of common bonds or a debt redemption fund. This would allow for common support before economic dislocation in one country develops into a costly crisis for the entire euro area." [This is an extraordinary statement for IMF MD - as I show in my forthcoming Sunday Times article, pooling sovereign debt risks will mean euro area sovereign debt/GDP ratio in excess of 110% by 2014-2015. Where is Europe's capacity to raise such debts and where its economic capacity to finance such debts?]

"And, on the upside, breaking the shackles of the sovereign-financial nexus will allow financial institutions to deliver credit and, in turn, create growth and jobs." [This is a rather silly conclusion/ promise that resembles the Irish Government's promises that first a global systemic guarantee, then Nama, subsequently extensive recaps - all policies advocated in this speech by Ms Lagarde, albeit at EA-wide level, instead of national levels - will create a healthy banking system with ample funding and risk-taking capacity to lend into the economy. In Irish case - this clearly did not happen. Neither has it happened in Japan. Why increasing the scale and spread of the diseases - the insolvent banking system - to supernational level should do the opposite?]

2/4/2012: Banks bailouts and bonds eligibility

Two important documents relating to banks bonds, Sovereign Guarantees and the bondholders' haircuts.

First, the ECB decision of March 21 that was rumored to have been implemented by the Bundesbank last week - allowing the NCBs not to accept as collateral Government-guaranteed bank bonds from the countries currently in the EU-IMF financial assistance programmes (aka Greece, Ireland and Portugal). Here's the link. Key quote (emphasis mine):
"Acceptance of certain government-guaranteed bank bonds: On 21 March 2012 the Governing Council adopted Decision ECB/2012/4 amending Decision ECB/2011/25 on additional temporary measures relating to Eurosystem refinancing operations and eligibility of collateral. According to that Decision, National Central Banks (NCBs) are not obliged to accept as collateral for Eurosystem credit operations eligible bank bonds guaranteed by a Member State under an EU-IMF financial assistance programme, or by a Member State whose credit assessment does not comply with the Eurosystem’s benchmark for establishing its minimum requirement for high credit standards. The Decision is available on the ECB’s website."

Hat tip for the link to @OwenCallan of Danske Markets.

However, the latest information is that Bundesbank clarified that it will continue accepting all EA17 Government bonds. See link here. Confusion continues as to what Bundesbank will and will not accept.

Second, today's release by the EU Commission of the consultation paper on dealing with future banks crises and bailouts. Titled "Discussion paper on the debt write-down tool – bail-in". The paper clearly states (emphasis is mine, again):

"Rather than relying on taxpayers, a mechanism is needed to stop the contagion to other banks

and cut the possible domino effect. It should allow public authorities to spread unmanageable

losses on banks' shareholders and creditors."

The proposals advanced by the EU are not new: "In most countries, bank and non-bank companies

in financial difficulties are subject to "insolvency" proceedings. These proceedings allow either

for the reorganization of the company (which implies a reduction, agreed with the creditors, of its

debt burden) or its liquidation and allocation of the losses to the creditors, or both. In all the

cases creditors and shareholders do not get paid in full."

Per EU: "An effective resolution regime should:

• Achieve, for banks, similar results to those of normal insolvency proceedings, in terms of allocation of losses to shareholders and creditors
• Shield as much as possible any negative effect on financial stability and limit the recourse to taxpayers' money
• Ensure legal certainty, transparency and predictability as to the treatment that shareholders and creditors will receive, so as to provide clarity to investors to enable them to assess the risk associated with their investments and make informed investment decisions prior to insolvency."

There is no point at this stage to explain that in Ireland's case, NONE of the above points were delivered in the crisis resolution measures supported by the EU and actively imposed onto Ireland by the ECB.

It is, however, worth noting that the Option 1 advanced by the EU includes imposing losses on senior bondholders and that the tool kit for doing this includes debt-equity swaps. Readers of this blog would be well familiar with the fact that I supported exactly these measures.

29/3/2012: China's Banking Sector Analysis

A very revealing paper on Chinese banking sector - link here. A lengthy summary of some points:

The study describes "aggregate developments of the sector and compare them to the situation in other countries. ...Our results confirm that the Chinese banking sector is truly in a class of its own, especially given the level of China’s economic development. Despite significant reforms, the state and various public organizations still own controlling shares in the largest commercial banks. The state is also present on the borrowers’ side; it is estimated that about half of state-owned commercial bank lending still goes to state-controlled companies." [Note: this induces rather unique risk into China's banking sector - the risk of losses on both sides of the transaction and also quality risk to banks assets, as state-owned enterprises in China tend to be higher risk]. 

Furthermore: "More than 90% of total banking sector assets are state-owned in China (Economist, 2010), while Vernikov (2009) puts the corresponding figure for Russia at 56%. In general, reforms in the Chinese banking sector have lagged relative to other sectors of the economy."

Thus, "Chinese policy has striking parallels to the Russian experience; there has never been a major effort to privatize banking and banks today continue to be directly or indirectly controlled by the state or public institutions." Except, in Russian case, there are far fewer state enterprises and once controlled for extraction sector enterprises [less subject to traditional risks], there are even fewer state-controlled enterprises links to state-controlled banks of the lender/borrower relations side. Furthermore, "the lack of capital controls, of course, means that Russians have greater freedom in choosing providers of their financial services."

"Despite listing and the presence of foreign investors, all the large commercial banks are still majority state-owned. The share of state and state-owned entities at the end of 2010 was 83.1% in ABC, 70.7 % in ICBC, 67.8 % in BOC, and 60.1 % in CCB. The corresponding number for the Bank of Communications was 32.4 %"

"In this way, the banking system can serve as an important policy tool. (see below)

"Another distinctive feature of the Chinese banking sector is the variety of its banking institutions. New types of banking institutions, especially those serving rural areas, are emerging all the time. While equity and debt markets are still tiny relative to the banking sector and their importance as sources of financing of investment remain minor, they have evolved rapidly in recent years."

Some interesting facts: "The government’s stimulus efforts to avoid recession in 2009 resulted in a massive spike in bank lending that increased the consolidated banking sector balance sheet by approximately a third. Rather than pull back, bank lending went on to expand an additional 20 % in 2010. Lending outside the banking sector’s balance sheet has also grown strongly (García-Herrero and Santabarbara, 2011). These lending trends in themselves should be sufficient to raise concerns about the quality of bank loan portfolios and the need to curtail growth of bank lending in coming years..."

"Bank loans are the most important source of external funding for the non-financial sector in China. They accounted for 75% of all external funding sources at the end of 2010, and exceeded 80% during the crisis years of 2008 and 2009 when other external sources were difficult to obtain. As we saw in early 2009, the Chinese authorities can turn to bank lending as a policy tool when the need arises."

The unbalanced nature of Chinese banking translates into significant concentration of State power in lending: "Bank lending grew between 2006 and 2010 at the average rate of 20% a year, thanks in part to the government stimulus program in the face of the global economic re- cession. Loans to non-financial companies accounted for around 70% of new loans. State- owned commercial banks (SOCBs), traditionally the biggest loan providers, accounted for 43% of all new loans issued in 2009 (their share was 51% in 2001). SOCBs accounted for about half of the total banking sector loan stock at the end of 2010. This proportion corresponds to their share in total sector assets."

And more: "Even though the Chinese banking sector is huge for a middle-income nation, bank lending is heavily skewed to state-owned companies. Allen et al. (2008) note that the size of China’s banking system, in terms of total bank credit to non-state sectors, was 31% of GDP in 2005. This figure is not too different from the average of other major emerging economies with a weighted average of 32% of GDP. Looking at total bank credit, including loans to state sectors, the ratio of China’s bank credit to GDP rises to 110% − a level higher than even in countries with German-origin legal systems (weighted average 106%). The difference between total bank credit and private credit suggests that most of the bank credit is issued to companies that are ultimately owned by the state. Also Okazaki et al. (2011) report that bank lending in the recent years has mostly gone to large SOEs. In 2009, about 50% of SOCB loans were extended to large SOEs. Private enterprises received some 14% of total lending provided by the banking sector."

14/1/2012: Irish banking crisis - on a road to nowhere

This is an unedited version of my Sunday Times article from January 8, 2012.

In the theoretical world of Irish banking reforms, 2012 is supposed to be the halfway marker for delivering on structural change. Almost a year into the process, banks are yet to meet close to 70% of their total deleveraging targets, SMEs are yet to see any improvements in credit supply, households are yet to be offered any supports to reduce their unsustainable debt burdens, longer-term strategic plans reflective of the banks new business models, now approved by the EU not once, but twice are yet to be operationalized, and funding models are yet to be transitioned off the ECB dependency.

In the period since publication of the banking sector reforms proposals, total banks core and non-core assets disposals are running at some €14 billion of the €70 billion to be achieved by the end of 2013. Even this lacklustre performance was heavily concentrated in the first nine months of 2011, when few of Irish banks competitors were engaging in similar assets sales.

Since then, things have changed. Plans by the euro area banking institutions, already announced in Q4, suggest that some €775 billion worth of euro area banks’ assets will come up for sale in 2012. That is more than 8.5 times the volumes of assets disposals achieved in 2011. And 2012 is just the tip of the proverbial iceberg. According to the Morgan Stanley research, 2012-2013 can see some €1.5-2.5 trillion worth of banks assets hitting the markets. With 2012 starting with clear ‘risk-off’ signals from the sovereign bond markets and banks equities valuations, the near term future for Irish banks deleveraging plans can be described as bleak at best.

Further ahead, the process of rebuilding capital buffers, in both quantity and quality, can take core euro zone banks a good part of current decade to achieve. In this context, Irish banks deleveraging targets are grossly off the mark when it comes to timing and recovery rates expectations.

Progress achieved to-date leaves at least €35-40 billion in new assets disposals to be completed in 2012 – two-and-a-half times the rate of 2011. The two Pillars of Irish banking alongside the IL&P are now facing an impossible dilemma: either the banks meet their regulatory targets by the end of 2013, which will require deeper haircuts on assets and thus higher crystallized losses, or the 2013 deleveraging deadline is bust. In other words, Irish banks have a choice to make between having to potentially go to the Government for more capital or suffer a reputational cost of delaying, if not derailing altogether, the reforms timetable.

This is already reflected in the negative outlook and lower ratings given by S&P to AIB last month. The rating agency stressed their expectation of the slowdown in assets deleveraging in 2012 as one key rationale for the latest downgrades. Post-recapitalization in July, AIB core Tier 1 regulatory capital ratios stood at a massive 22%, the fact much lauded by the Irish authorities. However, per S&P “AIB’s capital ratio… will be between 5.5% ad 6.5% by 2013” due to materially “higher risk weights [on] capital, estimated deleveraging costs, as well as further capital erosion from the core business”.

Bank of Ireland finds itself in a better position, but, unlike AIB, it has much smaller capital reserves to call upon in the case of shortfall on July 2011 recapitalization funds.

Another area of concern for Irish banking sector relates to funding. Central Bank stress tests (PCAR) carried out in March 2011 assumed that by the end of 2013 Irish banking institutions will be funded on commercial terms. This too is subject to significant uncertainty as euro area banks enter a period of rapid bonds roll-overs in 2012-2014. Overall, the sector will face ca €700 billion of bonds maturing in 2012 and total senior debt maturing in 2012-2014 amounts to close to €2.2 trillion once ECB’s latest 3-year long term refinancing facility is factored in. For comparison, in 11 months through November 2011, euro area banks have managed to raise less than €350 billion in capital instruments, and various senior bonds. Again, international environment does not provide any grounds for optimism about Irish banks ability to decouple themselves from the ECB supply of funds.

In the short run, Irish Pillar Banks dependency on central banks’ funding is a net subsidy to their bottom line, as central banks credit lines come at a fraction of the expected cost of raising funds in the marketplace. This makes it possible for the banks to sustain their extend-and-pretend approach toward retail borrowers.

However, in the longer term, reliance on this funding represents major risks of maturity mismatch and sudden liquidity stops. The latest data clearly shows that the major risk of Irish banking sector becoming fully dependent on ECB as the core source of funding is now a reality. Reductions in the emergency liquidity assistance loans extended by the Central Bank of Ireland are now matched by increases in ECB lending to these banks. A recent research paper from the New York Federal Reserve shows that Irish banks continue to account for the largest proportion of all loans extended by the ECB to the banking systems of the euro area ‘periphery’.

Lacking functional banking sector, in turn, puts a boot into Government’s plans to use reforms as the vehicle for reversing credit supply contraction that has been running uninterrupted since 2008.

Another major risk inherent in the Irish banks’ funding and capital dependencies on Central Banks and the Government is the risk that having delayed for years the necessary processes of restructuring household debts, the banks can find themselves in the dire need of calling in the negative equity loans. This can happen if the Irish banking sector were to be left lingering in its quasi-transformed shape when ECB decides to pull the plug on extraordinary liquidity supply measures it deployed. While such a prospect might be 2-3 years away, it is only a matter of time before this threat becomes a reality and the very possibility of such eventuality should breath fear into the ranks of Ireland’s politicians.

As the current reforms stand, the sector will not be able to provide significant protection against the ECB policies reversal, even if the Central Bank-planned reforms are completed on time. The reason for this is simple. Our twin Pillar banks will be facing – over 2013-2018 – a rising tide of mortgages defaults and voluntary property surrenders, as well as continued mounting corporate loans losses as the economy undergoes a lengthy and painful debt overhang correction, consistent with the historical evidence of similar balance sheet recession.

While the capital for writing these assets down might have been at least in part supplied under PCAR 2011, the banks have no means of managing any added risks that might emerge alongside the mortgages defaults, such as, for example, the risk of their cost of funding rising from the current 1 percent under the ECB mandate to, say, 6 or 7 percent that private markets might charge.

For all the plans for banking reforms proclaimed for 2012 by the Central Bank and the Government, in all likelihood, this year is going to see more mounting corporate and household loans writedowns, amidst the continuation of the extend-and-pretend policies by the banks. The longer this process of delaying losses realization continues, the less viable the remaining banks assets become. And with them, the lower will be the credit supplied into the real economy already starved of investment and funding.

Box-out:

Irish banking sector structure envisioned under the Government reforms plans will not be conducive to an orderly deleveraging of the real economy and simultaneous repairing of the banks balance sheets. Sectoral concentration, in part driven directly by the Government dictate, in part by the massive subsidies provided to insolvent domestic banks, will see a colluding AIB & BOFI duopoly running circles around the regulators, supervisors and politicians.

How serious is this threat of the duopoly-induced markets distortions in post-reform Irish banking? Serious enough for the latest EU Commission statement on Bank of Ireland restructuring plans to devote significant space to outlining high-level set of subsidies that the Irish authorities are planning jointly with ECB.

No one as of yet noticed the irony of these latest amendments to the Government plans for the banking sector reforms: to undo the damaging effects of state subsidies to the incumbents, the EU and the Government will offer more subsidies to the potential newcomers. Such approach to policy would be comical, were it not designed explicitly to evade the real solution to the banking sector collapse in this country – a wholesale restructuring of the sector, that would have used insolvent banks’ performing assets as the basis for endowing new banking institutions to serve this economy.

30/12/2011: Taleb's quote

AN excellent quote from Nassim Taleb via @econbrothers :

"If we attempt to systematically extinguish all forest fires, we will eventually experience a big one".

Which, of course, goes to describe concisely and precisely the fallacy of rescuing all banks that Europe has pursued as a principled policy. The old Schumpeterian creative destruction is a required condition for functioning of the private economy, with the latter being the required condition for functioning of the public economy as well. Bankruptcy - as a tool for clearing the hazardously dead forest of private enterprises - must apply to the banks too.

By underwriting the entire private banking system, the EU has created the Mother of All Hazards - a dry forest with numerous pockets of quasi-extinguished fires burning. Now, all we need is wind...

13/11/2011: Non Performing Loans and links to macroeconomy

‘Often, the banking problems do not arise from the liability side, but from a protracted deterioration in asset quality, be it from a collapse in real estate prices or increased bankruptcies in the nonfinancial sector’’ (Kaminsky and Reinhart, 1999).

How true this sounds today. Take Euro area banks:

1) Collapse in US and European real estate valuations in recent years has triggered fall off in the value of linked assets held on the banks balance sheets

2) Collapse in the European bonds valuations has triggered a precipitous decline in core assets, including capital-linked assets

3) General recession have further undermined core assets on the loans side in corporate, SME and household lending.

A recent IMF paper: “Nonperforming Loans and Macrofinancial Vulnerabilities in Advanced Economies” by Mwanza Nkusu (2011) (IMF WP/11/161, July 2011) looks into the asset-focused linkages between financial and macroeconomic shocks, aiming “to uncover macro-financial vulnerabilities from the linkages between nonperforming loans (NPL) and macroeconomic performance in advanced economies”.

Based on a sample of 26 advanced countries from 1998 to 2009, the paper deals with two empirical questions on NPL and macrofinancial vulnerabilities: 

1) the determinants of NPL and 

2) the interactions between NPL and economic performance. 

With respect of the first question, the literature suggests that the determinants of NPL can be macroeconomic, financial, or purely institutional. In addressing the second question, the paper investigated “the extent to which falling asset prices and credit constraints facing borrowers may backfire and lead to an extra round of financial system stress and subdued economic activity”. 

The findings show that “NPL play a central role in the linkages between credit markets frictions and macroeconomic vulnerabilities. The results confirm that a sharp increase in NPL weakens macroeconomic performance, activating a vicious spiral that exacerbates macrofinancial vulnerabilities. …The broad policy implication is that, while NPL remain a permanent feature of banks’ balance sheets, policies and reforms should be geared to avoiding sharp increases that set into motion the adverse feedback loop between macroeconomic and financial shocks.”

Per authors: “empirical regularities …shape the modeling of NPL, …include the cyclical nature of bank credit, NPL, and loan loss provisions. In particular, in upturns, contemporaneous NPL ratios tend to be low and loan loss provisioning subdued. Also, competitive pressure and optimism about the macroeconomic outlook lead to a loosening of lending standards and strong credit growth, sowing the seeds of borrowers’ and lenders’ financial distress down the road. The loosening of lending standards in upturns depends on the existing regulatory and supervisory framework. In downturns, higher-than-expected NPL ratios, coupled with the decline in the value of collaterals, engenders greater caution among lenders and lead to a tightening of credit extension, with adverse impacts on domestic demand.”

In other words, first order effects of ‘positive’ pressures on lending expansion are reinforced by ‘positive’ second order effects of reduced risk management provisions, regulatory slackening and counter-cyclical capital buffers. Once things blow, however, the same effects again reinforce each other. The bubble acceleration is supported by both moments as well as the bubble explosion – yielding higher peaks and deeper troughs.

Thus, the determinants of NPL “are both institutional/structural and macroeconomic”.

The institutional / structural determinants are found in financial regulation and supervision and the lending incentive structure. “Intuitively, disparities in financial regulation and supervision affect banks’ behavior and risk management practices and are important in explaining cross-country differences in NPL.” 

The macroeconomic environment drivers work by altering “borrowers’ balance sheets and their debt servicing capacity. The set of macroeconomic variables [includes]… broad indicators of macroeconomic performance, such as GDP growth and unemployment...”

The core findings of the study are: 

• “A sharp increase in NPL triggers long-lived tailwinds that cripple macroeconomic performance from several fronts. …of all the variables included in the model, NPL is the only one that has both a statistically significant response to- and predictive power on- every single [macroeconomic performance] variable over a 4-year forecast period. …Regardless of the factors behind the deterioration in loan quality, the evidence suggests that a sharp increase in aggregate NPL feeds on itself leading to an almost linear incremental response that continues into the fourth year after the initial shock.”
• “The confluence of adverse responses in key indicators of macroeconomic performance—GDP growth and unemployment—leads to a downward spiral in which banking system distress and the deterioration in economic activity reinforce each other.”
• “The broad policy implication [is that] …policies and reforms should be geared to avoiding sharp increases that set into motion the adverse feedback loop between macroeconomic and financial shocks. … preventing excessive risk-taking during upturns through adequate macroprudential regulations is the first best.”

In other words, folks, you can’t ignore the macroeconomic effects of Non Performing Loans, as Ireland’s Government is implicitly doing by refusing to focus on repairing household debt overhang here. And, via a link between negative equity and NPL (the study cites evidence that house prices have direct negative effect on NPL – with house prices collapse leading to increased NPLs), we can’t ignore negative equity effects either.