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Economic Insights: Stress Tests, Bank Reform and Beware the euro

Last updated: 09:46 22 Jul 2010 EDT, First published: 08:46 22 Jul 2010 EDT

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Out of Europe

Crunch time or stitch up?
As more details emerge over the bank stress tests the more obvious it is becoming that most bank are either strong enough already to pass or will receive the necessary government support to ensure they  pass. The Governor of the Central Bank of Ireland said that both Bank of Ireland and Allied Irish Bank will pass only a few days after the Finance Minister had reported that AIB needed a further €7.4bn and the government would help. Others are finding it difficult not to talk up their countries’ own banks. This makes the exercise seem a little phoney but is certainly not entirely bad news.

As expected, the French banks have successfully lobbied for the Basel II definition of Tier 1 capital to be applied, which includes some less than permanent funds (unlike the FSA tests which only included core equity). The shrinkage rate to be applied to Greece sovereign debt is (after all) 17% (which seems too low), Spain and the UK are both about 10% (UK outstanding debt is a much higher percentage than Spain’s is the explanation), France is at 6% and Germany less than 5%. A leaked memo rather dispiritingly showed that as late as last Thursday there were still discussions going on about the stress scenarios. Mrs Merkel has today made a cryptic comment about taking into account the EZ bailout mechanisms. What can she mean? None of the countries will need to reschedule at all or, if they do, funds will be available to prop up banks who lent to them?  The Slovaks proved not so hard to persuade to ratify the EFSF stabilisation fund and it has been (wisely) decided to extend the fund’s life beyond 2012 if necessary. The Slovaks proved not so hard to persuade to ratify the EFSF stabilisation fund and it has been (wisely) decided to extend the fund’s life beyond 2012 if necessary. At least, the procedure for announcing the results is clear: after the close of business on Friday both the aggregate and individual figures will be published.

Everyone a winner?
Portugal and its banks have been downgraded again by the credit rating agencies and are having to rely increasingly on ECB funding (perhaps some of them will fail?) Spain has had two successful bites (€6bn in the previous week and €3bn of 15-year bonds last week) at refinancing the €24.7bn of repayments due in July, with strong overseas interest led by China (with 27 banks being tested, surely there will a fail or two there?). Greece is sticking to 3 and 6-month bills for the time being but is determined to keep returning to the market (no chance of failure here say the government and central bank, really?). Meanwhile, Moody’s have downgraded the good guys of Ireland to Aa1 because of ‘the government’s gradual but significant loss of financial strength’ (no failures there?). And the bad guys in Hungary are telling the IMF and EU to take a walk (surely a fail here, if only for the cheek?).

Euro excesses
The euro opened at $1.2642 and bounced up again after gathering strength on Monday and Tuesday, touching $1.30 on Friday before closing at $1.2926. In the recent past such a strong performance against the dollar would be associated with an increase in risk appetite but, as mentioned above, the market turned sharply to risk aversion on Thursday. In fact, the euro surged against risk currencies such as the Canadian and Australian dollars as they fell against the US dollar. It looks as if the market, after building up short positions since last December, suddenly felt oversold and a self-fulfilling buying panic broke out. Once they had started dealers were always going to push up through $1.28 and test $1.30. There is, however, a lot more to be done before the current levels can be sustained and most euro crosses have softened on Wednesday so far.

Bank Reform
The approval last week by the US Senate of the Bank Reform Bill, which had already been passed by the House, was a significant milestone in the global campaign to prevent a repeat of the crisis that followed the collapse of Lehman Brothers in September 2008. It may be useful, therefore, to assess the progress made in the US, UK and EZ where most of the problems have occurred.

Financial Stability

New Top Regulators. In the US a Council of Regulators is to be created to monitor and protect macroeconomic stability with powers to intervene if a product, practice or action of one or more institutions poses risks to the financial system. In the UK the new Financial Policy Committee within the Bank of England will have overall responsibility for macroeconomic policy while the MPC continues to be responsible for monetary policy. The EU has not yet gone that far: it has one Commissioner (Olli Rehn from Finland) responsible for Economic and Monetary Affairs and another (Michel Barnier from France) responsible for Internal Markets and Services.

New and/or reinforced regulators. Both the US and UK are setting up within the Fed and BoE respectively separate regulators for the banks/financial institutions and for consumer protection. In Europe there are various groups emerging such as the Committee of European Banking Supervisors (responsible for the Bank Stress Tests) and others to implement new consumer compensation schemes. There are also to be EU-wide regulators for each of the banking, insurance and securities sectors but the relationship with national regulators is as yet unclear.
Increased capital. The US and UK have already subjected their major banks to stringent stress tests and obliged them to raise new capital, including from the state if necessary. This was not popular with the banks and their European counterparts seem to have been more successful in limiting both the stringency of the stress tests and the consequences of failure: more will be revealed on July 23.

Hiving off riskier activities (the Volcker Rules). Although the transitional arrangements may last for 5 years or more, US banks will be required to put trading services for clients into separately and more highly capitalised subsidiaries that will not have access to the Fed’s discount window. There will be tight limits on the amount of a bank’s capital that can be invested in hedge, private equity and real estate funds. This does not quite represent the reintroduction of the Glass Steagall Act but it goes quite a long way. The UK government, especially Vince Cable, and the BoE seem keen to follow suit but will await the report (due next summer) of the Banking Commission chaired by Sir John Vickers. The independent but influential Future of Banking Commission (sponsored by Dr Cable while in opposition) has made fundamental recommendations specifically referring to the Volcker Rules. In Europe the banks again seem to be more successfully resisting such changes on the questionable basis that they would have difficulty raising sufficient capital.

Derivatives to be traded on recognised exchanges. This will involve much greater disclosure by the banks and all parties will thereby have a better understanding of each transaction they are entering into. This could well restrict the exponential rate of growth of more complex instruments. The UK is already considering similar requirements while some governments in Europe are contemplating outright bans on some kinds of transactions.
Shadow banking. This refers to funding provided by organisations that are not banks and do not have, therefore, access to the Fed. Mortgage-backed securities are the most notorious example and arguably the principal cause of the bank crisis. It is not yet clear how far the new regulations will extend but it appears arranging banks will be required to put some of their own capital at risk in a securitised issue. This is an area likely to generate much future controversy but mainly in the US.

Making Banks Stronger

Stress tests. Undoubtedly, these have made the US and UK banks stronger. An air of suspicion is hanging over the European tests as ministers and central bankers in country after country say that their banks will pass. To some extent the results were ‘fixed’ in advance by limiting the ‘haircuts’ on sovereign debts.  A 100% pass rate would be counterproductive and it must be assumed that the only failures will be those which needed bailing out anyway.
Higher capital requirements. The French and German banks have been lobbying for further delays in introducing Basel II let alone Basel III (the main difference is excluding from Tier 1 Capital anything other than core equity). However, the last G20 Summit agreed that Basel II should be implemented in major financial centres (including Paris and Frankfurt?) by the end of 2011 and everywhere else by the end of 2012. Implementation of Basel III is to begin by the end of 2011, whatever that entails. The US Bank Reform Bill is consistent with this in excluding various ingenious (but redeemable) preference share instruments from equity. Both the Fed and the FSA applied narrower definitions for their stress tests.

Bank failures better handled

Too big to fail. For the time being this problem has not been dealt with. Six US banks (Citigroup, JP Morgan, Bank of America, Wells Fargo, Goldman Sachs and Morgan Stanley) have assets totalling $9.4trn. The UK government has not yet decided to break up the Big Four over here. The Europeans are only talking about account holder compensation schemes.

Power to wind up. In the US the regulators will be allowed to seize control of a failing bank and conduct an orderly winding up. The sudden collapse of Lehman is generally reckoned to have been disastrous even by those who believed it should be wound up. This task should become easier once the different business activities have been fully separated and the banks are able to write meaningful ‘living wills’. In Congress the Republicans fought long and successfully to prevent taxpayer money being put into failing banks and also to block a levy on the banks to pay for future failures. Living wills are likely to be adopted in the UK and possibly to be made publicly available.

A lot more restrictions on banks
Regulators galore. The cynics say that the true winners of the bank crisis will be all the new regulators and the lawyers involved in drafting the new regulation. The really cynical are already saying that the biggest winners will be those bankers and their lawyers clever enough to circumvent all the new regulations.
Bankers’ pay. The idea is to restrict not just the amount but the form (i.e. shares vs. cash) and timescale of payments. The FSA has already introduced rules in the UK and other European countries will follow suit.
New taxes. The IMF were asked to make recommendations to the G20 and proposed two taxes: one on the riskier liabilities in the balance sheet (short term wholesale funding, commercial paper) and the other on profits before deducting employee pay. Canada and others are strongly opposed but the UK is going ahead on both fronts. France and Germany are planning to follow suit and President Obama has said he intends to do something in this area.

Our Conclusions
1    More attention will be paid to systemic risk and probably (hopefully?) by people who are qualified to do so.
2    Greater disclosure on risky products should help reduce risk. Bankers will say this will reduce profits and others will say the profits are illusory as even if they build up over a cycle they always get wiped out in a crash.
3    Banks will be stronger financially as a result of recapitalisation. European banks will lag their US and UK counterparts.
4    Bank failures and near-failures are likely to be handled better.
5    Bankers will be fettered by regulations and be less well paid. Many people will welcome this but some bankers will turn their hand (and other people’s money)to other risky activities with very high rewards.
6    The taxpayer rather than the consumer needs greater protection but all the new regulators will concentrate on consumer protection at great expense.
7    Somebody somewhere is already working on ideas that could lead to the next financial crisis. History offers little encouragement that all the bank reforms will be enough to thwart them.

Currency Fundamentals Watch
On May 19 we offered some thoughts on seven major currencies and, overall, they have moved in the directions we had suggested but the fall and recovery of the euro have been larger and more rapid than anyone suspected.
US dollar: Interest rates remain the main variable but these seem to be even further off and this could well limit the upside. Swings in risk appetite appear to be having less effect but the dollar is now looking less likely to become a ‘good news’ currency.

Euro: The single currency seems to be at the mercy of very large speculative flows both defensive (covering exposures) and aggressive (opening new exposures) as opinion veers over the chance of its surviving.. Economic fundamentals remain weak although German exports have increased sharply in 2010 on the back of a softer euro. The ECB appears to be backing away from any QE measures that would weaken it.
Pound: The Emergency Budget has been well received despite the expectations of consequently lower GDP growth. Despite the current debate about stubborn inflationary pressures a base rate hike seems as far off as ever and any reversal of QE now looks unlikely before early 2013.

Yen: Another ‘victim’ of huge speculative flows and the government would like it to weaken substantially. It may well take several months to happen but the yen looks vulnerable to a sudden swing against it.
Renminbi: The bullet was bitten and the dollar peg ended. The authorities may well prefer (as do the MAS in Singapore) to use a gradual increase in the exchange rate to dampen inflation rather than putting up interest rates.
Canadian dollar: After Tuesday’s slightly surprising increase the BoC will probably now hold interest rates for a few months which should discourage further any new attempt on parity with the USD.
Australian dollar: Despite the election in August the usual day-to-day volatility is likely to be in a relatively narrow range.

Beware the euro
Movements of the recent magnitude are typically driven by large speculative flows rather than reflecting economic fundamentals although the latter can act as catalysts. We would suggest the following simplified chronology:
The story starts, as many do, in the summer of 2008 when global markets began to panic and the Lehman crash provoked further falls in most risky assets (i.e. other than the dollar, yen and bonds). From July to October the euro fell from around $1.605 to $1.233 in November

By the end of 2008, however, a combination of a recovery of market nerve and end of year profit-taking saw the euro bounce all the way back to $1.47.

By March the euro had slumped again to $1.245 The rest of 2009 saw a strong recovery in global risk appetite and the euro was one of the beneficiaries surging to $1.514 by November.

Over the turn of the year the euro (and pound) became decoupled from other favoured risky assets and by March it had slumped to around $1.37

The Greek crisis took hold from March and by the end of April had become part of a wider fall in global risk appetite. As many began to doubt that the euro could survive the rate fell in early June to as low as $1.187, within sight of its birth rate of $1.18 in January 1999.

Out of the panic and acrimony of the EZ leaders emerged the European Financial Stability Fund and some, but far from all, of the doubts about the euro’s survival began to recede. That seemed to be enough to persuade many investors that they should cover their one-way bets and take some profits. This happened on a sufficient scale to induce another wave of speculative buying and one by one technical resistance levels were breached until $1.30 was touched on 16 July.

S1.30 was reached again on Tuesday 20th but the euro is once again looking vulnerable as investors await the results of the bank stress tests.

These large swings serve to discredit the euro as strong and stable, rivalling if not replacing the dollar as a global reserve currency. It will, of course, continue to be half of the most traded currency pair and because sterling gets pulled along by it the EUR/USD rate has to be monitored closely.
  
We would repeat our warning that whilst our various comments on currencies may be helpful for hedging purposes they are not trading recommendations.

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