What us, worry? Banks double down on risk

Other investors argue that banks are sitting on bigger inventories of securities to provide liquidity to capital markets, and that otherwise; investors could have much more trouble buying and selling securities.

By (Reuters)

Published: Wed 27 Jan 2010, 3:01 PM

Last updated: Mon 6 Apr 2015, 10:27 AM

Bond time bomb?

Perhaps the greatest concern, however, is that banks are hoarding government bonds.

According to the BIS, banks are buying government bonds for two reasons: because of lower demand from consumers and companies for loans; and because they want to reduce the riskiness of their balance sheets.

Another factor is that regulators, in an attempt to ensure that banks are better able to withstand a sudden freeze in the capital markets, are demanding that they hold greater reserves of liquid securities. In practice, these are likely to be government bonds.

In the United States, holdings of government bonds by banks fell from 16 percent to around 10 percent in the decade up to 2007, according to the Federal Reserve, but have increased again since the crisis struck.

Some bankers believe this is a significant issue.

Historically, banks’ risk models have tended to assume that the bonds of developed countries were close to risk-free assets. No longer. The government finances of peripheral countries such as Greece and Ireland are already creaking. And many investors believe it is only a matter of time before ratings agencies lower the UK’s credit rating. A downgrade — or, heaven forbid, a default — could leave banks exposed.

“Banks are filling their books with long-dated government paper, funded with short-term government funding,” said a senior executive at a large UK-based bank, who asked not to be named. “It’s the biggest carry trade in the world.”

Interventionist Governments

Apart from creating systemic risks, however, large-scale purchases of government bonds by banks are also failing to fix the paltry flow of credit. Despite the liquidity being pumped into the economy, lending to consumers and small- and medium-sized businesses has not yet picked up.

It is not entirely clear banks should be blamed. One explanation is that demand for credit has fallen as consumers and companies decided they had too much debt. The moribund state of the securitisation market has also crimped lending, as has the burden of badly performing commercial real estate loans in the U.S. on medium and small-sized banks.

Bankers also point out that some people who took out loans during the boom should never have been allowed to borrow so heavily.

Even so, this situation contributes to the widespread public perception that bailing out banks has been of no benefit to the broader economy. The longer this continues, the more likely it is that governments will interfere in banks’ affairs.

Indeed, it is perhaps surprising that government interference has been so limited to date. Since the crisis erupted, governments have upheld a fragile consensus that any financial reform should be implemented on a global basis.

Naturally, that’s made this process slow and time-consuming. Though regulators have made progress in drawing up new rules dictating how much capital banks should hold, these will not be finalised until the end of the year, and will probably not be in force before 2012.

“Because the crisis was so big and because the capital markets are so rich, you can’t have three or four central bankers sitting in a room and deciding,” said a European central banker who asked not to be named. “That means the technocratic debate takes a lot longer.”

In recent weeks, political pressure has spilled over as countries — particularly the United States — have unilaterally introduced new taxes and regulations. President Barack Obama wants to tax banks’ wholesale funds and has promised “a fight” with Wall Street if it resists his proposal to stop investment banks from engaging in proprietary trading. The United Kingdom has introduced a 50 percent windfall tax on banks who pay their employees bonuses of more than 25,000 pounds. Faced with a combination of fiscal pressures and profitable but unpopular banks, other countries are bound to attempt similar moves.

These moves may make political sense. But some investors fear that overt bank-bashing by politicians will undo much of the benefit of the bailout.

“Political interference could derail all the efforts made so far in restimulating the economy,” says Davide Serra, co-founder of Algebris, a London-based hedge fund that specialises in financial stocks. “If you crack confidence because you see fights between financiers and governments, these actions have a massive cost to the economy.”

Deleveraging Dilemma

Any discussion about the response to the crisis must acknowledge the need to reduce the levels of debt that have been built up. A study by McKinsey, the consultancy, found that previous deleveraging episodes have generally taken four forms: a period of belt-tightening, in which credit growth lags behind economic growth for many years; massive defaults; high inflation; or a period of rapid GDP growth as a result of a war effort or an oil boom.

The most likely outcome is that deleveraging will lead to a long, slow slog. Indeed, falling property prices in the developed world mean many consumers are now more leveraged than they were before. According to Oliver Wyman, the ratio of household liabilities to financial assets in the U.S. is now 40 percent. Two years ago, it was 29 percent.

Another big concern is that the global economic imbalances — whereby Western economies import and consume and Asian economies export and save — have not yet been addressed. China’s foreign currency reserves are now $2.4 trillion. Japan has reserves of about $1 trillion.

Mervyn King, the governor of the Bank of England, likens this buildup of international assets and liabilities to adding blocks to a tower.

“With skill, it can be done for a surprisingly long time. But eventually the moment comes when adding one more causes the tower to fall down,” he said in a recent speech. “If countries do not work together to reduce the ‘too high to last’ imbalances, a crisis of one sort or another in financial markets is only too likely.”

For central bankers, politicians and policymakers, then, the challenges are immense. They must withdraw the financial support that has been provided to the financial sector without triggering a collapse, but before new risk-taking creates the conditions for another collapse. They must overhaul regulation to make banks safer while reversing the moral hazard that has characterised the current round of bailouts. They must manage a controlled reduction of government debt. And they must attempt to rebalance the world economy without withdrawing into conflict and protectionism.

There is little doubt that the authorities’ swift response to the crisis prevented an even more severe economic collapse. But the global financial system is far from being fixed.

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