Vladimir Putin, Sanctions and the Ukraine

Roy C. Smith and Ingo Walter
 

Vladimir Putin, a martial arts enthusiast, must be an admirer of Muhammad Ali, master of the famed “rope-a-dope” strategy in boxing. Putin’s antics are a mirror image of Ali’s in-and-out style, but in a different arena. Annexation of territory, soldiers losing their way on somebody else’s property, cross-border artillery barrages, anti-aircraft missiles that aren’t there but leave 297 passengers blown out of the sky, solemn agreements unremembered after lunch.

Many observers think Putin’s strategy is working. The Obama Administration’s reliance on sanctions and world opinion seem too weak to derail Putin’s aggression - which suggests a tougher, military alternative that would fall largely on the US. But supplying and supporting the Ukrainians militarily in Russia’s back yard could easily lead to escalation.

Reliance on military involvement may well be unnecessary. In the long run, Putin’s actions are self-destructive on several important economic fronts that are likely to be powerful enough to moderate them sooner rather than later. Each relies on the disciplining force of economics and markets.

Despite Putin’s periodic interventions, Russia’s economy has become highly linked to the global economic and financial system - to the great benefit of the Russian people. Exports (mainly oil and gas) account for 43% of its GDP and more than 50 percent of its fiscal revenues. Rising oil prices and increasing global involvement enabled Russia to achieve an average annual GDP growth rate of 7.1% from 2004 to 2008 and attain prominence as an emerging market economy - something that was unthinkable a couple of decades ago. While Russia’s growth rate declined after the global financial crisis, like most other countries, it was still able to attract $94 billion in foreign direct investment in 2013. At the beginning of 2014, Russia even broke into Bloomberg’s list of the top 50 countries for doing business.

Putin’s bellicose initiatives have resulted in modest sanctions which, limited and recent as they are, have already had a significant effect on markets. Russian GDP growth in 2013 dropped to 1.3%, down from 4.8% in 2012, and is expected to be zero or less for 2014. The ruble and stock prices are down around 15% for the year, the 10-year Russian government bond, reflecting an increase in inflation to 7.5%, now yields 9.7%. Capital outflows exceeded $100 billion in the last year. Access to foreign financial markets, from which Russian banks have obtained the majority of their funding, has been denied and inward investment has effectively been brought to a halt. Oligarchs are getting their money out as best they can while Russian banks and industrial groups are repatriating theirs to avoid future sanctions.

New sanctions now being considered by the EU at America’s urging could limit non-contractual oil and gas sales and the use of the dollar and euro payments systems, as well as blocking access to funds held externally by Russians. In combination, these would substantially constrict the Russian economy and most likely drive it into recession.

Today’s financial reporting requirements and payments tracking technology make it very difficult to evade sanctions, and their enforcement by determined regulators is relatively simple - as was demonstrated in the recent $9 billion BNP Paribas settlement with the US government. Sanctions take time, but they can work.

Putin’s actions have frightened Russia’s most important customers. Already the EU is accelerating efforts to find alternative suppliers and sources of energy – Europeans may restart nuclear reactors, invest more in conservation or in fracturing, recommit to wind or solar sources, or import LNG from the US. Technology has increased their choice of practical alternatives, certainly over the longer term, and Putin has provided an excellent reason to move ahead with greater urgency.

Russia’s European customer base formed a steady, safe, lucrative and growing market for its energy exports. Now it will increasingly have to replace these customers with less dependable and less profitable markets elsewhere. Russia’s recent 30-year ($400 billion) deal with China is an example, but it will take years before shipments flow and much can change in the relationship between Russia and China over the life of the contract.

The Ukraine conflict began a year ago with a domestically popular effort by Kiev to link more closely to the EU in order to expand economic opportunity. It was halted by Ukrainian President Viktor Yanukovych apparently at the behest of Vladimir Putin, who did not want to “lose” the Ukraine to the West. Demonstrations on Maidan Square ended with Yanukovych’s forced departure and the formation of a new, much more westward leaning government that was soon opposed by Russian-backed separatists in the East.

When forced to choose between the kind of prosperity common in Poland and other Eastern European countries and reverting to political and economic subservience to Russia, it is not surprising that the majority of the Ukrainians selected Europe. Their willingness to endure hardship and violence to move in that direction may be surprising, but their actions did not go unnoticed by others in the Russian Federation, or within Russia itself.

Putin’s rope-a-dope tactics aimed at preserving the Russian sphere of influence appear to be popular in Russia, where national pride and honor have been revived. Russians have long suffered economic hardship in the past, but, having tasted prosperity, will they tolerate losing it? Could the next Ukrainian-style demonstrations happen in Red Square?

Over time, Putin’s actions threatens to isolate Russia from the world free-market economy, which operates on the basis of maximizing growth and opportunity. A retreat into a Soviet-style shell will have consequences he may not be able to endure for long. He needs a political solution that creates an effective “reset.”

Mr. Obama’s job is to keep his eye on the long-term prize – turning things around with Putin to get him back on-message in the global economy. Global economic pressures -- workable new tools of the 21^st Century that are preferable to Cold War saber rattling -- can be very powerful in helping to shape national behavior.

Blueprint Needed to Rebuild Structured Finance

By Roy C. Smith

While the corporate side of global finance is recovering well, another side that suffered in the crisis is still ailing so badly it is a drag on the US economic recovery as a whole. Mortgage-backed securities may have got a bad name in 2007-2008, but some way to revive the structured finance market must be devised to get the housing market out of the doldrums.

Corporations around the world issued $2.1 trillion dollars of new bonds in the first half of this year, according to Dealogic, setting a record.  The issues included corporate investment grade, high yield and financial industry bonds. Corporate new issues of stock (including a big increase in IPOs) also increased over the first half of 2013, to $489 billion, a 20% improvement.  So global capital markets are on track to provide about $5 trillion of corporate finance in 2014.

Banks also provide global syndicated loan facilities (including bridge and other leveraged loans, and refinancing) to corporate clients. For the first half, the volume of all such loans was $1.7 trillion, up 8% on 2013 and the highest since 2007. 

The main difference in capital market activity since the crisis, however, has been the plunge in global “structured finance” (securitised debt). In 2006, $2.8 trillion of global structured finance issues were sold.  By 2013, volume had dropped 70% from its peak, to $790 billion, and at a pace of $356 billion in the first half of 2014, it appears to be drifting even lower. Most of the decline in structured finance has been in mortgage-backed securities, especially those issued without US federal agency guarantees.

In the US, banks make mortgage loans based on credit scores, then sell the loans to federal housing finance agencies (the Federal National Mortgage Association, Fannie Mae, or the  or Federal Home Loan Mortgage Corporation, Freddie Mac) that guarantee the loans and package them into mortgage-backed securities to be sold to the market.  The banks recover their investment and repeat the process, providing a continuous, relatively low-cost flow-through mortgage finance system that greatly aids the real estate industry.

A Serious Structural Problem

The collapse of the mortgage finance system has left a serious structural problem. The system is now being squeezed at all its vital points.

The federal mortgage agencies are not playing the flow-through role they were. Before the crisis they were aggressive, overleveraged and devoted to expanding home ownership by lending to weaker credits. But  since being taken into federal “conservatorship” in 2008, they have deleveraged, become more cautious and been made to run a tight ship.

Under conservatorship (which lasts indefinitely) the agencies have had to rebuild their balance sheets, repay the government the $187 billion of bailout funds they received, and distribute all free cash flow to the government, not to investors. In the process, the agencies have cut back their purchases and securitisation of mortgages from pre-crisis levels; in 2013 these were 13% less than the year before,  and down a little more in the first half of 2014.

Non-agency credit sources have disappeared; the agencies now guarantee nine of ten US residential mortgages.

Banks, addressing their own balance sheet problems, have pulled back on loans to borrowers with lower credit scores. But the pace of the pull-back has accelerated. In the first half of 2014, total mortgage lending declined by 53% from 2013 levels, according to Inside Mortgage Finance, and non-bank mortgage lenders among the top 30 originators accounted for 23% of the market, up from 11% in 2012.

Partly this decline is because the largest US mortgage lending banks (Wells Fargo, Bank of America, JP Morgan and Citigroup) are wary of doing business with the federal agencies. The banks have complained of the massive government lawsuits over technical breaches and failures that occurred long after the loans were made, but felt they had to settle rather than face the risk of losing at trial. 

Fed chair Janet Yellen said in June that this concern by the banks has substantially dampened the recovery of the US housing market. Sales of existing homes in July  were 4% below the 5.4 million-unit level of July 2013 and sales to first-time buyers remain historically low, according the National Association of Realtors. House sales are still about 25% below what they were in 2006.

Restoring housing activity is a key, but still missing, component of the broad economic recovery that the government says it is seeking.  A drying up of mortgage credit has continued to be a drag on the housing market.  It may get worse before it gets better.

In August, John Stumpf and Jamie Dimon, chief executives of Wells Fargo and JP Morgan, respectively, warned (separately) that unless the government offered a “safe harbour” from such litigation, based on clearly defined rules for handling the business, they would hold back from making new loans to the millions of people with lesser credit scores that are looking for mortgages.

Resuscitate the private sector

The Treasury tried to get out in front of the housing finance problem in February 2011 when it announced a plan to wind down the housing finance agencies over time to be replaced by private capital that would be appropriately disciplined by Dodd-Frank’s enhanced regulatory umbrella.

The Treasury has done little since then to support the plan or to explain how it might happen. A bi-partisan effort in the Senate was made this year to bring a bill to restructure the housing agencies. This much anticipated bill, which endeavored to get rid of the federal agencies but preserve the government guarantee of mortgage loans and a commitment to “affordable housing” ,disappointed just about everyone when it was revealed in March, and is now permanently stalled in committee.  

The best hope for restoring mortgage finance activity is to rethink ways to get the private, non-government guaranteed portion of structured finance market restarted. Surely a new set of more conservative and transparent mortgage backed securities that would appeal to institutional investors (especially in this low interest rate environment) can be created, but it will take a combined effort of the banking industry, credit rating firms and public regulators to make it work. They will have to cooperate to establish a new set of standards for what goes into the securities, how they are to be analysed and rated, and how regulatory safe harbour rules will work to enable the issues to be underwritten.

This is really a job for old-fashioned investment bankers to take on, one that requires a lengthy series of patient negotiations with the various parties involved to produce a workable prototype for a whole new market to develop. Sigmund Warburg and his partners created the first Eurobond through such a process in 1963.

A similar effort is now essential to redesign the global structured finance market.

From Financial News, 8 Sept., 2014

Can Black Political Empowerment Help Save Ferguson?

 

Can Black Political Empowerment Help Save Ferguson?

Ingo Walter

Looking ahead at the future of Ferguson, Missouri after the events of recent weeks, it seems certain that the overwhelming African-American majority will press for empowerment in municipal affairs. This transition needs to come with a parallel effort to strengthen the municipal economy, drawing on any and all local and external resources to prevent a “politics of scarcity” that can end badly for the town and its residents.

Drive a short distance west of “ground zero” in Ferguson toward Lambert St. Louis International Airport, and you will find the overgrown lots, blocked streets and crumbling building foundations of Kinloch, once an all-black town of about 10,000 residents – one of nine such cities in the US back in the 1960s.  Kinloch at the time was a politically autonomous black community, created in 1948 by residents of an unincorporated area of St. Louis County – then a blank space on the map of mainly middle-class white towns that had incorporated in the region over the years.

Some residents had migrated to Kinloch from the South in the 19^th and early 20^th Centuries. Others settled as returning soldiers after World War I, and some moved from Illinois after East St Louis race riots in 1917. After World War II, new residents often sought refuge from poor living and housing conditions facing African-Americans in the City of St. Louis, particularly in the “projects.”

By incorporating, Kinloch residents were fully empowered at the municipal level, and were free to plan and conduct their own affairs by whatever means they chose to try improving their conditions of life. Indeed, the town was established on the premise that, through a substantial measure of self-determination, African-Americans could gain for themselves what they were denied in superordinate white-dominated political structures. The town formed a circumscribed and identifiable political unit, and its well-marked borders formed social as well as political boundaries. For advocates of separatist-style Black Power in those years, Kinloch might have provided an ideal beta-test for the independent development of black-led institutions and separatism.

But in a social and economic study of Kinloch at a time of serious US racial tensions in the late 1960s, John E. Kramer – then a sociologist at the University of Missouri - St. Louis – and I concluded that the overall effect of political autonomy on Kinloch’s economy was primarily adverse. For all of its political autonomy, Kinloch appeared to be a strikingly depressed and stagnant zone of economic deprivation even at its peak, in the midst of a rapidly growing region during the prosperous years of the 1960s. The social and physical contrasts between it and its immediate neighbors like Ferguson were remarkable and obvious.  

Making sustainable economic progress proved to be a tough slog for Kinloch. There were new street lights at street corners, a new fire engine and some other gains, but such progress may well have materialized anyway if the community had remained an unincorporated area of St. Louis County. A large 1965 federal grant for sewer con­struction might not have been forthcoming had Kinloch remained unincorporated, but the grant seemed less a consequence of political autonomy and the develop­ment of strong indigenous political institutions than the result of one individual's personal initiative. Most importantly, the Kinloch schools remained a hopeless exercise in economic hardship, even as social ties centered on the town’s churches were impressive and serious leaders emerged from time to time to try and make a difference.

Meantime local taxes were much higher than they would have been if the municipality had not been formed. The tax base was just too small. So Kinloch residents had lower disposable incomes under home rule and public revenue was woefully deficient. The sadly inferior schools the town was able to maintain had an evident and predictably deleterious effect on the academic and vocational skill levels of its work force at a time of plentiful jobs in the St. Louis region. Perhaps the most discouraging single image during our research was a large pile of books, donated by other St. Louis County school districts, piled in the library basement under a foot or two of water.

In the end, we concluded that the residents of Kinloch had gained little in a material sense from political independence, and may have lost a good deal more – we could find no identifiable connection between political autonomy and improvement of economic welfare. The economic “air supply” was absent, and there was nothing on the horizon back fifty years ago that might have given give substance to hope - the critical sequencing of economic development and political empowerment suggested in Jason Riley’s new book Please Stop Helping Us (2014) in the case of Kinloch was in effect reversed.

There is also the irony of attempting a separate-but-equal approach to civil and political organization even though that same approach had been ruled unconstitutional and inherently unequal in the educational sphere more than a decade earlier.

In the 1980s much of Kinloch’s land was taken over in an Airport noise abatement project and the most recent data (2010 Census) records a mere 299 residents. So it’s not possible to assess how Kinloch would have fared during the late 20^th and early 21^st centuries.
 

In today’s coverage of Ferguson, few media reports mention neighboring Kinloch, and when they do it’s about unruly kids crossing the town line and vandalizing local homes. Going forward, developments in Ferguson are uncertain. However, in Kinloch we have a valuable, nearby warning that empowerment, desirable as it may be, is limited in its ability to foster development. In the end, people want to improve their lives. Period. And that involves going back to the basics of creating marketable labor skills, attracting capital investment and providing well-funded public services. If the new Ferguson wants to succeed, an object lesson is right next door. Political empowerment by itself won’t cut it.

A “Safe-Harbor” for Ethical Conduct at Banks

By Roy C. Smith

The NY Fed said recently it would hold a “workshop on bank ethics and culture” in the fall. It is stepping up pressure on banks to exercise better leadership to prevent abusive conduct that still seems prevalent in some institutions long after the lessons of 2008 were absorbed. How it should do so is still in doubt.

Alleged rigging of LIBOR and foreign exchange markets, efforts to aid clients in evading US taxes, and conflicts of interest and inadequate disclosure related to dark pools operated by banks have been at the core of recent events that have upset regulators.

Most of these allegations have involved foreign banks operating in the US, but recent settlements of federal charges related to the sale of mortgage-backed securities by JP Morgan and Citigroup (and prospectively Bank of America) have kept US banks in the arena.

The Fed is suggesting that part of its annual stress test evaluations of big banks will include queries into their ethical and cultural fitness.  If the threat of additional multi-billion dollar lawsuits hasn’t been enough to get the attention of bank CEOs, then possibly failing a stress test should be. The combined power of the Justice Department and the Federal Reserve to punish discretionary findings of a qualitative nature is certainly an important game changer for the US banking industry.  But is a new reality.

The banks might argue that they have been unfairly required to shoulder most of the blame and financial responsibility for the economic effects of the financial crisis. Much (though not all) of what they did was to seek innovative but untested approaches to creating new products or client accommodations for which there was considerable demand by knowledgeable financial institutions.

The banking industry is global and very competitive, and individual banks must be innovative and accommodative to survive. They are also corporate entities seeking to maximize profits in accordance with the law and ethical norms. In times of market ebullience and technical changes such as CDOs and high frequency trading, what the law and ethical norms may be can be quite unclear.

The Fed probably takes the view that much of what actually happened was the result of the banks loosing control over the actions of their employees who were aggressively taking as much advantage of the bubble as they could to boost the banks’ profits and their own compensation. The ethical and cultural tone of a bank needs to be set at the top, the Fed has been telling executives, according to The Financial Times, which all of the bank CEOs, of course, say they do.

What the ethical and cultural workshops will accomplish is unclear. Such events have a history of being of little value, but, with some effort by the Fed, the forthcoming ones could be quite useful.

The Fed could begin by defining the standards it wants banks to meet. These should begin with the requirement that all banks strive to achieve a culture that values high ethical conduct and insists on treating all customers and clients fairly. The effort to do this is auditable to a reasonable degree.

The Fed could say that it will provide a “safe harbor” for banks (i.e., it will hold them harmless) if they can demonstrate that they have adopted and enforce policies that make unit heads and mid level management responsible for the integrity of products and marketing and sales procedures. Those that involve potentially injurious conflicts of interest, or rely on loopholes or technicalities to make it to market, need to be nipped in the bud. Violators must be stopped at the point of origination, and dealt with appropriately. Compensation policies also must be modified to allow generous bonuses for problem averting activities, but, as with all bonuses, with meaningful clawback provisions.

The safe harbor idea could be adopted by the ECB as well. It has a similar need to upgrade ethical standards.

Making mid level managers responsible for playing defense and well as offense may be a change that will require additional training over time, but will produce better senior managers. There are thousands of these people in every large bank, so a lot of management development work will be necessary to reprogram them.  Today banks are hiring thousands of new compliance officials to manage the new regulations they must accept, but these people are not the core future management of the bank, the mid level people are. Hiring more compliance people should not be in lieu of empowering mid level operating people.

The mid level guys are also the ones the banks depend on the to make adjustments to products and services so as to adapt to the new regulatory and market environment and to position their banks for the future.  Perhaps they need a way to discuss new product ideas confidentially with the Fed, either just before or after a new approach is introduced.  If the Fed challenges the new idea, the bank should be allowed to withdraw it with impunity.

For banks to be active and competitive they need also to be healthy and economically viable. Investing in greater defensive empowerment of the mid level could be economically very advantageous if it means banks can avoid the massive legal costs of the past few years in the future, and if the effort enables the banks to regain the reputational value that has been lost.

The largest capital market banks have been struggling for years to regain economic viability and to restore their reputations. They could benefit from some helpful understanding from the Fed, which, particularly in view of its enhanced discretionary powers, should advocate roll-back of restrictive regulations put on in the heat and darkness of Dodd Frank but not really necessary to maintaining banks’ fitness and properness in the future.

All this is good stuff to discuss at a workshop, but finding common ground for a workable safe harbor is the real objective.

From Financial News, 11 August, 2014

 

Understanding the Russian Sanctions

By Roy C. Smith and Ingo Walter

The latest tightening of the US and EU sanctions on Russian business and finance will provide an interesting lesson in international political, economic and military affairs. Here are some key issues to think about:

These Financial Sanctions Can Be Very Potent

They deny Russian access to capital markets in the US and Europe, which is to say global capital markets. Asian markets are not included but they are not significant enough to matter much.  This is the most important sanction imposed on Russia so far, since Russian banks and businesses have been obtaining about half of their total funding requirements from these markets over the past three years, according to the FT. 

Between them, Russian non-financial state-controlled companies ($41 billion), state banks ($33 billion), private banks ($20 billion) and non-financial private companies ($67 billion) will have $161 billion of foreign debt maturing in the next 12 months. The sanctions prohibit these borrowers from rolling-over this debt.

Where’s the Re-funding Money Going to Come From?

The Russian borrowers will have to obtain funds from sources other than the capital markets to avoid default.  The logical main source of refinancing is the Russian central bank, which can draw upon the country’s $500 billion or so of foreign currency reserves.  Russia has the means to absorb the effects of the sanctions for a few years, at least, but the effects on economic performance will certainly be meaningful. It could have the effect of shutting down Russia’s internal credit generating capacity.

If Russia fails to refinance its maturing debt, the borrowers will have to default – and since many of the borrowers are state-controlled, this will turn into a “sovereign” default. Default makes all outstanding foreign debt become immediately due and payable.

This will trigger all sorts of additional denials of credit to Russian banks and businesses, which would deepen the isolation of the Russian economy, reduce the value of its currency, increase interest rates and inflation and curtail domestic growth, which is now forecasted at about 0% for 2104. 

Adding to the pressure is the recent ruling of the international Court of Arbitration in The Hague that the Russian state misappropriated assets of Yukos several years ago and must return $50 billion to shareholders of the company. Russia does not want to pay this claim, but it is an obligation of the government and surely will involve default litigation if not paid.

Default most likely would trigger a rush by foreign creditors to impound Russian assets abroad (think of Lukoil’s gas stations and Aeroflot aircraft “arrested” at JFK Airport), plus certain foreign currency receipts - including (possibly) those related to sales of oil and gas and other commodities.

Some may not believe a default would have that much of an impact. Russia says it can become more self-reliant. But just ask Argentina about its economic track record since 2001, when it undertook the world’s largest default, compared to how the country would have done otherwise. Now that Argentina in on tenterhooks again after 13 years in default, stay tuned. Russia tried a debt “moratorium” in 1998, and learned to regret it. The key to avoiding default is the ability and willingness to service foreign debt. Russia may be able but unwilling.

The Other Announced Sanctions are Meaningful - But Longer-Term

They also include prohibitions on the access to oil and gas industry technology that is crucial to Russia’s ability to develop its energy reserves in the future, and limit transactions in the armaments industry. The effects of these sanctions are much more structural and will only be felt over the years, but they are important nonetheless.

The Sanctions Are Enforceable.

As we saw in recent US litigation of major European banks engaged in sanctions-busting, violations of the rules related to the enforcement of sanctions can involve very meaningful penalties. These rules are now not just American rules, but have been adopted and will be enforced in Europe also.

Economic Sanctions Can Replace Military or Diplomatic Moves

The Russian sanctions are the first set of US and European economic  “blockades” that have been applied to a major country with serious military capability. They may have a chance because of the increased globalization of the Russian economy which brought with it growth and increased prosperity for its people. Sanctions can result in a serious drop in Russia’s domestic economic welfare and possibly cause pressure on the government to change its behavior in Ukraine in order to avert domestic discontent.

But don’t bet on it. Russia is far from democratic. Russians are nationalistic and Putin at least temporarily is at the top of his game. He thinks Russians are stoic and suffer well – invoking World War II and decades of stagnation under Communist rule. His oligarchs and cronies are certain to squeal under the sanctions, but he can pick them off one at a time. And he can point to the spotty record of sanctions imposed on countries like North Korea, Cuba Iraq, Sudan and Iran in changing offending policies.

But whatever he says, these sanctions are going to be painful and reduce growth and economic opportunity for all the Russians. It will be an interesting time. Fasten your seat belts.

The New Unwritten Mandate for the Fed

Roy C. Smith and Ingo Walter

In recent testimony before Congress, Janet Yellen noted that “protecting the US from systemic risk is an unwritten third mandate of the Federal Reserve,” the other two being keeping inflation under control and promoting full employment.

Received wisdom says that managing two conflicting goals requires at least two policy tools. The classic duo of monetary and fiscal policy to manage inflation and unemployment has encountered plenty of problems over the years, with atrophied fiscal policy (heavily weighed-down by entitlement and other non-discretionary spending, and equally heavily politicized) placing a heavy burden on the Fed – one that is unlikely to go away anytime soon.

Now comes another policy target: safety and soundness of the financial system, using the same toolkit (with some unconventional tweaks) that is already stretched.

The three mandates get in each other’s way, making things worse rather than better.  

Zero interest rate monetary policy and Quantitative Easing were intended to stimulate consumption and investment spending, boost the trade balance through a weaker dollar, and cut unemployment. But, in keeping both short and long term rates well below market levels that would otherwise properly reflect a debt risk premium and inflation, both policies involve significant distortions of markets.

Neither policy, however, seems to have been particularly effective: Economic activity expansion since 2008 has averaged less than 2%, well below the US historical average of 3.5%.  Though the unemployment rate has fallen from a peak of 10% to just over 6% in the past six years, in June of 2014 only 59% of the civilian labor force was engaged in full time employment, still less than the 63% employed seven years earlier.  Now comes Obamacare, encouraging companies to substitute part-time for full-time and duck under company employment minimums. Around 17% of the labor force today is unemployed, stuck in part-time work or has given up looking for jobs.

The overall recovery of the US economy from the financial crisis of 2008 is one of the slowest on record.  It is certainly miserable compared to recoveries from the five previous US recessions, although defenders can always argue that things would have been immeasurably worse without the Fed’s unconventional policies. Who knows? We can’t run the world twice.

The stock market’s sharp recovery is an offset to the gloomy picture, but even that only reflects a modest 4.2% annualized growth in the S&P 500 index from its 2007 peak level.

We believe, along with many others, that the ongoing slow recovery has a lot to do with the curtailment of credit from the banking system to the real estate, commercial and entrepreneurial sectors of the economy due to efforts to “control” systemic risk by the Federal Reserve and other financial regulators.

From 2008 to 2012, US bank loans shrank at a rate of 4% annually – due in large part to de-risking household, corporate and bank balance sheets in the first couple of years of the recovery. Since 2012, loans have increased by 3% annually, a significant relative change but still a very low rate of growth in lending. Recently the Fed reported that much of the new lending was in the riskiest credit categories – borrowers that banks have been driven to for profits in an ultra-low interest rate environment. Heavily affected are small and medium-size businesses that are both reliant on bank finance and generators of a large proportion of new jobs in the economy.

For their part, banks have been under severe pressure to adapt to new regulatory regimes that have crushed several of their pre-crisis profit centers and added many billions to the cost of complying with the new rules. These rules are numerous (the Dodd Frank Act spawned about 400 of them) and have been slow in coming (only about half are finalized even today), which adds to the uncertainty as to what banks will or will not be permitted to do in the future. 

The biggest banks – those involved with substantial investment banking activities, and still defending themselves from a torrent of litigation stemming from industry practices leading up to the financial crisis – have not earned their cost of equity capital since 2009.  This is an important sector of the financial industry that is struggling to remain viable.

So, is the cost of under-performance in the economy worth the protection Americans have received by reducing systemic risk in the financial system? Last time solid economic expansion in the mid-2000s gave way to a collapse estimated by the Congressional Budget Office to have cost some $10 trillion in lost GDP, plus vast damage to particularly vulnerable parts of the population like pension beneficiaries.

The government has not defined systemic risk in the US financial architecture, other than to set a trigger of $50 billion in assets for imposing special risk-reducing regulations on the largest banks – a pretty arbitrary number.

At NYU Stern, the Volatility Lab headed by Nobel Laureate Robert Engle defines systemic risk as the gross amount of capital a bank would have to raise to replace capital lost to mark-downs of assets after a stock market decline of 40% over a six-month period. This approach recognizes that systemic risk is mainly a function of market risk at a time when markets undergo sudden, panic-driven changes - as occurred in 2008.

Using this definition, US exposure to systemic risk has declined by approximately 30% from its peak in 2008.  The risk reduction comes mainly from a shrinking in the size of the larger banks and a lowering of the volatility of their stock prices. But it suggests as well that there is a trade-off between squeezing the banks to reduce systemic risk and allowing them to make a living as providers of risk finance to the global economy.

The most useful thing the Federal Reserve can do now is to reduce the unsustainable cost of this trade off. It would help if the Fed would challenge the conventional wisdom that the banks are perpetually powerful, insatiable, manipulative and almost solely responsible for the crisis and its resulting economic hardships. This greatly overstates the problems that banks represent. Indeed, the Fed could say the time has come to return the banks to a normal, competitive and economically viable state. This can be greatly aided by saying that Dodd Frank Act has given it (and the Financial System Oversight Committee, to which it reports) sufficient powers to regulate the US banking system without having to rely on the voluminous, costly and often unnecessary stream of new rules incorporated in the Dodd Frank Act.

These new regulations are also costly to regional and smaller banks. New research shows that local and regional banks fared substantially better – and with far less reliance on government bailouts – than the big banks. So a financial system dominated by the need to control six or eight financial goliaths – controls that affect all the rest of the banks as well - may not be in the national interest.

Indeed, the Fed has shown that its combination of stress testing and appraisal of governance and management efforts can force banks to meet qualitative and well as quantitative standards for “fitness and properness” in order to be able to return capital to shareholders through dividends and stock buyback programs. There are only a dozen or so financial institutions in the country that pose real systemic issues, so the Fed, with supervisory staff imbedded in these banks, ought to be able to monitor what goes on sufficiently to meet the key safety and soundness standards.

These standards are based on the idea of reducing leverage and increasing capital to keep banks safe, but they also need to recognize that banks have to be sound as well. That means being healthy, sustainable businesses that attract investors.

Furthermore, the Fed needs to acknowledge that banks require healthy capital markets in which to raise funding sell loans through securitizations other avenues.  It needs to weigh in on what to do with Fannie Mae and Freddie Mac, to revive and deepen the mortgage-backed securities market - an enormous component of the US capital market that has not recovered much since the crisis, leaving inadequate availability of mortgage credit to support recovery of the housing sector.

The Fed remains the only institution with the political independence, credibility and institutional knowledge to do this.  Its power to intervene in problematic banks and nonbanks are considerable.  It has to be the main advocate in government circles for a healthy financial system, one that does not depend on market-distorting subsidies or intervention, or on politically inspired but growth-killing regulatory constraints to manage the delicate task of keeping major banks in line while enjoying the market freedoms to meet their shareholders’ objectives.

Time for a Moratorium on Prosecution of Banks

Roy C. Smith

As large investment banks begin reporting yet another quarter of lackluster earnings, leading them into their sixth year of failing to earn the cost of their equity capital, it is time to recognize that the industry is in severe distress and contributing much less than it should be to economic recovery.

Since 2008, large US and European banks have been designated the principal villains responsible for the financial crisis. Accordingly they have been hit with regulatory changes that have crippled their business models, and subjected to litigation by US federal and state attorneys general for mortgage and securities fraud, foreclosure abuse, market rigging of Libor, foreign exchange rates and metals prices, tax evasion, and circumventing money-laundering rules and sanctions.

Witness Citigroup’s announcement on July 7 of a $7 billion settlement to end all US government investigations of the banks’ pre-crisis involvement in mortgage-backed securities. A $3.8 billion provision slashed second-quarter profits to $181 million from $4.2 billion in the same period last year.

Bank of America is in endgame negotiations with the US Justice Department to settle similar charges and several other banks are expected to do the same, yet all the major banks are still under investigation in connection with other allegations.

It is clear that bad things did happen during a financial bubble that burst with a huge effect on the real economy. Regulatory changes and some prosecutions were necessary to restore stability to the financial system and to enforce tax and money-laundering laws, but the judicial pursuit of banks, rather than responsible individuals, has been taken to lengths that defeat the government’s other aim of restoring economic growth.

Most of the large investment banks replaced their chief, and other, executives, most of whom lost heavily as bank shares tumbled. But evidence of criminal (or civil) misconduct at the highest level of management was invariably difficult to find, though it was certainly sought. They may have failed as managers, but managers are not legally liable for mistakes.

Lacking sufficient evidence to convict senior executives, who would fight back in court, prosecutors pursued the banks’ corporate entities instead, which they know would prefer to settle than fight. Generally corporations are not sued unless there is evidence that management has corrupted the organization or failed to prevent such corruption.

The settlements have amounted to approximately $120 billion at the last count. The shareholders of the banks have paid the cost by subtracting it from capital they are required to increase as part of the most comprehensive and restrictive financial regulatory reforms since the 1930s.

As a result, the banks have become cautious, risk-averse and dull while they wait for the next shoe to fall. Share prices have slumped and much of the banks’ high-priced talent has quit to join boutiques, hedge funds or private equity groups.

Pyrrhic victories

So the high-profile litigation “victories” continuously announced by the US Attorney General, Eric Holder, and several of his state equivalents are substantially pyrrhic. They have won some battles but risk losing the more important war against economic stagnation and deflation.

True, the political gains have been satisfying – much of the public is convinced that bank bashing is a good thing. The settlements have contributed to government debt reduction (especially in New York State) and have enhanced the credibility of US efforts to enforce laws preventing tax evasion, money laundering and sanctions avoidance.

Citigroup’s chief executive, Michael Corbat, expressed his hope that the settlement last week would help the bank “to move forward and to focus on the future, not the past”. The Justice Department should follow the same advice.

At a time when economic growth in the US and the EU is dangerously below what it needs to be, government regulation and litigation have driven many of the largest providers of risk finance to the sidelines.

We need the banks to help economic recovery, and we need economic recovery badly.

It is time for governments to declare the war against the big banks to be over and won. It is time to remove the overhanging uncertainty of future settlements, capital shortfalls and permitted global activities to let the banks recover and adjust to their new environment.

Especially we need the Obama administration to declare a moratorium on the prosecutions of banks (but not of individuals) because these have entered the realm of diminishing returns, and because, under Dodd-Frank, regulators have accumulated sufficient powers to be able to monitor and control individual bank riskiness and governance effectively.

To make such a moratorium politically possible, the regulators could require enhanced governance conditions that might include the need for bank non-executive directors to acknowledge personal responsibility for the management of systemic risk (which they are largely required to do anyway) and to report concerns to regulators. The Federal Reserve did something similar during the banking crisis of the 1980s. Bank directors at the time took the acknowledgements seriously as an extension of their fiduciary duties.

Governments should also extend a moratorium on any further regulations that restrict banking operations or impose additional compliance burdens until they have a better understanding of the costs and benefits of the hundreds of new regulations already mandated by Dodd-Frank, Basel III and the European Central Bank.

Even better would be a quiet promise to put forth a corrective amendment to Dodd-Frank to eliminate extraneous, redundant and unworkable regulations as these are identified.

Regulators in the US and Europe need also to consider the deglobalization effects of their recent actions, and try to reverse the trend. Globalization adds to competition, liquidity and innovation, which are needed for recovery. It also adds to the complexity of systemic risk management, but the net effect is positive.

Systemic risk in finance is a consequence of a healthy system that exceeds its limits. Governments have rules to control these limits, but also use litigation to punish institutions they believe allowed rule violation to occur.

They know the banks will settle, so these are easy victories they have grown accustomed to enjoying.

They come, however, at a cost to a “systemic economic risk,” that of prolonging a painful period of slow to no growth in the global economy over a period now approaching a decade.

That is too big a war to lose for pyrrhic victories. We need the moratorium now.

From eFinancial News, July 21, 2014