Now is the Time for Deutsche Bank to Consider a Split

By

Roy C Smith and Brad Hintz

16 February 2015,  eFinancial News: Issue 936

 

It’s long well past time for Deutsche Bank’s long-suffering shareholders to challenge the holy writ of universal banking. The bank’s strategic challenges were made clear in late January when its fourth-quarter results showed return on equity of 2.6%, about 20% of its cost of equity capital. Management said the performance was “encouraging” – but the equity market continues to value the bank’s shares at only half book value.

Jürgen Fitschen and Anshu Jain, Deutsche’s co-chief executives, say they are committed to preserving the bank’s traditional “universal banking” strategy and determined to remain among the top five investment banks. But their “Strategy 2015+,” announced soon after they took over in 2012, now looks hopeless. Goals of a cost/income ratio of 65% and an after-tax return on equity of 15% by 2015 seem truly out of reach.

Yet, Deutsche Bank has been a relative winner, as other banks such as UBS, Morgan Stanley and Barclays have cut back their investment banking or trading activities. In 2014, Deutsche’s investment banking unit ranked third in both global debt underwriting and loan syndication revenue, according to Dealogic. Fitschen said: “We see good opportunities to win market share… when some of our competitors are pulling back from investment banking.”

Disappointing returns

But after four years of disappointing performance, it is time to recognize that shareholders have not profited from the bank’s gains in market share, nor are its unrealized expense aspirations the same as bottom-line performance. The massive regulatory changes since the 2008 crisis have severely affected the universal banking business model, bringing its viability into question. Constraints on the capital markets businesses continue to tighten as regulators pursue a goal of transforming the largest global banks into low-growth, but bulletproof, public utilities. There are now capital surcharges for systemically important financial institutions: “special” national capital buffers, leverage limits, liquidity standards, operating prohibitions against excessive risk-taking as well as proposals for new financial transactions taxes. All of these changes add costs and lower the return on equity of capital markets activities. Among the large banks, only Goldman Sachs has been able to generate returns near its cost of capital and that is because of a sharp reduction in compensation and continued liquidation of a legacy merchant banking portfolio.

And, there has been a tsunami of politically popular, punitive litigation that has stripped all of the universals of precious capital just as they need to increase it.

Deutsche Bank’s strategy of profiting from a war of attrition in investment banking cannot succeed. The firm still faces cost and margin issues, poor trading returns, continued demand for additional capital as well as cultural challenges in its London-based banking unit. Fitschen and Jain have promised a strategy update sometime in the second quarter. Rumors suggest this may involve the sale of recently acquired Deutsche Postbank. But, it is not Postbank that is hurting the bank, it’s the investment bank.

There is one successful example of a spin-off. After more than a decade building itself into a broad-based financial services company, American Express in 1994 reversed course. New CEO Harvey Golub decided to shed the Shearson Lehman investment banking and brokerage units, whose performance had seriously undermined the parent’s stock price. The brokerage business was sold to Smith Barney, and the investment bank, Lehman Brothers, was spun off to shareholders.

While these were controversial moves when announced, it is now clear that American Express shareholders benefited from the restructuring and that operating performance improved significantly, not only at Amex but also the companies it jettisoned.

Since then, however, the capital markets business has become more complex, and separating out trading and market-making from a modern universal bank would have major repercussions. Certain capital advantages related to portfolio risk analysis and netting of positions would be lost. The cost of funding for an independent trading entity would rise as the funding base shifted towards more long-term debt and institutional deposits. The marketing synergies between commercial lending and investment banking would be severed, which would be likely to erode market share. The shared technology and staff support costs of the universal banking structure would end.

Further, the newly independent investment bank would need to maintain sufficient capital and liquidity to meet regulatory requirements and to qualify for Baa/BBB credit ratings. For this to be achieved, the parent would probably have to take back some preferred stock or contingent convertible loans, as American Express did when Lehman was spun off, or third-party investors would have to be brought in.

Change is good

It would not be easy, but it could be done.

And it might create entirely new value. Determined managers of a newly independent investment bank would be forced to rethink their business model and accelerate the glacial rate of change in capital markets dominated for years by the universal banks. On the cost side, compensation ratios would fall, organizational structures would flatten, headcount would be reduced, back offices automated and support staff outsourced.

On the revenue side, an independent firm with limited financial resources would be forced to pursue the highest margin banking businesses and reduce commoditized products, while improving balance sheet turnover and returns on trading assets – all good for investors. After spinning off its investment banking activities, a smaller and de-risked Deutsche Bank, retaining some wholesale lending business, would still be a world-class commercial lender, a leader in serving mid-size industrial companies in Europe, a large and growing wealth manager and a powerful transaction services provider.

Its strong positions in the admittedly over-banked German and Italian retail markets still generate low-cost retail deposits that enable a profitable lending and investment portfolio. And without the siren song of investment banking and its maddening, constant fire-fighting demands on management, Deutsche Bank could focus on improving the banking and distribution businesses it knows best.

Most important, however, is the almost certain increase in shareholder value than would result from a break-up. The combination of the various individual business units might be valued on a stand-alone basis at as much as €55 billion. With today’s market value of €37 billion, reflecting investors’ grim view of the bank’s future, there is a lot of room for creating value through a restructuring. Spinning off the investment bank might be the best way to capture that value.

Roy C Smith is a finance professor at NYU Stern School of Business and former partner at Goldman Sachs. Brad Hintz is an adjunct finance professor at NYU Stern and former CFO at Lehman Brothers and top-ranked banks analyst with Sanford Bernstein

John C. Whitehead – Then and Now

By Roy C. Smith

John Whitehead died last week at 92. He had many accomplishments, the most important of which to me were his 37 years at Goldman Sachs, more than 18 of which as a member of firm’s important Management Committee. For the last 8 years he was co-Chairman of the firm along with John L. Weinberg, who was Chairman until 1990 and died in 2006 after 40 years with the firm. Whitehead is the last of the “old Wall Street” leaders to go.

John joined the firm in 1947. He became the principal assistant to Sidney Weinberg, a legendary figure who headed the firm for 38 years. John became a partner in 1956 after assisting Mr. Weinberg in one of his signature achievements, advising the Ford family on the initial public offering of the Ford Motor Company.

John headed the Investment Bank Division for many years, and authored Goldman Sachs’ “Our Business Principles,” the first effort by any firm in Wall Street to publish the ethical standards it followed and to which the firm still adheres.  

He was also the driving force behind moving a reluctant Goldman Sachs into becoming “a truly international firm.” He recruited me from the domestic corporate finance department to join this effort at its beginning in 1968 and for 20 years he was my ultimate boss (I had other bosses too).

His constant peroration to me, and others struggling to create an international business from next to nothing, was “just because these companies never hear of you, or Goldman Sachs, or investment banking, doesn’t mean you can't get them to do business with us.”

John retired in 1984, 30 years ago (and 15 before the firm went public), after feeling that investment banking was steadily drifting away from the world of small, intimate firms with which he identified. Even after leaving, John was one of the most visible individuals identified with the industry, of which he was often quite critical.  

Today, Goldman Sachs has about 100 times more revenue and 35 times more people than it did when John retired. Its market capitalization is $83 billion, as compared to about $300 million of total partners capital in 1984. But the firm is not just bigger; it is in a much more global, complex and dangerous business than he had ever imagined it could be. Even so, there are several investment banks that are twice as large as Goldman.

What used to be “global” meant having offices in London, Zurich, Tokyo and Hong Kong. Today’s Goldman Sachs has 39 international offices (23 in emerging market countries) vs. 16 in the US; roughly half the firm’s business-flow originates outside the US.

The business too is certainly more complex. The Glass-Steagall Act was repealed in 1999 and competition for investment banking transactions increased geometrically, putting great pressures on margins and profits. Trading became the dominant investment banking revenue source, thus requiring new management skills in funding and leverage, hedging and controlling risk exposure, handling conflicts of interest, and the sometimes difficult task “of separating “clients” (to whom loyalties were owed) from “counterparties” (to whom they were not).

And certainly the seismic changes since 2008 in the regulatory and litigation environment of the capital markets businesses has introduced compliance burdens and hazards that have not yet reached their outer limits.

Because of these changes, few of today’s leading investment banking firms earn their cost of capital, and the shares of several trade below book value.

Goldman Sachs has survived the crisis and its aftermath better than most. This is partly because the firm’s DNA still carries some of the essential elements from the Whitehead and Weinberg days.  Most important of these may be the goal of professional “exceptionalism” that has, since the beginning, eschewed large mergers, cultural dilution and loss of hands on control, and insisted on the preservation of a “partnership” senior manager compensation system, that is still unique in the industry.

Goldman Sachs has had several leaders since Sidney Weinberg died in 1968; John Whitehead, though a man of many other interests and activities in the last 30 years of his long, rich life, has been one of the most admired and lastingly influential.

What to Expect In Cuba

Note: In January 2015 your bloggers participated in an 8-day trip to Cuba under the recently liberalized Obama "People to People" program. The timing turned out to be fortuitous since the announcement of US-Cuban mutual recognition and possibly far-reaching liberalization occurred while we were there. Neither of us had focused professionally on Cuba before the trip. In Havana we had access to a number of Cuban academics and scholars concerned with economic and financial affairs. We did, of course, arrive with a number of preconceptions, having lived through some 60 years before and after the Cuban Revolution. In many ways what we found was surprising. 

Feb. 2, 2015

By Roy C. Smith

A recent visit to Cuba revealed as much enthusiasm in the streets of Havana, where signs still proclaim “Socialism or Death,” as in the US for the 17 December announcements by Presidents Obama and Castro to “normalize” relations. Normal relations would change everything, but there is still a lot to do.

Indeed, the Cubans had little choice over whether to do this as their economy is on the verge of collapse.

Cuba was Latin America’s third richest nation when the Revolution occurred in 1959. Today it is the ninth, ranking 110^th globally in GDP per capita. Cuba exports some sugar and tobacco but imports just about everything else, including 80% of its food.

Fidel Castro, now 88, declared his regime Communist in 1961; everything was nationalized and turned into a Soviet style command economy with 85% of the workforce employed by the state. Its Utopian economic model depended on massive support from the USSR for 30 years, and, after its demise, from Venezuela, whose continued assistance is doubtful due to falling oil prices and economic trouble at home.

Fidel emphasized social gains: effectively providing schools, medical and other services so his “New Cuban Man” is today literate, healthy, and classless.

But Cubans are also all equally poor with limited opportunity for improvement. Once elegant buildings from the colonial and post-colonial periods are crumbling into decay; there is still a housing shortage so several families share buildings and apartments. The population is aging and the birth rate is low. Few people have savings, and fewer still have checking accounts or access to credit.

A university professor we met earns $30 a month and freelances as a cab driver to supplement his income. His wife, a dentist, is on a three-year contract in Yemen. The doorman at a chic new restaurant for foreigners turned out to be a senior psychiatrist. Even the elite has to hustle to make ends meet.

But, Big Changes Since 2006

In 2006, after becoming ill, Fidel transferred power to his brother Raul, now 83, and Raul succeed Fidel as President in 2008. Unlike his charismatic, fanciful brother, Raul is taciturn, pragmatic and realistic. He has recognized the need to reform the Cuban economy “to provide a more prosperous and sustainable socialism.”

Raul quickly initiated a series of economic reforms that cumulatively have changed Cuban life significantly. Most Americans and Europeans have little appreciation of the considerable amount of deregulation that has occurred in the eight years that preceded the 17 Dec. announcement.

Farmers may now lease land from the government to cultivate whatever they want and keep half the profits. Accordingly, farmers markets have begun to flourish and fresh produce is plentiful.

Cubans may travel abroad, and Cuban-Americans to Cuba, much more freely.

The state still owns your home, but you have a right to live in it that can now be sold. If a family is lucky enough to own a car, it will probably be one that was on the road before 1959. Now, these “old timers” too can be sold in what is now called the “offer and demand” market. 

Small businesses now may be created. New shops, dance studios, art galleries and restaurants have sprung up everywhere in people’s homes or in leased spaced. Until recently these had to be one-family efforts, but now they can be done as “co-ops,” in which several individuals can combine their resources. Entrepreneurs in various forms are starting to get rich, creating some early signs of income inequality.

In 2010 Raul began laying off 500,000 workers from 2,000 state owned enterprises, forcing them to seek “self-employment” wherever they could in the private economy.

This was followed by a second wave of 500,000 that would mean a shift of about 20% of the country’s workforce to the private sector by 2016. This was the most drastic thing to occur in the socialist state economy since its inception, and was shocking to most Cubans, but accepted without social unrest.

In 2011, Raul pushed the Communist Party to adopt a further “311 Point” liberalization program, though much of it is yet to be implemented. One point is to allow much more open discussion of ideas about reforms; an influential cadre of bright, young economists from the University of Havana whom we met has emerged to urge a much faster implementation of the reforms.

But even after all these efforts, the Cuban economy grew only 1.4% in 2014.

On 15 January, President Obama announced a further liberalization of US citizens’ travel in Cuba and remittances by Cuban Americans, encouraging belief that the US is serious about normalization.  

What Next?

Diplomatic negotiations have begun, but are expected to take time and be cumbersome. There is no sign that the US trade embargo will be lifted soon, but its lifting is now widely discussed in Congress and lobbied by various interest groups.

Normal diplomatic relations will lead to more normal economic ones that will open a floodgate of market forces-- of Americans wanting to invest in the next great post-Communist turnaround opportunity, and of Cubans wanting to sell agricultural commodities and anything else they can in the US.

These new market forces will change things in Cuba faster and more profoundly than anything else.

But for Cuba such a sharp conversion to market economics represents a major existential challenge. If change occurs too quickly, as in China, Cuban socialism, the pride and rationale of the Revolution, may disappear. Raul and much of the old guard want to preserve the old system by reforming it, not replace it with modern capitalism. They want to go slow to protect Cuba’s socialism but once market forces are released and public expectations build up, they may not be able to. Raul has said he will stand down as President in 2018.

In the meantime, managing transition to a reformed, semi-market economy is going to a major challenge. Cuba lacks almost all the infrastructure it will need to move to the next level, including a basic financial system (banking, securities, insurance) and modern agricultural and industrial bases.

How well, and how quickly these can be created will determine whether Cuba, with its 11 million well-educated, increasingly entrepreneurial minded population can make the most of the opportunity. Doing so could mean ending up as a successful Caribbean entrepot nation (like Singapore) managing trade and finance throughout the region, transshipping goods, developing light manufacturing and its gorgeous beaches for tourism. This would require large amounts of foreign capital and managerial know-how that Cuba currently lacks and government rules currently impede.

If it falls short of this, Cuba is likely to make it only to being one of several, small, unimportant semi-socialist Caribbean island-economies struggling to get by and competing with each other for tourism dollars.

Thus the stakes are high, and, at this point, the odds seem fairly long. But there will be plenty of investors willing to take the bet. Its going to be interesting one.

What's Next For Cuba?

Ingo Walter

(CNBC Jan 29, 2015)

Now that the decision has been made in Washington to reset Cuban-American relations, it’s a good time for an outside perspective on developments since the Communists took control of the country almost 60 years ago and where things may go from here.

Pre-Castro Cuban history was certainly turbulent – early extermination of the native Amerindians by the Spanish, a long history of slavery ending in 1870, the 1898 Spanish-American War which brought colonial liberation but not much else, dominant foreign business interests in key sectors, and a US bolt-hole for gambling and organized crime that ended in the rampant corruption of the Batista regime.

Nor was the next chapter much more inspiring, with its extended guerrilla war, atrocities that few people talk about nowadays, waves of mass emigration of desirables and undesirables, the failed Bay of Pigs invasion and a missile standoff with an entrenched USSR that came close to a tipping-point to thermonuclear war – and of course the longest trade embargo in history.

Many old timers of Cuban origin have long memories and powerful resentments. Newer generations consider their seniors trapped on the wrong side of history and want to get on with change. Just about everyone feels strongly.

A dispassionate look at Cuba today reveals a unique contemporary “natural experiment” in social engineering, a form of collectivism abandoned long ago by almost all who attempted it – achieving improved social welfare by working against human nature rather than with it. You can push water uphill, but only by wasting enormous amounts of human and physical capital. And even people who subscribe to the objective of improved collective welfare will still try to do what’s best for themselves in their daily lives, regardless of the economic command and control structure.

In this sense the Cuban experiment was doomed from the start. Combined with the US embargo imposed in 1960, it assures Cuba’s position at the nadir among the world’s economic underperformers. But it also assures Cuba’s potential as a rising star if things are managed well after the blocks come off. In financial terms, Cuba will be a “buy” when the time comes. A recent visit revealed impressive strengths buried not far below the surface.

Over eleven million people, comparatively well educated, with unusually strong extended family ties and sufficient entrepreneurial vigor to be explosive once preoccupation with working around the “dead hand” of the state gradually fades away. The few sectors already liberalized show plenty of sprouts, like a long-vacant lot after a spring rain, suggesting the latent power of lifting price and wage controls sometime down the road – there’s a reason farmers, budding restauranteurs and taxi drivers are among the best-off Cubans today.

Capital formation too is constipated by an archaic banking system that executes
transactions at a tenth the efficiency one might see in Botswana, and fails totally as a source of credit to incipient businesses and households. Cuban cooperatives and lending among family and friends are among the few forms of financial intermediation.

Like everyone else, Cubans will borrow and lend, save and invest once the bottle is uncorked. Future tourists will be amazed how fast the overcrowded wrecks of old Havana buildings get restored or repurposed stretching far beyond the Old Havana tourist zone.

If labor and capital get moved closer to their growth potential, there’s also plenty of knowhow to work with abroad and at home. State-of-the-art technology will find its way into Cuba quickly through licensing or foreign direct investment once international companies decide government is serious about sensible, just as it has in many other successful developing countries. And there will be plenty to work with, notably a decent educational and healthcare infrastructure and an impressive cohort of talented and motivated professionals.

Decomposing the economist’s usual sources of potential growth into labor, capital and productivity suggests that a bet on Cuba’s economic performance under market liberalization is low hanging fruit. Of key importance is institutional and legal framework that anchors and guarantees property rights in a fair and transparent way, without which high risk premiums will put a damper on much that could be achieved.

But there’s more. The Cuban diaspora is a unique potential asset that can be drawn upon if outstanding legal and property issues can be handled (as they have been in Europe) and as the irreconcilable advance to old age. Cuban immigrants to the US during the decades of hostility have on average done very well indeed in the professions, skilled trades and other pursuits. They and their progeny exist in large numbers, and as they say “… you can’t take the Cuba out of a Cuban.” Centrifugal force can work its magic in speeding things up if the playing field is laid out right. The “secret sauce” of development is entrepreneurship, and many countries rely on entrepreneurs from abroad. Cuba has plenty of them just across the Florida Straits to combine with locals long practiced in end-running and improvisation.

Then there’s the fortuitous disappearance of Cuba’s historical “crutches.” With the collapse of the Soviet Union after 1989 and the end of the cold war, the Russian pivot to internal development and withdrawal of once-massive economic aid to a country that was now of peripheral interest led to Cuba’s “special economic period” (near-famine) in the early 1990s. Cuba was left high and dry. Hugo Chavez’s economy crutch was no match, and today hangs by a thread as Venezuela verges on economic implosion. Intravenous drips are no substitute for sustainability, and Cuba today has a chance to plot a viable new course under disciplined market conditions – with a possible tailwind from depressed global oil prices.

Overlying everything, though, is the political dimension. Future economic conditions may show high promise, but can easily be overridden by politics. Human rights is on the front burner, shown by last week’s high-level US official visit to Havana. Defining human rights isn’t easy, despite the degree of consensus anchored in the U.N. Charter. Even then, engaging with human rights violators today ranges from US “sound and fury” to Chinese “when in Rome.” With China among the three largest US trade partners, there is no shortage of cynicism.

Even with agreement on political substance and alignment of policies, there’s always the issue of how to move the needle. Do trade and financial sanctions help modify national policies or harden them? The decades-old American Cuba embargo has been called both an abject failure and the key blocker of an even worse outcome. Who knows? It’s a reasonable guess, though, that the time has  can work its magic though the power of human nature, the invisible hand of the market, and sound economic development.

A New Year of Existential Moments

by Roy C. Smith

Dec. 31, 2014 

This is the time of year when resolutions and predictions are made. The resolutions are rarely achieved and the predictions, even short-term ones, are often wrong. Nevertheless, here are some for 2015, listed in terms of their existential urgency to the societies involved.

First, Russia.

This will be the year that Mr. Putin comes under the greatest amount of domestic political pressure since unexpectedly taking office on New Year’s Eve, 1999. There were a number of anti-war protests in Russia in 2014, adding to others that have occurred under Putin’s rule. In December, anti-government protests were staged in Manezh Square, and popular Kremlin critic Alexei Navalny was detained for attempting to participate. These sorts of demonstrations, however, have been harmless to Putin so far, but things may change in 2015 as acute economic pressures begin to eat into the economic gains middle class Muscovites have accrued over the past 15 years.  Russia’s GDP growth, never above 2% since 2008, has dropped to zero after the 50% collapse of oil prices and the ruble, but the added effects of US and European sanctions, soaring interest rates, a 44% drop in stock prices offer a bleak outlook for 2015 GDP growth of minus 4% to 5%.

Putin’s national approval ratings (reported by the government) may be high due to his machismo in the Ukraine, but do they resonate in Red Square? His political bullying and increasingly kleptocratic regime now resemble those of Viktor Yanukovych, the Putin supported, strong-armed President of the Ukraine who was suddenly deposed a year ago after protests in Maidan Square by thousands.  No one expected that: what goes around in public squares, can come around.

The pressure of all this presents Putin with an existential moment: He might avoid the worst by withdrawing forces from the Ukraine and acting in such a way as to get the sanctions, which are the only variable he can control in his current situation, removed. These sanctions, particularly those that restrict financial transactions and access to the Euromarket, have been very potent and may just be enough to tip the balance against Putin. As such, they may represent a new non-military tool that can be applied effectively by Western democracies when they can act together against aggressive or troublesome regimes. Better sanctions than armies.

China

Twenty-five years after Tiannamen Square, and after nearly that many years of soaring economic growth, China too may face an existential moment in 2015 as its growth rate continues to fall to around 7%, significantly below the 8% minimum that Chinese officials have thought to be necessary to prevent widespread social protests by the newly enfranchised middle class and the hundreds of millions of unregistered job seekers flocking to the cities. Communist Party General Secretary Xi Jinping, still largely unknown to the West as he maneuvers forcefully to secure his power and position in China, faces a dilemma. Flood the markets with cheap money and bank loans to reverse the economic decline, risking a financial bubble and collapse not unlike the Japanese in 1989, or tighten the belts and weather the economic adjustment but risk another Tiannamen Square event. So far it appears that the former path has been selected; increased liquidity has driven stock prices up by 36% just since March, despite an economic slowdown that will continue in 2015.

A market crash in China would reveal massive amounts of unreported bad loans to state-owned enterprises, municipalities, real estate developers and others and the shock effect could be enough to halt China’s twenty-year run of exceptional growth. Such an event also would surely awake the dragons of political protest.

Europe

Having survived (for now) a sovereign debt crisis, the Eurozone (EZ) was only able to stumble across the finish line in 2014 with growth of 0.8%. The EU was only a little better at 1.1%, nowhere near in either case what it needs to be to lower widespread unemployment or to support the enormous social safety net that still exists in Europe.  Growth forecasts for 2015 are slightly better, but unfolding events could actually make the European economic future worse. Coming up are elections in Greece that could produce a government mandated to improve the terms of the bailout or end the country’s participation in the EZ; an urgent need, according to the IMF, for labor market reforms in France, Italy and Spain that seem impossible to achieve; and a likely indefinite dependance on market-distorting “quantitative easing” by the ECB as a last ditch effort to secure minimal growth in the euro area. There is also a growth-killing EU financial transaction tax scheduled to begin on Jan 1, 2016.

Popular confidence in the EU/EZ system, its “single market” and “single currency” is fading fast. Never a Federal system like the US, at best European economic integration resembles the ineffective Confederation Period in US history (1781-1788) that was replaced out of necessity by a federal Constitution. Thus Europe too faces an existential moment when it will be required to choose between serious political integration along federal lines, or to give up and revert to the status quo pre-euro. Until it meets this moment, Europe’s slow growth and high unemployment condition is likely to remain in place.

Emerging Market Countries

There are a few Emerging Market countries that produced growth in 2014 above 5%, though all were in Asia (China, India, Indonesia, Malaysia, Philippines and Viet Nam).  In Latin America, Chile, Colombia and Mexico are showing the benefits of having invested in institutional infrastructure, but Brazil, with 2014 growth of 0.8%, Argentina 0.3%, and Venezuela (despite its oil) minus 2.8%, lag behind because they haven’t. 2015 promises an existential moment for Cuba, which will need to make significant domestic reforms to survive as an economically independent state. Now that Cuba and the US have announced a rapprochement of sorts, market and political forces will put a lot of pressure on Cuba to move things along faster than they want to.  

The US

 Despite years of talk about losing its grip, the US has been the economy to beat going into 2015.  Third quarter growth of 5%, low inflation and interest rates and a strong dollar suggests that the US has finally pulled itself out of the ditch it has been in since 2008. The US private sector, the world’s largest by far, is less affected by government action than other economies, but it has still suffered from over-regulation, aggressive government litigation and a generally anti-business administration. Corporate America, however, has adapted to these pressures, improved productivity and profitability, and is in good shape for the future. The American public sector, on the other hand, suffers from financial distress in the States and large cities, and in their pension funds, but elected officials are beginning to deal with them. Recent elections may resolve some of the gridlock problems in 2015.

The last few years have reminded Americans of two important lessons ingrained in the country’s economic history: without free-market capitalism there cannot be enough economic growth to provide the social system the people want, and free-market capitalism  can only operate a democracy with the consent of the people. Perhaps these are grounds for compromise between Democrats and Republicans. Lets hope so.

Happy New Year

A Sobering Anniversary

By Roy C. Smith

Amid the holiday bubbly, some will recall that 25 years ago, on December 29, the Nikkei index stood at 38,916, its all-time high. What happened next has sobering lessons for China. The bubble burst in a most non-festive fashion – and it had been inflated by government efforts to stave off exactly the problem that besets China today.

The Japanese babaru keizai, or “bubble economy”, of the 1980s resulted from efforts to sustain the “miracle growth” that began in the 1950s and won Japan its reputation as an economic superpower. After two decades of export-fueled growth, in the middle of the 1970s, Japan had started slowing towards a world average growth rate. Japanese officials sought to counter the trend with large amounts of easy money.

The ensuing “excess liquidity”, which reached 5.5% of GDP in 1986 and 1987, did not pass into goods and services as inflation but into rising prices of stocks and real estate. At the market’s peak, stocks in the Nikkei index traded at an average of 70 times earnings. Japanese institutions, corporations and households (and many foreign investors) all bought these assets, very often with borrowed money, because of their belief in the limitless sustainability of Japanese economic success. The Nikkei index rose six-fold in the 1980s, compared with a three-fold increase in the US stock market.

Then came the crash. As the Nikkei dropped 63% to a low of 14,309 in 1992, it sucked the value out of all other financial assets and collapsed the financial system that had taken the assets as collateral. The Nikkei continued to slide for 17 years, reaching a low of 7,055 in 2009.

Though the bursting of the Japanese bubble was nastier than most, bubbles do come and go. What is most frightening about the Japanese experience is the extent to which the confidence of the Japanese people in their economy was destroyed. Despite 25 years of Keynesian stimulus programs (that have pushed Japan’s government debt to GDP ratio from 50% in 1989 to 250%, the highest in the world), and a decade of zero-interest rate monetary policy, Japan’s average annual growth rate since 1990 has been scarcely above zero.

China is the “miracle economy” of today. It has much in common with the centralized, export-led economy of Japan before 1990. And it is vulnerable to similar sorts of asset bubbles that can devastate its economic momentum and progress.

Indeed, China was just getting started when the Japanese market blew up. Though China’s slow but steady opening up to Western markets was set back for a couple of years by the Tiananmen Square massacre – seven months before the 1989 Nikkei crash – Deng Xiaoping’s persistence in discarding Communism for “socialism with Chinese characteristics” led to 20 years of growth at an average rate of 9.5%

China’s basic economic strategy was the same as Japan’s: use a tightly controlled banking system to leverage the country’s high savings rate to finance plants and equipment that can manufacture high-quality, low-cost goods to be sold abroad for foreign exchange. Force overseas companies wanting access to the Chinese market to provide foreign direct investment and the latest technology, and gradually move manufactured products up the technology curve. Open and liberalize stock markets, privatize state-owned companies and let the world buy into the show as China breaks through (as it has) to become the world’s largest economy based on purchase-power parity.

The Shanghai Stock Exchange Index rose gradually after reopening in 1990 from 1,000 to 2,000 in 2001, after which, reflecting world equity markets, it slumped to about 1,500 in 2004. Then it jumped four-fold to 6,000 in 2007, only to be brought back to the 2,000 level after 2008. The index has not grown much since – losses may have driven away early believers, deflecting speculative demand into real estate. China’s stock market still lacks a broad institutional base of pension funds, insurance companies and mutual funds. As these develop, the demand for stocks will increase substantially. Today, China’s combined stockmarket capitalisation is about the same as Japan’s.

But, after 25 years, China’s growth rate is slowing and creating political headaches for its new government. Much of the slowdown reflects low growth in China’s exports but some is because of rising wages and operating costs in China, where economic and social expectations have risen. Disappointment in these expectations, or with local or regional political factors, may have been behind the 180,000 incidents of social unrest in 2010, estimated by The Economist.

China’s existential problem is that if economic growth drops below 7% or 8%, factory closings, unemployment and social demands could threaten Party control. Growth is likely to be 7.4% or less this year (down from 12% in 2010), so the government is trying hard to reverse the trend.

It has engaged in stimulus programs and lowered interest rates to spur growth. While the government is pumping money into banks to increase lending to state-owned enterprises and local governments, bank regulators are concerned about non-performing loans and leverage. Excess liquidity is rising, especially in the under-regulated non-bank sector, but inflation remains low. A Japanese-style asset bubble may not be far away. Bubbles are hard to predict, partly because they can be hard to distinguish from what others view as “trends,” and partly because it is hard to tell when and where the first chinks in the dam will appear.

Total debt in China (largely undertaken by opaque state-owned enterprises and local and regional governments) now equals 250% of GDP, up from 130% in 2008. But, like Japan in 1989, China’s banking system is fragile. Non-performing loans are disguised, and under-reported. Relative to the rapid expansion in non-government loans outstanding, the banks report a very unlikely decline in bad debts.

A serious setback in Chinese stocks and real estate could, as it did in Japan, force the realisation of losses that could severely affect the 300 million mostly urban “middle class” that have mortgages and own stocks. According to a recent report in The Financial Times, 90% of Chinese households own at least one home, and 76% of the assets or urban householders are in real estate.

China has a sufficient pile of foreign exchange reserves and other resources to bail out its banking system if need be. Japan did too.

But if a series of financial shocks hit the middle class, it may be difficult for the government to retain the confidence of the people in the country’s economic prospects, particularly if exports remain tied to sluggish Western growth rates. If that confidence is lost, China’s superpower status and the longevity of the Party may be in doubt.

From: Financial News, Dec 8, 2014

Bank Cultures Rely On Effective Controls

By Roy C. Smith and Ingo Walter                                                                     

 

Of all the financial markets that should be resistant to manipulation, the foreign exchange (FX) market surely tops the list. With $5.3 trillion traded daily by thousands of buyers and sellers across the world, this should be a hyper-efficient market.

Foreign exchange is traded in a self-regulated broker-dealer market dominated by large, responsible banks and other intermediaries serving financial and non-financial clients worldwide. It has run seamlessly for decades, including during the global financial crisis of 2008-2010.

The FX playing field is a design masterpiece, blending efficiency, innovation stability and robustness. Equals are treated equally and unequals treated unequally in a transparent, competitive framework that extends from massive dealing banks at the center to nonfinancial firms making wire transfers or hedging currency exposures.

FX traders’ live in a fishbowl where gains and losses are taken as they come and there are no rocks or weeds to hide under. As befits such a business, traders must be as tightly controlled as a Pit Bull on a leash – alternately extending or tightening trading limits with changing market conditions and traders’ skills – controlled by experienced supervisory managers who have been there and done that.

So how could six traders in the FX business -- Citigroup, JP Morgan, HSBC, Royal Bank of Scotland,UBS and Bank of America - agree to a $4.3 billion “settlement” to dismiss charges of FX market misconduct by US, UK and Swiss authorities after a year-long investigation? This is the largest group settlement ever, and the first to target the FX business. The specific charges involved failure of the banks to prevent traders’ efforts to manipulate the FX market - irrespective of whether they succeeded, which quite likely they did not.

To many, the settlement seemed just and appropriate, coming on the heels of similar scandals in the Libor, mortgage-backed securities, commodities and retirement savings markets. Years after the 2008 financial crisis, these same banks, and a few others yet to be dealt with, seem still to be out of control and need to be forced to do their jobs properly. This is a sad commentary on the effectiveness of market discipline.

But to others, the settlement seemed to be an example of bullying and over-reaching by regulators to extract disproportionately large payments from banks to settle charges that a few apparently poorly supervised FX traders misbehaved. Instead of punishing the miscreants, their direct supervisors and, in turn, their senior managers, it is the shareholders of the banks who are stuck with the bill – billions that could have been returned as taxable income to shareholders or used to increase bank capital.

The New Normal

Indeed, the FX settlement is the latest in a long line of massive legal actions against banks as corporate “persons” responsible for the actions of those whom they employ. In this connection, prosecutorial efforts to make shareholders liable for problems caused by employees has been aimed at forcing boards of directors to reform their banking cultures to make them more responsible to the public interest, upon which their banking charters are ultimately predicated.  

This is the real lesson for bank shareholders, and, fair or not, this is the “new normal.” The legal power to sue banks for infractions, supervisory failure and associated cultural dysfunction is undisputed and here to stay. And the system is stacked against the banks. Prosecutors almost never have to prove their cases in court because bank boards fear the reputational damage of a public jury trial and that a “guilty” verdict would open a floodgate of civil litigation. So, they settle on the best terms they can get

The current FX case also demonstrates how US-style litigation has spread to Europe, where the UK’s Financial Conduct Authority (FCA) and the Swiss Financial Market Authority (Finma) have teamed up with US banking authorities. In all three countries, it is possible that criminal charges against individuals may follow.

Holder Factors In

Charging corporations as persons responsible for the conduct of their employees was unusual until 1999, when Eric Holder, at that time US Deputy Attorney General, wrote a memo to federal prosecutors outlining the criteria for bringing such charges. His memo - which has been superseded by a series of others - set standards that the Government followed in suits against Enron, WorldCom and other corporations caught in scandals during the early 2000s.

The basic idea of the Holder memo was that corporations are expected to provide a culture of good citizenship and appropriate business practices which fully comply with the law. It contained several “factors” to be considered by prosecutors in bringing charges against corporations – these included pervasiveness of wrongdoing within the company, a history of misconduct, timely and voluntary self-disclosure of wrongdoing to regulators, cooperation in the ensuing investigations, and the existence and adequacy of compliance programs, including management efforts to prevent, identify and discipline wrongdoing (italics added).

The test for whether a corporation meets these tough standards is not entirely clear, but the burden of demonstrating that it has in fact done so rests with the corporation itself.

Some of the banks involved in the FX settlements - particularly those with a history of employee misconduct in other markets - may have been uncomfortable demonstrating the ability of their management organizations to spot and prevent trouble. No doubt there have been cases of FX trading desks being pressured to boost their profitability using aggressive tactics, failing to examine new “trading strategies” for compliance shortcomings, or failing to listen to whistleblowers.

A New Standard

Given the Holder factors, it is increasingly hard for banks to plead ignorance or incompetence. No longer will it do to say “we have procedures in place, but we cannot be expected to keep track of everything every employee does.”

The proliferation of settlements across different financial markets makes it clear that banks increasingly will have to show they made credible and persistent efforts to keep their people in line. They must now be able to demonstrate that they have organized themselves into proactively watchful, compliant organizations by training, motivating and rewarding thousands of middle managers for spotting and fixing trouble before it happens. Such a functional approach to controlling behavior is the essence of the missing “cultural” issue in banks. It does however beg the question of how to reward these people appropriately for things that didn’t happen as opposed to things that did.  

Even with the best of intensions and commitment of resources things can still go wrong. But if a bank can show it has in good faith done all that any responsible organization could have done to prevent, detect and halt employee misconduct, then it can expect to avoid the kind of litigation that has damages shareholders and undermines its reputation and performance.

Bank boards of directors are beginning to get the message. They appreciate that getting these Holder-type issues wrong can be hugely expensive, and can lead to even worse consequences if their cultures are perceived to be tolerant of misconduct.

The good news is that banks can turn things around. This requires pruning the FX ranks of chat-room miscreants and re-training those who remain. People selected for middle management must be inculcated with the idea that they can and will be be rewarded for how well they play “defense” as well as “offense.” Internal whistleblowers need to be encouraged, not marginalized – itself not an easy thing to do. Department ad hoc committees at the operating unit level need to be able to thrash-out and resolve conflicts-of-interest and compliance issues on the spot as they arise.

This will require a major reworking of middle management responsibilities and accountability for a large segment of a bank’s managerial structure – maybe one in every ten or fifteen employees. But it can be done, and done effectively, if the necessary will and resources are applied.

The latest series of FX settlements  make it very clear that the banks have no choice but to do all this, and do it quickly.