Barriers to Entry on Wall Street

By Roy C. Smith

It is now suggested that barriers to entry in global investment banking are so high as to create a powerful oligopoly – don’t be so sure.

A recent editorial in the WSJ suggested that Hillary Clinton, who was paid an inflated $675,000 for a speaking engagement by Goldman Sachs, invoked a silent quid-pro-quo in which she would say she would be tough on the banks, but in reality would protect the industry.  Wall Street must believe it because Ms. Clinton’s campaign has received more contributions from the financial services industry than any other candidate’s has.

The editorial went on to float the idea that Wall Street has benefitted by Dodd Frank, Basel III and all the other increased regulation of systemically important financial institutions, because they have raised the barriers to entry to the global investment banking business, leaving those that were well entrenched (like Goldman Sachs) safely within an oligopoly.

Indeed, Goldman Sachs’s CEO, Lloyd Blankfein, was quoted as saying last year that the “intense regulatory and technology requirements” have made  “this is an expensive business to be in if you don’t have the market share in scale.”

This may be true, but the value of being a member of the oligopoly was certainly not so clear as of the end of 2015.

All of the oligarchs reported earnings significantly diminished by heavy litigation costs, layoffs and cost-cutting measures and by sizeable write-offs of goodwill from earlier acquisitions to build market share in scale.

Despite a record year in mergers, 2015 was by no means a good year for the oligopoly. Global securities market new issues totaled $6.9 trillion, down from $7.5 trillion in 2014, but a third less than the record $10.2 trillion raised in 2006.  Securities issues were 58% of total capital raised (including from syndicated bank loans) in 2015, as compared to 69% in 2006.

Further, the market shares attributed to the top ten lead-managers of combined global debt, equity, syndicated loans and M&A transactions dropped to 66% in 2015 from 94% in 2006.  The top five represented 41% of the market in 2015, but 57% in 2006.

Market shares have also been pared by competition from non-oligopic banks and by specialized nonbanks, such as the dozen of so boutique investment banks (about half of which are less than ten years old). Lazard Frères, the largest such boutique, ranked 11th in the combined 2015 lead-manager league tables, despite being active only in M&A. Three other similarly focused boutiques ranked among the top twenty originators for the first time in 2015.

The oligarchs’ market shares in trading, derivatives, hedge funds, private equity and venture capital, all of which contributed significantly to their profits in the past, also have been reduced by regulatory changes that limit the ability of major banks to compete in these areas.

More important than market shares, the intense pressure on profits from greatly increased capital and liquidity requirements, much reduced leverage, and an endless wave of litigation seeking settlements for sins for the crisis period, complete the picture of life today among the oligarchs. 

In the political arena, oddly, most of the leading candidates from both sides want to break up the banks. The popular perception continues to be that big banks that wrongly were bailed out during the crisis are still too powerful and dangerous. The reality, however, is that they all have been forced to drink from a poisoned chalice and only the strongest, and most adaptable can be expected to survive.

All of the European investment banks have undergone major management changes to affect these adaptations. UBS has done the most to shrink its investment bank (and its market share has shrunk accordingly); the others have promised something similar, but have not yet done enough to convince their long suffering investors that they are truly turning things around.

The American oligarchs appear to be relying on a strategy of “optimizing” their balance sheets.  This is a complex re-engineering task that forces all the different business units to justify the capital allocated to them. So far, this is proving more difficult to do than they thought – many of the variables involved in such an effort, are themselves variable, and vary differently over changing market conditions that are hard to predict.  And the regulatory constrains to be optimized are very tight.

Despite several years of such effort, it is starting to become clear that optimizing will not work, at least not for Bank of America, Citigroup or Morgan Stanley. Even if they could balance things out optimally, the resulting return on equity is still too low to cover their ongoing cost of equity capital.  The market already knows this, even if the boards of these banks do not.  Like the Europeans, they will have to adopt more radical changes to get to where they need to be.

The changes, by the way, cannot come from scaling up market shares through mergers – as was done over the past twenty years. Investors know they don’t work well, and because, under Dodd Frank, regulators would probably deny most large bank mergers.

The changes will have to come from the banks breaking themselves up – so Bernie Sanders or Ted Cruz or their EU equivalents won’t have to.

For the supreme oligarchs, JP Morgan and Goldman Sachs, which are already very focused on capital markets, it may be possible to achieve optimization through management improvements and major upgrades in technology, but the market remains skeptical, even of them. They, however, can hope that the other oligarchs will quietly fold their tents and slip away, leaving the battlefield to them when market volumes return to what they once were.

It is true that the regulatory climate has left the capital markets industry surrounded by near impossible barriers to entry – that is, barriers to entering the business as it was. The barriers protect the survivors, but have also changed the survivors’ former business into one that no one can live with.

Aversion of this article appeared in eFinancial News on March 9, 2016.

  

Oil Prices and The Ghost in the Machine

by Roy C. Smith

Many years ago I asked the late Nobel laureate Paul Samuelson what was the most important thing he had not been able to learn about economics, and was surprised when he said “the formula for an avalanche.”

By this he meant how financial panics are triggered.  

At that time, financial panics were fairly rare, though mini-bubbles occurred periodically.  Today, especially after the 2007-2008 financial panic that began in mortgage-backed securities and spread to all forms of corporate securities, we are more aware of what might be called “volatility spikes.”  There have been three periods since 2008 when the volatility of the US stock market exceeded 35% (it normally is about 20%), not including the month of January 2016 when the VIX only reached a high of 27%).

Volatility, the variation of returns relative to an index or benchmark, can be measured for anything that trades, including stocks, bonds, currencies and commodities such as oil, which experienced one of its sharpest volatility spikes ever over the past 18 months when prices dropped 75%.  

Crude oil prices dropped by 72% in the year following the 2008 financial crisis, then the largest annual price change for oil since the Iran Revolution in 1979.

What interested Prof. Samuelson about avalanches, he said, was the sudden change from ”normal” conditions to highly abnormal ones in which everything that one knew about prices was suspended in favor of an irrational rush-for-the-exits mind set.

The Economics of Oil Prices

What we know about oil prices now is not much different from what we knew a year ago: Goldman Sachs forecasted an excess of global production over demand in 2015 of about 1.5 million barrels per day, or 1.5%. Though global economic growth was slowing, demand for oil was still increasing modestly, even after taking China’s slowdown into account. So the imbalance has been almost entirely because of supply factors. Saudi Arabia, which needs the cash but also wants to preserve its market share from encroachment by Iran, was the main reason, but US shale producers kept pumping too, apparently to avoid the cost of closing, then reopening their fields.

We also know that many new investments in exploration and oil field improvements have put on hold, which is logical when prices decline and cash is short, but as a result future production levels will decline until these investments are resumed. Thus there is a natural adjustment process built into the system that should stabilize prices over supply-demand cycles.

And, of course, the many economic benefits of lower oil prices should encourage global economic growth and future oil consumption, and therefore increase future demand.

So, how do we explain this year’s major collapse in oil prices, especially given the fact that the drop is not the result of a sudden political or economic shock that drove all the other instances of volatility spikes in oil?

Apparently the laws of economics, which would require some price adjustment but not one of 75%, seem to have been suspended in favor of a Samuleson avalanche.

Speculation

You might think it is because of heightened “speculation” by hedge funds and commodities dealers. Maybe so. A 2014 IMF Working Paper by S. Beidas-Strom and Andrea Pescatori investigated the importance of speculation on oil prices and concluded that that speculation (investments by non-users of the commodity) explained between 3% and 22% of trades, a wide range but perhaps not enough to throw the whole pricing mechanism into disarray over an eighteen-month period.  Speculators operate on both sides of the market, so they actually can contribute to price stability during market upheavals.

No doubt we will soon be reading about the next “Big Short,” in which some obscure oil traders made billions shorting crude oil, or stocks and derivatives tied to it. But, just as in the mortgage-backed securities market rout of eight years ago, for every seller there is a buyer who thinks the fall has gone far enough and wants to profit from a recovery. So far, these buyers (including several well known hedge funds) have lost billions. Many financed their positions on margin, which leveraged their losses or subjected them to forced sell-outs at prices set by lenders as the market deteriorated further.

Even so, since 2010 most large Wall Street banks have ended or reduced their commodities trading activities for regulatory reasons, removing their considerable buying power from the market.  This has reduced the role of speculators in the oil market considerably.

Irrational Behavior

In 1967 Arthur Koestler wrote an insightful book called The Ghost in the Machine that dealt with the idea that human beings still possessed DNA inherited from primitive ancestors, which could force behavior that in modern times might seem irrational or self-destructive.  Koestler worried about this in the context of the nuclear age; we, however, might have to consider whether such a ghost (or maybe instead something very new) could be present in today’s trading machinery.

Of course, irrational behavior is nothing new in financial markets - indeed it’s not so irrational to sell a position because you are convinced others are selling theirs.  But to the extent that such behavior can produce huge unexplained volatility spikes in basic commodities that are sustained for a year or more may be something new.

Leon Cooperman, a hedge fund guru who manages the Omega Funds, has been dealing with irrational markets for more than forty years. On January 15, he said that the turmoil in the stock market was not fully justified by underlying factors. A bit later, though, after the turmoil had further increased, he said there was something going on in the markets that he was uncomfortable with that he could not entirely explain and had made him more cautious. 

What was that something?

In its January 23rd issue, The Economist had a leader entitled “Who’s Afraid of Cheap Oil?”  The article pointed out that rising oil prices were bad, and falling prices were good for economic growth, but this time prices falling so far and so fast might not have been good after all.  That’s because the global economy and political system may be too fragile to adjust to the price changes without immediate negative consequences that outweigh the usual positive ones.

Lower prices, the article says, have already caused a drop in new investment in the global energy industry (including coal and alternative energy sources) of about $500 billion, which will detract from global economic growth, the estimate of which recently was lowered by the World Bank to only 2.9% for 2016.

Lower oil prices are also already having a disinflationary effect on consumer prices, to the frustration of central banks seeking to revive inflation to the 2% area as an incentive for growth.

And, The Economist points out, declining prices severely impact the ability of some energy and related companies to service the considerable debt that has been added over the past few years when prices were much higher. Fears of defaults on risky debt have already pushed Emerging Market and junk bond spreads over Treasury rates to their highest levels since 2012.    

Weak Suppliers and the End of OPEC

But the real ghost in the machine and oil-market game-changer is the desperate need by major producers to keep pumping despite the serious negative effects low prices impose on them. OPEC no longer is able to manage prices by curtailing production. Saudi Arabia needs cash to service its growing external debt (its current budget deficit is 12.7% of GDP), to fund its challenges to Iran in Yemen and Syria, and to keep peace at home.  The Russian Ruble has collapsed along with oil prices; most of its economy, which fell by 3.8% in 2015, depends on oil and gas sales; sanctions still restrict the economy and inflation is around 15%. Venezuela, Libya, and Iraq are on the brink of economic collapse and must sell every barrel they can. Iran, with sanctions removed, wants to make up lost ground.  These troubled countries together account for about 40% of world production. 

The biggest buyers, who benefit the most from cheap oil,  (China, India, Japan, Korea, and – still- the US) have been able to play sellers off against each other in the spot market. 

And they probably still will be able to do so over the next few years as long as the political and economic instability among major producers continues.

China’s Transitions Should Not Freak Us Out

By Roy C. Smith

In December 2014 I wrote a column for eFinancial News noting the 25^th anniversary of the great Tokyo market crash of 1989, after which all traces of Japan’s decade-long standing as an emerging economic superpower disappeared forever. The column compared Japan’s rapid postwar economic development and vulnerabilities with China, which has followed a similar economic strategy and now faces similar difficulties.  At the time no one paid much attention. China’s growing power was indisputable, and indeed, China was then beginning a broad economic effort to offset declining growth rates by stimulating domestic consumption.

The immediate impact of this effort, largely implemented by local and provincial governments and SOEs, was to inflate stock prices by about 200% over a nine-month period. The bubble collapsed last summer, and the government (similar to Japan in 1990) launched a series of heavy-handed efforts to force markets back to normal. These efforts worked for a while, but as soon as they were withdrawn, selling began again. The government’s interventions had in fact made the stock market riskier and more uncertain.

This year, stock markets have got off to one of their worse starts ever, largely because of an outbreak of further selling in China, complicated by “circuit breakers” that close markets after daily declines of 7% or so. (The New York Stock Exchange’s circuit breaks trip at a 20% change).

Western observers have interpreted the Chinese selling (SHCOMP is down 18.0% so far this year, despite considerable government support) to mean that the debt-laden Chinese economy will crash and drag down all the others.  The MSCI Emerging Market index is down 9.6% on the year, and even the S&P500 is down 8.4%

China’s economy does have some serious problems. Its estimated 2016 GDP growth rate is less than 7% -- the lowest since 1993 except for one-year crisis-driven drop to 6% in 2009 -- and many observers who now distrust Chinese economic data discount even this rate.  Conventional wisdom in and about China seems to hold that growth below 7% could generate widespread social unrest that could threaten the Communist Party control of the country.

This being the case, President Xi and his party have a great interest in using their considerable powers and skills to revive the economy.  When Xi came into office he appeared to understand that a major priority had to be to shift economic output from the export to the domestic sector, and for this to happen, market forces would have to play a more important role.

But market forces are hard to control, as the government has just discovered.  The dilemma for China is how much to rely on market forces to make the necessary transition to domestic consumption if these forces have such uncertain outcomes. Even so, China has sufficient market activity now to make a reversion to traditional “command” economics impracticable.  Mr. Xi and his colleagues have a lot at stake in getting this right.

In 1989 Japan was the world’s second largest economy; its market crash took about two years to reach bottom, where it remained for several more years. The early 1990s were stressful times in Western markets, but these markets recovered and were not much interested in what was happening in Japan.

Compared to the size of its economy, Chinese stock markets are small and should have minimal impact on Western markets. Fears of the contraction and of a credit crisis in China will reduce Chinese demand for imports (including oil), and lower its exchange rate, but not otherwise have lasting significant impact on US and EU economic conditions.

But the “three transitions” that China must make over the next decade – to domestic markets, to freer markets, and to improved political rights and opportunities -- will make things better in China over the long run s they have in other formerly authoritarian states like Taiwan and South Korea.  The Chinese transitions might be painful within China, but until they are completed, China’s role as an enduring economic superpower must be questioned. In any case, the transitions  are necessary and should not frighten us.

From eFinancial News Jan 13, 2016

Is Bernie Sanders Right About Glass Steagall?

By Roy C. Smith

Yesterday Sen. Bernie Sanders announced a seven-point plan to rein in Wall Street greed once and for all by “breaking up the big banks and re-establishing firewalls that separate risk-taking from traditional banking.” Sanders is a populist, so of course his plan has a populist ring to it; but, nevertheless the plan ought to be analyzed on the merits.

The key feature of the plan is to re-impose the 1933 Glass Steagall Act that separated traditional banking from the securities business, and which Congress repealed in 1999.  Much resisted by Wall Street when it was passed, the law changed the competitive environment of the US financial system, but led to fifty years of stability in banking and the development of robust capital markets that enabled companies to obtain large amounts of financing for longer term, riskier projects. By 1983, the US capital markets were the envy of the world and efforts to import US financial market technology and knowhow to Europe and Japan were well underway.

However, a global banking crisis began in 1984 with the Federal Reserve’s takeover of Continental Illinois Bank, which failed because of poor credit risk management and the consequent inability to roll over maturing deposits from large financial institutions. Other large banks had similar problems, so the crisis ultimately spread throughout the US, and then migrated to Europe and Japan, where, like the US, a Glass Steagall-type of law was also in place. Many banks had to be rescued by government funds during the fifteen years or so that the crisis endured. However, the suppression of bank lending imposed by government rescuers further shifted financial activity to capital markets, where corporate needs during the relatively high growth years of the 1980s and 1990s were fully met.

After the crisis, the banks realized that much of their business with large corporations had been disintermediated to capital markets where short term working capital could be raised more cheaply in commercial paper, medium tern notes and bond markets in the US and the Euromarket. The banks complained that their European competitors could participate fully in capital markets, but they were losing business because they could not. Bank loans, too, had become tradable in markets and had, partly through developments in derivatives technology and capacity, become integrated into fixed-income securities markets. Further, they argued, the Basel Accord that set a minimum requirement for risk-adjusted capital adequacy had been agreed, so another crisis was unlikely. It took several years to build support, but Glass Steagall was repealed in 1999.

After the crisis in 2008, governments around the world once again poured funds into large banks to prevent their failure and domino-like contagion of the problem throughout the global financial system.  The rescues involved several trillions of dollars (mainly expended by central banks through lender-of-last resort and market support activities) but stabilized the global financial system within a few months. 

Three observations of this history are worth making.

One – Glass Steagall did not prevent the banking crisis in the US and Japan in the 1980s and 1990s. Nor did the Basel Accord prevent the crisis of 2008.  Regulations don’t always accomplish what they intend.

Two – the crises involved many performance-oriented banks all around the world that were following similar business strategies in competition with each other (though under an extensive regulatory regime). These strategies focused on enabling companies and financial institutions to take on risk and projects necessary for growth. It was not just because of unlawful conduct, greed or incompetence that the crises occurred; it was much more a matter of systemic market failure. 

Three – government intervention was the only way that the financial system could be saved from total collapse with much more severe effects on the real economy than actually occurred. Too-Big-to-Fail policies were indeed necessary; the government was the only source of funds to act as a lender of last resort under such circumstances. Taxpayers actually made a considerable return on their investment in such programs as TARP and stabilization efforts by the Federal Reserve when these positions were unwound.

After the 2008 crisis when Congress was debating the Dodd-Frank Wall Street Reform and Consumer Protection Act (passed in 2010), a re-imposition of Glass Steagall was considered.  The arguments for it were that banks had become too big, clumsy and herd-like (and greedy) to manage market risk well enough to avoid the possibility of a future failure. The easiest way to reduce this risk would be to make banks give up capital market activities.  There was merit to the argument (that also applied in 1999) but banks strongly resisted a one-size-fits-all policy that would permanently bar banks from capital markets where three-fourths of the capital raised by large corporations occurred. They also objected to a policy that would affect them but not their foreign bank, or US non-bank, competitors.

Another argument was the extent to which bank lending had become integrated with securities markets, making activities difficult and expensive to separate, monitor, and enforce.

In the end, Dodd-Frank did not separate banking and securities businesses, or force banks to reduce themselves to smaller sized entities, but it did many other things that give much more power to regulators to control the financial system, and limit risk taking by banks. Dodd-Frank claims that it has eliminated Too-Big-to-Fail situations in the future, but it attempts to do so not by restricting their bigness (except in terms of a maximum market share of US bank deposits), but by restricting the amount of risk of failure than the banks can take on.

Dodd-Franks defines “systemically important” banks as those with assets greater than $50 billion (about 40 US banks), which are to be subject to much tighter regulations than non-systemic banks. It also empowers the government to designate “systemically important non-banks” (the so-called “shadow banks”) and to regulate these the same as the large banks (four non-banks have been designated as systemically important so far). 

Dodd-Frank has many other provisions, including annual stress tests necessary to pay dividends, regulation of proprietary trading (“speculation,” which Bernie wants to tax), derivatives markets, executive compensation, rating agencies (Bernie wants to force them to become non-profit organizations), and consumer protection.

The irony of all this is that the weight on the big banks of Dodd-Frank, Basel III (a tough upgrade of the original Basel Accord), and various new national banking rules around the world, has made it very difficult for banks to comply with all the new regulations and still make a return on investment greater than their cost of equity capital.  Almost all of the major banks have failed to produce a net positive return on equity since 2009, so all are required to alter their basic business models to enable improved returns.

Accordingly all banks have their eyes on one of their own, Well Fargo, which has sailed through the regulatory changes relatively unscathed.  Wells, essentially a retail and consumer bank, never had a very extensive capital markets activity beyond what was needed to service its mainly small and mid-sized corporate clientele. Today it is the world’s largest bank by market capitalization, trades at 1.7 times its book value (the rest trade at an average of about 1.0x), and generates 5% net return on equity (after subtracting the cost of equity).

For big US banks like JP Morgan Chase, Citigroup and Bank of America, the best approach to modifying their business models as a result of regulatory changes may be to spin off to shareholders their riskier and more capital intense investment banking units. Doing so would improve shareholder returns, make regulators happier and enable their investors to participate in two different, but separate, business models. Doing so would also, de facto, break up these banks as if Glass Steagall had been restored.

Bernie Sanders probably has the right idea about what would be good for the banks and everyone else. But, restoring Glass Steagall is not necessary because Dodd Frank imposes so much regulatory weight on them that their best way forward may be to break themselves up.

But, the banks haven’t done so yet, and don’t seem to be inclined to do so.

Maybe things will be different by the time of the election, or by 2017 when the new administration will be pulling its legislative agenda together. But, if Bernie should somehow pull off a win, then he still has to face a Republican House or Representatives (and maybe a Republican Senate to), which will make his financial reform package tough (probably impossible) to pass.

Happy New Year from Rosie

by Roy C. Smith

Yes, it has been an ugly year.

We’ve had Syria, terrorism, the refugees, a collapse in oil prices, a European sovereign debt crisis, trouble with China and Russia, and world economic growth slumping towards a pathetic 3%. And we have had Trump and the Republican wannabes that make Hillary look good, and a lot of other stuff that has taken the winds of confidence out of our sails.

Unemployment is down to the 5% level, but only 63% of the workforce has jobs, the lowest percentage since 1978.

US stocks are likely to end the year in the red for the first time since 2008, but investors are nervous about rising interest rates without seeing much to look forward to in the general economy.

So, I asked my old friend Rosie Scenario out for a holiday drink, to see if she could cheer me up.

“You’re too gloomy,” she said.

It is true that the US economy has had a rough fifteen years, with two financial crises, a Great Recession and a war in the Middle East that has cost $4-$6 trillion and still isn’t over.

But, she added, after a prolonged period of slow economic growth that has averaged barely 2% per year, things are settling down for a long-term recovery.

The Fed has decided that after eight years the economy is strong enough to leave to its own devices, so it has ceased its price-distorting QE interventions, and allowed rates to rise a little, at least symbolically. Both regulators and litigators have hammered the banks, but corporations have been able to get what they needed from a record level of new bond issues, and consumers and small business are getting a boost from “peer-to-peer” lending, “fintech” and from private equity funds.

The traditional economic “factors of production” – wages, resources, capital and enterprise – still at low costs, are ready for another round of expansion. Real estate activity is up about 10%, consumers have cleaned up their balance sheets and are active again. US GDP for 2016 is expected to be about 2.5%; not great but better than it has been, and building up momentum for a push in the right direction.

Rosie also sees the international situation also looks better than it did.

It has been bleak, she said, but the worst is over. The EU and the euro looked like it might be shaken apart by its sovereign debt crisis, but Angela Merkel and the ECB showed they had the clear head and courage to commit the resources needed to settle things down. The hodge-podge economic union of 28 states, with a common currency used by 19 of them, has survived its first serious existential crisis and is stronger for the experience.

A bigger set of problems now exists in the BRIC countries that are also facing existential issues. Brazil has been affected by collapsing commodity prices and high inflation, but its main problem, like Argentina’s, is political, and can be turned around by a new government.

Russia’s GDP will be down 3.6% this year, mainly due to oil prices, but Putin’s machismo behavior that drew sanctions over his Ukrainian actions has added to his difficulties, and sent him a message – his fifteen years of domination of Russian politics has been enabled by a robust growth in per capital GDP, but because of the recession and the collapse of the ruble, GDP per capita (in terms of current prices) will be 40% less in 2015 than in 2013.

Putin knows that strong, authoritarian leaders in Kiev, Cairo and Tripoli have been brought down by public protests, and seems to realize now that further confrontations with the US and the EU will only make his economic problems worse. After all Europe is Russia’s biggest customer for its oil and gas, and increasingly there are alternative sources of supply available to it. All in all, Putin is likely to end up more helpful than we expected in Syria and Iran, and start to make nice again to get back into the good graces of the EU. Maybe the UN’s agreement to secure a cease-fire in Syria, in which Russia played an important part, is an example. 

China, too, faces big issues in the next few years – it has to be able to deliver economic growth sufficient to satisfy the billion or so Chinese who are not yet among the middle class but aspire to be there. Growth has fallen from 12% in 2010 to 7% in 2015, with government expectations of 6.5% in 2016 (and others looking for less). Efforts to confront falling growth rates resulted in a stock market bubble that burst last summer. Serious government efforts to stabilize markets were not very successful, showing the limits to its power.

Indeed, China’s growing influence in the world has been a result of its extraordinary growth over the last thirty years. A slowdown in growth rates to a more normal level brings many challenges to the Chinese government -- domestically to avoid pressures for the level of political freedom that rival Taiwan has achieved; in South East Asia, where Chinese bellicosity has been fueled by its rising economic power; and in the broader world where China has been accepted as a superpower, but without showing it has the capacity to remain one.  It is hard to see how China’s Communist Party can remain in power without a transition to a more open and democratic state in the future. Slowing growth rates may accelerate this process, which would be good for China, its neighbors and trading partners.

Terrorism is still a big issue, Rosie says, but nowhere near as big as we (and our political candidates) make it out to be. Radical Islam has been most dangerous to other Muslims in the Middle East. It has been less dangerous in Europe, but of course its profile there now is very high (and likely to get the attention it needs). In the US since 9-11, terrorism has been less dangerous than school shootings; so far consisting only of radicalized individuals or small groups operating on their own.

In the US and the EU, terrorism is largely a police issue and the more incidents there are, the more cooperative police become with each other in developing their abilities to prevent attacks. In the Middle East, military force will be needed to contend with ISIS, but it will have to be supplied by Middle Easterners.

Finally, Rosie thinks our wild and awkward political process is likely to produce the best of all possible results.

The drama of primary elections is necessary in a country of 330 million people, who have different things to say about issues and want to vent about them. Sure, candidates say and do whatever they can to attract votes, but in the end, it winnows down to two (or possibly three) viable candidates, who stimulate the economy with billions of dollars of spending on advertising and other expenses. After the election, we either have a “divided government,” i.e., one in which the Presidency and the Congress are not controlled by the same party, or we don’t. If we don’t, then the party in control can enact whatever platform it can get by a 60-vote hurdle in the Senate. That condition doesn't occur very often, and is unlikely this time.

If it doesn't happen, the country will muddle along somehow, with minimal changes in major political or economic positions. When no one gets what he or she wants, not much actually happens. We can live with that, especially if it keeps stuff we really don’t like from being enacted.

The President, of course, can start wars or other military engagements that are hard to get out of.  After a year or more of listening to the candidates, we will know which are more warlike than others. Whatever it thinks of any candidate at any particular time, however, the American electorate has very little enthusiasm for wars in the Middle East or anywhere else.

Meanwhile, after a tumultuous year, the new Speaker, Paul Ryan, managed to get the House Republicans (and the others) to pass a $1 trillion government-spending bill, rather than shut down the government.

So, all in all, Rosie says, things are also messy, but the US will continue to be the strongest economy in the free world, positioning itself through market actions for a return to higher growth rates. The rest of the world is sorting itself out for the best, and our politics aren’t as bad as they look.   

Well, Rosie has always been able to cheer me up (at least for a few weeks), and maybe she will cheer you up too.

Happy New Year from us both.

Did the Fed Really Curb its Emergency Lending Powers?

By Roy C. Smith

Last week the Federal Reserve announced that it would adopt restrictions imposed by Dodd Frank to limit its emergency lending powers under Section 13(3) of the Federal Reserve Act, but it now has even more room to act in the next crisis.

Section 13(3) provisions allow the Fed to lend funds to any entity outside the banking system if circumstances are deemed to be “urgent and exigent.”

In 2010, a Congress angered by federal “bailouts” of banks and other financial institutions passed the Dodd Frank Act, including in it an amendment to the Federal Reserve Act of 1913 to limit 13(3) programs that enabled loans to Bear Stearns and AIG during the financial crisis. The amendment requires such programs be limited to those with a “broad base” of eligibility (now interpreted to mean involving at least five different participants) that are also approved by the US Treasury Secretary.  The idea is to limit 13(3) to only being able to provide liquidity to multiple, solvent financial institutions in times of crisis.

It took the Fed five years to come up with these new rules to implement the amendment, despite its being spurred by Senator Elizabeth Warren, Representative David Vitter and others in Congress from both parties who seek to limit the Fed’s powers.

The Fed’s action, according to Congressman Vitter, “is the first real acknowledgment from the Fed that it needed to do more to curtail its own bailout authority.” 

The new rules will prevent the Fed from lending money to prop up a single failing firm, said Fed Chairman Janet Yellen. Both the Bear Stearns and AIG rescue operations were considered crucial to the 2008 effort to stabilize the financial system by both Ben Bernanke, then Fed Chairman, and Hank Paulson, Treasury Secretary at the time.

But a lot has changed since 2008 that makes the one-off emergency lending powers of Section 13(3) less important to maintaining stability.

First, there are no longer any potential too-big-to-fail financial institutions that are outside the orbit of regulatory control established by Dodd Frank for “systemically important” financial firms.

Of the five large, independent US investment banks existing in September 2008, only two have survived and both are now bank holding companies regulated by the Fed. And, four of the largest other US nonbank financial firms have been designated as systemically important by the Dodd Frank authorized Financial Stability Oversight Council, thus requiring them to be regulated by the Fed and subject to enhanced capital controls, intervention and other constraints that should reduce systemic risk, and thus the need for a future 13(3) loan.

Other large nonbanks (e.g., Fidelity, BlackRock, and some hedge fund groups) have successfully argued that as managers of other people’s money through hundreds of different investment vehicles, they should not be considered as a single entity whose failure would have systemic effects.  So far the Fed has bought (or has been forced by political pressures to buy) into these arguments, so presumably it would have no reason to assist them in a crisis.

So, the lost power to intervene in individual cases of systemic risk is now a power no longer needed. However, since September 2008, other powers available to the Fed to avert and manage crises have been greatly increased.

Dodd Frank conferred additional authority and influence on managing systemic risk to the Fed. It now conducts annual qualitative stress tests on large banks and can deny those who fail the ability to pay dividends or do other things. The Fed also sets capital adequacy levels, leverage limits, and the requirement for “total loss absorbing capital” (in which bond holders participate in losses). It monitors banks closely and has the power, and apparently the will, to force them to remain in safe waters.

The banks have complied with the Fed’s post-crisis requirements, so are safer. But this has meant that much of the financial risk the banks used to carry on their balance sheets has migrated into capital markets and the nonbank sector.

This sector is a multitude of nonsystematic firms that operate in financial markets, but it is not directly subject to Fed regulatory control.

But, don’t worry, the Fed has found important ways to assert de-facto control over the nonbanking sector too.

This is done through market intervention programs, in which the Fed, through asset purchases, can inject large amounts of capital to preserve market functionality and alleviate liquidity panics. After September 2008, the Fed began an unprecedented effort to stabilize financial markets across the board, ultimately expanding its balance sheet to $4 trillion from less than $1 trillion.

Indeed, as early as March 2008, after Bear Stearns was rescued by JP Morgan (with Fed assistance), the two-dozen or so authorized market makers in Treasury securities were struggling to maintain their funding arrangements. As a result, the Fed established a temporary Primary Dealers Credit Facility and Term Securities Lending Facility to assist them. This was the first time in the history of the Fed that it had provided funding for nonbank broker-dealers in its efforts to maintain market stability.

These programs usually are ended after stability returns, but the Fed seems comfortable in starting them up whenever they seem to be needed.

Today, as a result of capital and other constraints, many banks have reduced their exposure to the repo markets, and nonbank money market funds and other participants have increased theirs. Consequently, in 2013 the Fed offered a $300 billion Reverse Repo Facility to assist dealers in this important market.

If a problem in the nonbank sector should require it, the Fed can intervene more precisely by declaring a 13(3) lending condition after designating five or more intended recipients in order to stabilize their broad based ability to roll over maturing liabilities of their own or of funds they manage. This would be within the scope of the new rules, even if only one firm (targeted for assistance) actually used the facility.

Though there are many in Congress who would like to clip the wings of the Fed further, the Fed is more powerful than ever. "We're perfectly happy now that there are alternative ways to deal with a failing firm,” said Ben Bernanke recently, “the Fed doesn't have to intervene in [individual cases] the way we did in 2008."

And, he might have added, what we have learned from our various intervention efforts has increased our confidence that when another crisis comes we will have the tools needed to meet it.

Building the European Champion

By Brad Hintz and Roy C. Smith

Barclays, Deutsche Bank and Credit Suisse have all announced plans to cut back capital market activity under new CEOs brought in to revise the business models.  What to do with the investment banking remnants is the difficult part, but an imaginative solution is available.

The three European universal banks have used investment banking as a way to supplement slow growing domestic banking and subscale asset management businesses. Over many years, going back to Big Bang, they have poured their dreams and capital into acquisitions of businesses and talent that they hoped would enable them to occupy the high ground of global capital markets, only to encounter wave after wave of pain and suffering. Finally they appear to be bowing to the inevitable – cutting back investment banking to the bare minimum needed to sustain and protect their basic banking businesses, and, one way or another, jettisoning the rest.  

What makes this difficult to do is that investment banking represents 20-40% of these banks net revenue, and over half of their balance sheet. What makes it good to do is that at least 70% of their troubles come from this culturally alien business that they have all had to engage mostly American hired guns to manage. 

The lost income and the prestige will be missed, but the impaired balance sheets and the debilitating exposure to regulatory constraints and litigation will not. Getting rid of the troublesome investment banks leaves the parents with much diminished scale and more limited aspirations, but the rebooted banks would be able to concentrate on their commercial and retail businesses and have a chance to improve their stock prices considerably, as UBS has done, while greatly easing the minds of their regulators.

But transitioning out of investment banking is not easy. A simple solution might be to transfer some portion of the unwanted assets to the non-core pile and liquidate them over time. Doing this might release required capital of 10% or so held against risk-weighted-assets (RWA), but the liquidation itself is likely to require haircuts that would consume most of it.

We looked into Barclays Chairman John McFarlane’s suggestion that a “European champion” capable of competing with the Americans might be put together from among the parts of the European players.  We studied a combination of Barclays Capital and Deutsche Bank’s investment bank, two of the strongest, to test the feasibility of the idea. 

In terms of market share, the idea is compelling. With over $28 billion in revenues this new European champion would command a number two market share in fixed income trading, number three in institutional equity trading, and in investment banking it would hold the leading market share in both debt and equity underwriting and would be number two behind Goldman Sachs in mergers and acquisition advisory. Even if one were to assume a 10% client defection this new combination would remain a top three investment bank with powerful positions in Europe, the USA and Asia.

The regulatory capital position of the new entity looks reasonable with an equity capital to RWA ratio of 12.9% compared to a 13% ratio for the Goldman units. On a pro forma basis the new entity would generate an 8.2% ROE in 2014 versus Goldman Sachs estimated ROE of 9.4% in its investment banking and trading businesses. This performance remains below the cost of capital for a standalone investment bank but the potential for some merger synergies, balance sheet rationalization and a shift in the mix of the product portfolio makes a 10% ROE a reasonable near-term goal.

But there were some problems.  The combined balance sheet of the new firm is 50% larger than Goldman’s balance sheet due to the new firm’s heavy reliance on fixed income sales and trading and therefore the pro forma leverage ratio is too high. It's RWA to asset ratio also is suspiciously low which may imply challenging regulatory discussions in the future.  All this will require further surgery and adjusting to shrink the trading units to a more reasonable size with a balance sheet able to secure a BBB debt rating.

For such a combination to work it will require new some new entrepreneurial energy, capital and resourcefulness beyond what’s available at the parent banks. This could be obtained by pairing up with one or more private equity investors to build a new, viable business outside the EU banking regulatory regime, though the firm most likely would be considered a SIFI and subject to Basel and some other rules. The new investors would assemble a high-grade, well-incentivized management team from the best in the business that would pull together such other assets and talents it needed.

The new firm could be funded in part by offering cash, some debt, Buffett-like preferred stock, or equity to banks selling the RWA, and by selling LP interests to institutional and other investors. Ultimately the new firm would present itself as an independent privately owned investment bank, with managers and employees owning significant stakes. It would hope to have an advantage over the banks in attracting both top talent and capital.

Such a solution is complicated, but doable. The large discounts from book value at which Barclays and Deutsche Bank stocks currently trade leave room for negotiations that incentivize new investors and still recover shareholder value for the banks.

Barclays has selected Jes Staley, an American investment banker, to become its next CEO. Although this suggested to some that Barclays was committed to retaining its commitment to investment banking, a different message seems more likely. As McFarlane surely knows, and Staley will soon find out, the future of Barclays Capital after ringfencing in 2019 is bleak. The two thus will be forced to look for alternatives to simply continuing as before. What exactly they or the other banks will do we will have to wait to see, but Barclay’s choice for its next CEO, with long experience in asset management, and more recently with hedge funds, understands the private equity terrain very well and would know how to explore a solution from that direction.

 eFinancial News, 9 Nov. 2015