Two themes over the past week must offer stark evidence of the sheer imbalance
in the global banking system: Agricultural Bank of China (ABC or AgBank)
launched the world's largest initial public offering, raising over US$22
billion, and European banks are widely expected to fail rigorous stress tests
being promulgated at the insistence of the European Central Bank (ECB).
Among the acres of newspapers expended on the need for and construction of
stress tests for European banks, the key missing element is, almost
predictably, "why?" As in, what is it about the European banks that made them
particularly prone to the excesses of each credit crisis, which in this current
one has
effectively wiped out all but a handful of banks in the region?
Understanding these weaknesses would be central to exploring the future of
banks in Asia - for example in China, an area of special concern to investors
given the vast sums of money being raised, and the rather proximate (and
painful) experience with bank equity in Japan.
European weaknesses
One could quite easily write an entire book about why European banks are in the
state where they are today. Without that luxury, the objective here is to look
at key factors that sometimes fed each other and ultimately contributed to a
meltdown of the banking system.
The primary factor to systemic weakness in Europe is the lack of consolidation.
There are thousands of banks across the continent - Germany alone boasts close
to 3,000 banks - all with their own idiosyncratic behavior, focus areas and,
more dangerously, regulatory requirements.
Despite the onset of the common currency and trade area for the past 10 years,
banks have been zealously owned across national lines. The few exceptions are
in Germany, where there are foreign-owned banks like HVB (part of Italy's
Unicredit group), and Austria (where a number of banks are German-owned). Why
has that been the case?
a. Too political to fail: in contrast to the "too big to fail" argument that
dots the landscape in the US and Asia, the primary argument in Europe is to
disallow pretty much any bank from failing. This has had a counter-intuitive
effect on the European Union; namely that "nationalism has gone local"; thus
every bank including community banks has ardent political supporters wanting to
maintain the status quo. The mess in Spain with the local savings banks
("Caja") is driven entirely by such regional political aspirations; in a larger
context, the French have zealously guarded their banks from German encroachment
or Swiss efficiency, mainly for nationalist reasons.
b. Myriad regulations: it isn't just the number of banks that worries people,
it is also the bewildering array of such institutions, ranging from savings
banks to regional banks and commercial and investment banks that co-exist
within the same framework. Adding to the confusion for example in Germany is
that some regional or Landesbanken are the regulators of the savings banks
(Sparkassen) who may actually own the shares of the Landesbank.
I don't even want to think about conflicts of interest in such a situation.
With multiple regulatory frameworks in place, it quickly becomes clear that
"arbitrage" involving the different banking regulators becomes easy at one
level; equally, consolidation becomes tricky if not impossible at another
level.
c. Rigidity of labor is another factor, albeit one that is more common across
the landscape for both companies and banks. European buyers can hardly ever
seize the type of efficiency improvements that offer immediate value
enhancement for equity players in the US and Asia simply because in most cases
excess staff cannot be fired. This reduces the willingness of banks and their
shareholders to take acquisition risks within a country or even regionally
across Europe
d. Competition considerations are also important to appreciate the fractured
landscape. Unlike the generally laissez-faire regulations that ended up
creating the "too big to fail" class of banks in the US, the European
competition watchdog is much more activist. A merger of the kind that created
today's JPMorgan Chase would be impossible to contemplate, let alone construct,
in Europe. When RBS bought the ABN Amro group (to its eternal regret later on,
which is another story altogether) it was forced to shed a number of businesses
that were perfectly profitable and complementary to its existing suite of
businesses.
e. Indifference: the lack of a widespread equity culture and more specifically
the hunger for strong EPS growth that drives US managers to take substantive
risks is central to the benign indifference to the consolidation principle in
Europe. Too much choice is a bad thing, too: any potential buyer has hundreds
of targets; narrowing down on a bottom-up (fundamental) basis is nearly
impossible. Looking at such ideas top-down is a function of macroeconomic
variables that aren't strictly the preserve of smart bankers.
The lack of consolidation has several effects:
a. Subscale and unprofitable: European banks are almost alone in the world in
terms of the sheer losses that are absorbed in an area of banking that is
bread-and-butter elsewhere in the world, namely retail banking. With too many
choices, prices are set too low and rates paid out for funds too high
b. Low capital bases: since income diversification and counter-cyclical
cushions are virtually absent in the European banking landscape, banks in
general are poorly capitalized. This is usually acceptable when economies chug
along nicely, but quickly becomes fatal when things fall apart.
c. Excessive concentration through either product or regionally (or as in the
case of Spanish banks, both) is an ill that plagues European banks across the
board due to the lack of consolidation in the sector. Understanding this
requires an appreciation of concentration risk. Imagine that an earthquake hits
a country (as it did in Kobe in the mid-1990s). One of the first requirements
in the post-rescue reconstruction efforts would be to use credit instruments.
This is rendered impossible when banks in the region have also been wiped out
because of their concentrated lending to the same region.
d. Technology is a tough question for European banks. Typically they either
have too much or too little of it. Investors seeking "sophisticated" products -
such as the folks who lost their wealth in 2007 - have an excessive reliance on
quantitative models and esoteric risk-management techniques. In contrast, many
retail institutions lack basic computing architecture. Right-sizing the sector
requires an integration of various types of franchises, which is rendered
implausible for reasons cited above. The use of technology isn't a panacea for
banking system ills per se, but the lack of risk-assessment techniques becomes
all the more painfully apparent during a crisis.
The second factor is demographics, in particular the rapid aging of the
European population. Much as in the case of Japan, the key problem this
presents for banks is that when consumption as a whole declines (older people
consume less than younger people, eg on houses, cars and so forth), the need
for credit declines even as the supply - savings - goes up. This glut of
savings typically creates headaches for banks, which are obliged to accept
deposits but cannot necessarily place funds profitably.
German banks have suffered this problem since the 1980s. When the Berlin Wall
came down, there was an immediate upsurge of lending interest to the former
East German side. However, a combination of poor demographics, the lack of
economic growth in the East and the absence of a credit culture put paid to any
expansion plans. Instead, the newly rich East Germans simply deposited more
money (from their newly exchanged deutschemarks) into the banks. Similarly, the
implosion in Russian sovereign debt in 1998 caused further inflows for European
banks.
Excessive inflows of savings were also accompanied by the structural factors of
low consumption that afflict demographically challenged populations. This
development alone could have vastly eroded the profitability of retail and
community banking in Europe and driven more banks to seek more exotic
investment opportunities in bonds, leveraged loans and the like.
That was the main driving force behind European banks opening branches all
around the world. Their timing couldn't have been worse. The rush into Asia
during the early 1990s culminated in the absurdly large losses suffered during
the Asian financial crisis of 1997. Before that, various banks from southern
Europe had managed to lose massive amounts of money in Latin America (albeit
not quite to the same extent as American banks that had rushed in to diversify
from the imploding US economy of the 1970s).
As deposits grew faster and European banks found themselves unable to expand
balance sheets further through geographical expansion, increased risk-taking
through lower-quality exposures (high yield) and extending maturity (longer
term) came into vogue. From the regulatory perspective, this soon made the
balance sheets of European banks not just difficult to read but also impossible
to value properly. That in turn forced regulators to push for greater
transparency and market-based benchmarking of assets.
The push towards markets was soon made easier by another development - the
capital adequacy regime imposed by the Bank for International Settlements, BIS
for short, which is based in Basel, Switzerland. Mention the town to any banker
and the first reaction will likely be a shudder.
Basel capital reforms implemented in the 1990s were to prove more dangerous for
banks though. While the initial version was fairly broad-based, the second
version (Basel II) attempted to codify into regulatory practice the notion of
risk-weighted assets, with the assessment of risk being driven by credit
ratings. This was an important development because it explicitly moved banks
away from home-turf advantage (they knew their borrowers) to a less transparent
but still standardized practice around credit ratings.
What would you rather do when a regulator calls about your capital adequacy -
explain 5,000 files for borrowers, each of whom has about $10,000 against his
name, or simply buy a bunch of bonds for $5 billion and explain it away in one
sentence as "triple-A rated"?
More than in the US and Asia, this opportunity for expanding assets without
having to raise new capital was seized on by European banks. The regulations,
for which various European governments and banking groups had lobbied, were
almost tailor-made for the sector. In one fell swoop, a number of key
structural problems associated with cross-border lending and the accumulation
of illiquid securities had been eliminated.
With rules-based investment inevitably comes the opportunity for malfeasance.
In effect, a combination of the above three factors made European banks captive
customers for the kind of products that Wall Street would later manufacture.
The story though isn't quite complete yet. There were two other factors that
came into play in the earlier part of this decade, both of which played havoc
on the investment behavior of European banks, driving them en masse towards
self-destructive behavior.
The first of these factors (call them accelerants) was the European
Commission's decision to ban government guarantees on various banks that
operated in the commercial space and competed for lending business; in
particular the developments affected the functioning of German Landesbanken.
Previously, much like the operations of US agencies such as Fannie Mae and
Freddie Mac, bonds issued by Landesbanken carried implicit guarantees from
German states, thereby carrying significant credit ratings (triple A). The
ruling of the competition commission in 2004 paved the way for such bond
issuance to cease, but did provide a single-window exemption, namely that bonds
could still be issued until a certain time in 2005 with attendant government
guarantees. That clause, called "grandfathering", forced them to issue an
excessive amount of cheap bonds, in turn accentuating their liquidity and
making more acute the need for deployment.
The last factor was the monetary easing by the US Federal Reserve, which played
a big part in the pursuit of "sophisticated" triple-A products as yields on
government bonds fell sharply, at times below the cost of borrowing of even the
cheapest bonds by the German banks. This "negative" carry had to be taken out
of the picture by purchasing more structured investments that were highly rated
(remember the banks had excessive liquidity, not capital) but yielded more than
"true" triple-A assets such as US government bonds (due to the structuring
mechanics of Wall Street).
All these factors essentially pushed the European banks into the vortex of
almost unconscious investments into heavily structured products created by Wall
Street.
Implications for China
Even as China and its fans celebrate the launch of the AgBank initial public
offering this week, itself paving the way for four of the top 10 banks in the
world by capitalization to be Chinese, warning signs have emerged.
The first point of concern is the rampant political interference in the Chinese
banking system, with the central bank forever tweaking rules on lending,
especially to the property sector, altering levels of reserves against certain
types of loans and so on. This makes the decision-making process forever
hostage to political changes; for example, when the economy slows down the
government inevitably relaxes guidelines about lending. This behavior is
counter to the principles of sound banking, and as such strikes at the heart of
the valuation being placed on Chinese banks today.
The second factor is very similar to the core affliction of European banking,
namely the demographic time-bomb that China has become. The rapidly aging
population combined with rapid economic growth means that conditions are ripe
for exactly the kind of logjam that the European banking system (and the
Japanese banking system before it) went into.
Much like the criticism about European banks, the deployment of technology in
China is uneven; much worse is the use of risk-management techniques that have
become more common globally. The uneven pace of implementation combined with
the lack of accounting transparency renders the financial positions of many
Chinese banks questionable in many respects.
Lastly, there is the continued issue of corruption - not quite a European
affliction but certainly one that played a part in Japan previously - which
could further accelerate the losses being suffered by investors in Chinese
banks.
Present heady growth in the sector, combined with the strength of the
government financial position, makes this the best time to properly implement
measures that would prevent the Chinese banking system from heading in the same
direction that European banks followed over the past 20 years. There are
already enough reasons to suspect that it could be too late to structurally
reform and rescue the sector; wasting more time could prove inadvisable in the
extreme.
(Copyright 2010 Asia Times Online (Holdings) Ltd. All rights reserved. Please
contact us about
sales, syndication and
republishing.)
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
