A capital question

RBA Governor and occasional Chaser’s War stand-in Glen Stevens had this pearl of wisdom to share re the GFC:

The intention, after all, is that lenders will operate with more capital against the risks they are taking. But capital is not free; shareholders have to be induced to supply it, and it will have to be paid for. High-quality liquid assets typically carry lower yields too, so mandating higher liquidity will have some (modest) cost as well. Admittedly it can be argued that shareholders of financial institutions will have a less risky investment and so should be prepared to accept lower returns.

My question is, if investors are already expecting insane returns on capital invested in banks, will this change anything or will it simply put more pressure on banks to produce the same returns on a bigger capital base?  See here for the historical data. The bottom line is that in the 11 years to 2008 the big 4 banks had an average ROE of 18.4% compared with yields on 10-year Government bonds of 5.8%.  Just how risky are these things?

Asleep at the Wheel

The Senior Supervisors Group is an august body of 10 financial market regulators, with a very heavy representation from North America (Fed, Fed NY, SEC, the quaintly named Comptroller of the Currency and Canada’s Superintendant of Financial Institutions) and Europe (French Banking Commission, Swiss Financial Market Supervisory Authority, German Federal Financial Supervisory Authority and the UK’s Financial Services Authority).  Japan’s Financial Services Agency rounds out the ten.  So that’s:

North America	50%
Europe	40%
Asia	10%

Right.

The SSG has recently released an exciting report entitled Risk Management Lessons from the Global Banking Crisis of 2008.  Click here to see it.

A couple of things sprang to mind as I leafed through it:

• The crisis of 2008?  I didn’t think 2009 was so hot either.
• What’s with the cover page?

• The arrangement of logos is just too suggestive of something else:

The man who would be Mervyn King

Merv had a bunch of very insightful things to say recently, reported here in the Torygraph.  Especially eye-catching was this view:

"It is in our collective interest to reduce the dependence of so many households and businesses on so few institutions that engage in so many risky activities. The case for a serious review of how the banking industry is structured and regulated is strong."

He added: "The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion," adding: "It is hard to see how the existence of institutions that are 'too important to fail' is consistent with their being in the private sector."

Harping back to an old but related theme, if the risk free rate of return is 5% or thereabouts (before tax) and the banks are chasing 20% returns (after tax), presumably the differential between them represents a gigantic risk premium which doesn’t quite add up to their “too important to fail” tag.

Yet More Bill

Sept. 2009 and Bill Evans at Westpac continues to hold a big lead over the rest of the field:

Meanwhile the CBA has been asking the question: “How good are economic forecasters?”  A good question given where they are on the ladder.  Have a look at the article here.

One of the conclusions is:

But CommSec did find that a good approach for investors was to follow the consensus. An average of the
20 forecasters consistently outperformed the majority of individual forecasters over differing time periods. Of the 77 indicators tracked, the consensus economic forecast picked the direction of movement 78 per cent of the time. And on 60 per cent of occasions the consensus result was amongst the top forecasts.

Check their findings against the “Avg” indicator above – looks like pretty good advice to me.  The only better advice would be “follow Westpac” which would be reasonably courageous for a CBA economist.

Bill Evans – my hero

Bill Evans at Westpac has done it again, retaining a huge lead over the opposition in the rate tipsters ladder:

Not surprisingly the WBC groupies have been out in force….

 

NAB provisions – back to the future

Chalk another one up to the men in grey.  Amidst all the talk of the huge increases in NAB’s bad and doubtful debt provisioning, bear in mind that it’s just getting back to where it was before the bean counters decided that provisions were evil and may lead to the dreaded profit smoothing.  They must be thrilled to bits with the volatility now apparent in bank reported earnings.

2008 Snout/Trough Index – the big Kahuna

In my recent post covering the 2008 Snout/Trough index I kept my comparison to the four major banks, but the recent talk of paring back the cash bonuses payable to Macquarie Bank execs prompted me to add them to the list.  Sure enough, they’ve left rest of the pack many lengths behind, storming into the lead with an incredible 60 page remuneration report, almost 90% of the overall Directors’ report.  That’s right, they spend 60 pages talking about remuneration, and 7 pages talking about everything that isn’t remuneration.

Bank	Remuneration Report pages	Remun Rpt as % of Directors’ Rpt
MBL	60	90
ANZ	22	85
CBA	20	74
NAB	19	63
WBC	17	68

Make mine a Davidoff!

Men in grey pressured by men in dark blue

I see that Bloomberg reports that the accounting standards people in the US (FASB) are being “pressured by lawmakers” to change the fair-value rules which are “blamed for worsening the financial crisis”.  Apparently this will enable “significant judgment” to be used instead of slavishly following market prices in cases where lack of liquidity renders those prices useless.

Hopefully some common sense will prevail but I’m not holding my breath.

See the story here.

Nero fiddles while Rome warms up

Loved the symmetry here.

League table update – all hail Bill Evans

The December ‘08 update of the tipsters league table showed that Westpac had come from nowhere to take the lead, overtaking ANZ (which had held the lead since August ‘07) and my team (which had previously led all the way back to August ‘01).  It’s worth noting that as recently as December ‘07 Westpac were stuck on the rails in second last position.

So why the dramatic improvement for the Bill Evans-led team at Westpac?  Essentially it boils down to the speed with which they recognised that serious problems were afoot and big monetary policy initiatives would be needed.  Bear in mind that as recently as May ‘08 several forecasters were calling a 7.50% cash rate for March ‘09 (ANZ even more so – see below), implying another 0.25% rate hike on the then-current rate.  Westpac were predicting a 7.25% rate at that time – a massive 4% above the actual result, but still better than the consensus view.  As economists lowered their forecasts over the rest of the year Westies were consistently at the bottom of the range, and are now reaping the benefit:

So what happened to ANZ?  As recently as September ‘08 Saul Eslake and his team were leading the league – they’ve now gone so far back in the running that a steward’s enquiry might be warranted.  The reason for this form reversal stems from mid-2008, when ANZ’s forecasts had the biggest variance to actual results we’ve seen since we started tracking this stuff in 2000.  ANZ’s forecasts at that time versus actuals look like this:

	Jun ‘08	Sep ‘08	Dec ‘08	Mar ‘09
Forecast	7.25	7.50	7.75	7.75
Actual	7.25	7.00	4.25	3.25

This makes an average absolute differential for the four observations of around 2.13% (a record high) – not bad when you consider that the June ‘08 result was virtually a given when these readings were taken.

Note that we don’t expect the record differential of 2.13% to hold up for very long – if Westpac’s forecast of a 2.50% cash rate by June ‘09 comes to pass the average differential on ANZ’s July 2008 forecasts will be a massive 3.44%, at which time we may bypass the stewards and go straight to the trackside veterinarian.

ASIC Summer School

I see the ASIC Summer School is on again.  No doubt the term “summer school” means different things to different people but in my mind it’s indelibly associated with just one thing – you failed your year-end exams but have a chance of redemption via summer school and the dreaded supplementary exams.  Perhaps that’s appropriate in this case.

Hopefully they’ll publish the papers from this thing, as there’s one or two items that we’d like some clarification on, such as:

• - the financial crisis: what went  wrong and what we’ve learned
• - have the International Financial Reporting Standards survived their first important test?

The first day of the conference generated some very astute observations from a couple of ANZ heavies who were present:

Mike Smith, CEO. "Banks should be boring," Mr Smith said. "Banks have got quite interesting recently and they shouldn't be in that space."

Ian MacFarlane, Director.  Mr Macfarlane said banks in Europe and the US were inadequately regulated, and resorted to increasingly risky measures to boost profits because they constantly feared being taken over by their rivals.  Australian banks did not have to aggressively chase risk to the same extent because they were protected from being taken over, he said.  This point relates to a (unintended?) consequence of the four pillars policy, which prevented consolidation among the top four banks.

Where to now?

This graph from dshort.com makes for depressing reading:

 

 

 

The Snout/Trough Index 2008

A couple of weeks ago I was reluctantly compelled to point out that NAB’s 2008 Financial Report contained a 19 page remuneration report, which constituted a massive 63% of the Directors’ Report.

I now see that ANZ has put them to shame – the 2008 Annual Report includes a whopping 22 page remuneration report.  This makes up 85% of the total Directors’ Report.  That’s right – they spend 22 pages talking executive pay and 4 pages talking about everything else.

That’s what I call getting your priorities right.

For the sake of completeness, here’s the 2008 Snout/Trough Index:

Bank	Remuneration Report pages	Remun Rpt as % of Directors’ Rpt
ANZ	22	85
CBA	20	74
NAB	19	63
WBC	17	68

Hola! Australian and Spanish banks beat the world

Gidday!  Que?

In a Winnie Blue & Gazpacho fuelled triumph, banks in Australia and Spain have scooped the pool as the world’s most profitable, according to a paper by the esteemed Boston Consulting Group.

The paper entitled “Creating Value in Banking 2009 – Living with New Realities” looks at a variety of performance indicators over the period 2004-2008.  This one caught my eye in particular:

 

It seems that the Aussie and Spanish banks in averaging around 16% ROE over 2008 have left the rest of the world in their dust.  But I’ll reiterate the issue I raised earlier – namely, if Govt bonds are sitting around 6% (before tax) and banks are earning 16% (after tax), does this imply a 10% risk margin?  What does this say about the nature of the risks being run to generate that 16% return?

Deckchairs Overboard

Nice piece by Paul Krugman here, questioning how useful the US Govt’s shuffling of equity between preferred and common stock is likely to be.  This graphic illustrates how simple the problem is for a number of the US banks:

A neat summation too: “I just don’t get it. And my sinking feeling that the administration plan is to rearrange the deck chairs and hope the iceberg melts just keeps getting stronger.”

Keynes Mark II and Banks’ ROE

Another good piece in today’s AFR, this time by Robert Skidelski, about the nature of the failure the financial markets are now experiencing, and what this means for the future. This snippet gives you an idea where he’s coming from:

But the crisis also represents a moral failure: that of a system built on debt.  At the heart of the moral failure is the worship of growth for its own sake, rather than as a way to achieve the ”good life”.  As a result, economic efficiency – the means to growth – has been given absolute priority in our thinking and policy.  The only moral compass we now have is the thin and degraded notion of economic welfare.  This moral lacuna explains uncritical acceptance of globalisation and financial innovation.

This bit alone raises some interesting issues, not the least being that lacuna is a great word and one we should use more often.  But seriously, who is to blame for all this?  One thing I’ve tried and failed to comprehend over many years is what it is that’s driving the banks, because surely that’s the direct cause of the financial crisis, regardless of whatever shortcomings the regulators, ratings agencies and central banks may have had.

This table shows the returns on equity achieved by the big four banks in Australia since 1998, compared with the average 10 year bond rate for each of those years.

	2008	2007	2006	2005	2004	2003	2002	2001	2000	1999	1998	Avg
ANZ	14.5	20.9	20.7	18.3	19.1	20.6	21.6	20.2	19.3	17.6	14.6	18.9
CBA	19.8	20.7	20.4	18.2	12.5	10.7	14.7	13.5	22.1	20.5	18.5	17.4
NAB	14.3	17.1	17.7	15.0	15.8	18.3	17.0	18.4	18.1	17.3	17.8	17.0
WBC	23.1	23.5	23.0	21.7	19.9	19.2	21.7	21.1	18.4	16.8	14.7	20.3
10Y GOVT	6.1	5.9	5.5	5.3	5.7	5.3	5.9	5.7	6.5	5.6	5.8	5.8

I realise that the basis of preparation of these numbers varies by bank, but the fundamental question remains: why do banks seek (and achieve) a return on equity of 15-20% (and that’s after-tax) when the risk-free bond is yielding 5-6% (and that’s pre-tax)?  I’d hazard two points on this:

• If the risk premium is really that big, should such risky institutions be allowed to form the cornerstone of our economy?
• If the risk premium isn’t really that big, why do the banks feel it’s their responsibility to deliver these returns?

Given the way our banks are capitalised, managed and regulated I don’t think for a moment that the risk premiums embedded in these returns are warranted.  But what would happen if one of the banks actively targeted an ROE of 10 or 12%?  Presumably their shares would be dumped.  So is this what it all boils down to – institutional investors demanding such high returns from banks that they’ve turned themselves into casinos to generate those profits?

I’ll keep pondering!

Unhealthy Obsession

I just stumbled on an interesting snippet from the NAB 2008 Financial Report:  

  Note that the remuneration report takes up a whopping 19 pages, or 63% of the report of the directors.

How does this stack up with the rest of them?

Might be worth mapping this unique KPI over the last few years.

Job Losses – Making Grim Look Grimmer

I’ve seen this graph bob up in a couple of places over recent days – it’s pretty alarming as it shows job numbers in the US falling off a cliff when compared to job losses in previous recessions.

However, it fails to account for the increase in the size of the US economy between those dates, and more to the point the increase in the number of jobs.  Rather than comparing the drop in job numbers in absolute terms it’s obviously more appropriate to look at the drop in percentage terms. 

 

It’s still scary, but has less of an Armageddon feel to it than the top graph.

Masters of the Universe

Today’s AFR has a nicely worded piece by American academic Harold James entitled “Superbanks are not economic visionaries”.  Following a bit of a history lesson James concludes as follows:

…even for the US, the notion of a world held together by Citigroup’s business plan is simply too costly.  There is a danger that in the push to nationalise banks as a consequence of the financial crisis, governments will see it as their duty to implement strategies .

The strategic vision of a bank shaping the economic fortunes of a country, or the whole world, is as flawed as was the idea of central economic planning.  In this sense, 2007-09 is the capitalist equivalent of the communist demise of 1989-91.

James’ article reminded me of Tom Wolfe’s classic The Bonfire of the Vanities, and the “masters of the universe” who were in fact anything but.

Gottliebsen was Spot On

Robert Gottliebsen, writing in the Business Spectator yesterday, made comment on the unique way in which government is pressuring the banks to pass on cuts in the official cash to their home loan borrowers straight away and in full, while no mention is made of how and when rates are cut for the biggest employer in Australia, the small business sector.

The RBA’s Statement on Monetary Policy issued today not only bears this view out, it reinforces it.  The Statement devotes considerable space to the topic of how well Australian banks have done in passing on rate cuts to home borrowers, in comparison with banks in a number of other countries (who have by and large retained huge margins for themselves).  Alas for small businesses around the country (and by extension the people they employ, the people they might have employed and the people they used to employ) the story hasn’t been so kind, as the following extract from the Statement shows:

Split Infinitives and the Bank of Queensland

Some inspired reporting from the AFR yesterday, touching on a Bank of Queensland guidance update:

“…the bank heartened investors by reiterating that impairment charges for the 2009 year remained in line with 2008, despite the rapidly slowing economy causing other banks to raise dramatically their own provisions for bad loans.”

This raises three important issues:

1. The AFR clearly trains its journos well in avoiding split infinitives.
2. Presumably if BoQ had cut their bad debt provisions investors would have been deliriously happy.
3. If this constitutes good news I wonder what constitutes bad news?

A Big Iceland

Some sobering thoughts from the Business Spectator on the drama unfolding in the UK.  Click here for the full article.

Odds on a Depression, or Depression Odds-on?

While Centrebet here may be running a book on the chances of a recession in Australia, Intrade has gone one better by doing the same thing for a depression.  I’m a bit confused about the definition they’re using for Depression, but the really depressing thing is the way the odds have moved in recent times, as the graph demonstrates.  Note that the prices on the right hand scale (currently 55.5) represent the likelihood of a depression (around 55% based on these numbers).  Click the graph to see contract specs etc.  It’s also worth having a look at Calculated Risk here for their summary of the definition of “depression” and why it’s flawed.

Closer to home, it’s encourage to see that Centrebet punters are taking a slightly less jaundiced view of the Australian economy, with the price for an Australian recession in 2009 drifting out to  $1.27 from $1.20 in mid-December.  Click the graphic for more info.

 

 

Alas there seems to be a bit of a disconnect between Centrebet and the SFE – the mid 2009 cash rate implied by bank bill futures prices clearly suggests a fairly serious recession in the offing.

First Home Owners Grant Inflates Housing Prices!

Who would have thought it?

Read the Crikey story here.  And how’s this for a wrap up?

“If the Government really wanted to help first home owners they would remove the Howard Government’s grant altogether, but who are we to let a sound economic policy get in the way of a populist vote grab?”

Kevin ‘07 Christmas Card

Subprime in a Nutshell

  …or as Basil would say: “Nutcase more likely”.

 

 

 

This is a very neat one page summary of the subprime fiasco and subsequent global financial crisis.  It ties together the roles played by the lenders, borrowers, investment banks and rating agencies, although there’s no mention of how or why the regulators went missing in action.

Click here to read the article.

'Greenspan Put' May Encourage Complacency

Terrific article from the FT warning us that the infamous "Greenspan Put" may encourage complacency and create moral hazard.

That was in December 2000, a mere eight years ago.  A nice call there by Peronet Despeignes.  Not so nice call by Big Al Greenspan, whose aura was so pronounced back in 2000 that it can be seen clearly in the photo to left.

Click on the article for the full story.