Wednesday, April 3, 2013

David Stockman on European banks

David Stockman, US Budget Director during the Reagan presidency, caused more than a stir with his article titled "State-wrecked: the corruption of capitalism in America". It is a full-fledged attack on the Fed's loose monetary policies, an expanding social safety net, bank bailouts, misguided Keynesianism, and the large budget deficit. Not being an economist, I cannot comment on that with substance but I do note that, within 24 hours, six noted economists took down Stockman's article with economists' arguments. Prof. Krugman called it 'cranky old man stuff'.

There is another piece of information published by Mr. Stockman recently. Since it involves banks, I understand it a lot better. Below is the text: 

The real story of the present is the shadow banking system, the unstable and massive repo market, and the apparent daisy chain of hyper-rehypothecated collateral. It looks like the sound bite version amounts to the fact that the European banking system is on the leading edge of collapse for the whole system. These institutions are by all evidence now badly deficient of the three hallmarks of real banks—deposits, capital and collateral.

BNP-Paribas is the classic example: $2.5 trillion of asset footings vs. $80 billion of tangible common equity (TCE) or 31X leverage; it has only $730 billion of deposits or just 29% of its asset footings compared to about 50% at big U.S. banks like JPM; is teetering on $500 billion of mostly unsecured long-term debt that will have to be rolled at higher and higher rates; and all the rest of its funding is from the wholesale money market , which is fast drying up, and from repo where it is obviously running out of collateral.

Looked at another way, the three big French banks have combined footings of about $6 trillion compared to France’s GDP of $2.2 trillion. So the Big Three french banks are 3X their dirigisme-ridden GDP.  Good luck with that!  No wonder Sarkozy is retreating on France’s AAA and was trying so hard to get Euro bonds.  He already knows he is going to be the French Nixon, and be forced to nationalize the French banks in order to save his re-election.

By contrast, the top three U.S. banks which are no paragon of financial virtue—JPM, BAC, and C—have combined footings of $6 trillion or 40% of GDP.  The French equivalent of that number would be $45 trillion for the U.S. banks.  Can you say train wreck!

It is only a matter of time before these French and other European banks, which are stuffed with sovereign debt backed by no capital due to the zero risk weighting of the Basel lunacy, topple into the abyss of the shadow banking system where they have funded their elephantine balance sheets. And that includes Germany, too. The German banks are as bad or worse than the French. Did you know that Deutsche Bank is levered 60:1 on a TCE/assets basis, and that its Basel “risk-weighted” assets are only $450 billion, but actual balance sheet assets are $3 trillion? In other words, due to the Basel standards, which count sovereign and other AAA assets as risk free, DB has $2.5 trillion of assets with zero capital backing!

This is all a product of the deformation of central banking and monetary policy over the last four decades and the destruction of honest capital markets by the monetary central planners who run the printing presses. Furthermore, this has fostered monumental fiscal profligacy among politicians who have been told for years now that the carry cost of public debt is negligible and that there would always be a central bank bid for government paper. Perhaps we are now hearing the sound of some chickens coming home to roost. 

I have made similar arguments about the large European banks before. Stockman cites Deutsche's leverage at 60:1; I calculated it on the basis of the latest annual financial statements at 40:1. Either way, it is far, far too high for a bank which does not view itself as a highly leveraged hedge fund.

The capital adequacy ratios stipulated by Basel-2 certainly serve a purpose but the one purpose they DO NOT serve is containing the size of a bank. The only way to contain the size of a bank is to contain leverage (total liabilities in relation to equity). In fact, leverage used the be the primary size control instrument in the US until not too long ago. Similarly, leverage is one of the most important factors in assessing the credit risk of corporations.

Back in the 1970s, there were 9 socalled 'money center banks' in the US. The name derived from the fact that were heavily financed with interbank funds. By law, most of those banks could not have branches and thus had only limited ability to attract deposits. Continental Bank of Chicago had the highest ratio of interbank funding in relation to total funding with about 80% (i. e. 80% of its funding consisted of money purchased in the interbank market with average tenors of not much longer than 30 days!). Even at Bank of America which did have a couple of thousand branches in California, that ratio was still 60%.

The banks' leverage was about 20:1. Until the failure of Continental Bank of Chicago in 1984, neither the interbank funding nor the high leverage had been much of an issue. Then it became an issue. Today, JP Morgan and Citibank have leverages of about 10:1.

High leverage entails several important risks. First, total assets reach unduly high levels and, thus, increase the credit risk of the bank. As importantly, the total funding requirement reaches unduly high levels and there it increases the funding risk. When markets get nervous, they could quickly become very nervous about interbank funding of the highly leveraged banks.

On a Saturday in the spring of 1984, the host of The McLaughlin Group, a widely watched talk show, made a comment like 'I know that there are only two things which Paul Volcker (Fed Chairman) is worrying about. One, that a Latin country like Argentina could default. And, two, that one of our money center banks, say the Continental Bank, could fail'.

A Japanese journalist, after watching the show, telexed to his Head Office that, according to rumors, Continental Bank had filed for Chapter 11. Monday morning, everyone looked anxiously at Tokyo to see what the Japanese banks would do. They called their loans to the Tokyo Branch of Continental Bank. The sun went West and a few hours later, all eyes were on the German banks and, particularly, on Deutsche. It was thumbs down. They all called their loans to the Frankfurt branch of Continental Bank. By the time New York opened, it was clear that the game was over for a bank which had just celebrated its 125th anniversary and which had been voted the 'Best managed bank of the 1970s'. Within less than 24 hours, the bank had lost one-third of its funding.


  1. Am I right in reading that the French banks are in more trouble than the American ones?

    I find this a little hard to believe, but then with off-the-books banking, it's hard to believe the figures that the American banks have run up.

    So let's start with some facts. The problems in today's economy stem from the moment that the US banks refused to honour their pledges to other banks and institutions. That these had been rated AAA meant nothing to the Americans. Their money was worth more than any trust we might put in their integrity.

    The sum in question was around $6trillion. Withdrawn all of a sudden from the world's economy. It pulled the rug from honest hard working folk such as myself - and I do not regard that as fair dealing from institutions whose daily bread is integrity and trust. I dealt in that and built a business - their understanding of it destroyed many more than just mine.

    So what have we here?

    An American bank puts some of its toxic derivatives onto the taxpayer. Now this isn't BNP Paribas' $2,5trillion (a total?) this was PART of BOA's derivative mountain - the bit that went bad.

    ***** It was a modest $76trillion. *****

    That is to say 30x as much as the French bank - and transferred to the taxpayer in broad daylight and with the sort of disdain for the regulators that one now expects from US banking institutions whose integrity cannot be challenged.

    $76 trillion, by the way, is around 3x the US GDP.

    Oh! They all cry, but derivatives all have counterparties! Okay: so why then didn't BOA deal with them themselves?

    Because there were simply too many to handle. The pile is simply too big to deal with they would need the entire of human history to untangle that nasty lot - and they'd have to pay good money to experts in the mean time. Bye-bye profits! Nope: easier to dump it on the government.

    It's what you expect from an institution that has pride in its integrity.

    1. I think one has to bear in mind that, since the crisis of 2008, American banks have undergone much more stabilization (triggered by the government) than European banks. In fact, I can't think of any one thing which has changed with European banks. So that would be my explanation as to why American banks look better than European banks today.

      "The problems in today's economy stem from the moment that the US banks refused to honour their pledges to other banks and institutions. That these had been rated AAA meant nothing to the Americans" - I know of no case where an American bank refused to honor any pledge (other than Lehman). If they had, they would have been declared bankrupt. Deutsche, instead, refused pledges with legal tricks. They had issued big-time standby-L/Cs backing up the commercial paper issued by SIVs holding sup-prime paper. The idea of such standby-L/Cs is that the SIV has a fallback to bank credit should it one day no longer be able to sell its commercial paper. When that happens, the SIV calls on the standby-L/Cs. That happend to Deutsche. One of the prime cases was a Canadian SIV. They called on the standby-L/C and Deutsche found some legalese which allowed them not to honor it. I wish I knew how that case was eventually settled but I am sure that there were several other, similar ones.

  2. I usually consider most modern economists to be dealing, at best, in irrelevancies and to be political stooges at worst. I have made my opinions clear in this blog in the past. However in this case I have to agree with them. Mr Stockman is either nostalgic of the good old days or a gold-standard nut. My suspicion is that these tirades are lamenting lost class power:suddenly being a rich capitalist is far less politically important. This is because you may decide to take your money elsewhere but this may have limited results, as the central bank can simply print some more. Not to mention that the social safety net makes the poor uppity and they don't obey their betters.
    It is true that central bankers have become very powerful. They decide if a bank or other financial institution will survive its managerial buffoonery and how (with all the political pain this entails) They can even topple governments: if Mr Draghi comes out and says that Deutsche bank (in the news for colossal fraud) as I write this) is dodgy and a depositor bail in might be in sight I can see Ch. Merkei loosing the election during a minor panic.
    The only way governments can do something about it is to make sure that the source of the bankers' power is clearly delineated and protected from bankruptcy of the other sections of the bank:adequately protect the PAYMENT SYSTEM in a bank. If there is generous small depositor protection as well the banks will lose lots of their political power and central banks can concentrate on their main role: protecting against systemic collapse during a major panic and running monetary policy (already too much power).
    Finally I must point out that behaviour like the one mentioned above is pretty common in large swaths of the OTC markets.I suspect SIV's are considered parts of the more wild parts of the investment markets where such practices are fairly common: getting the bonus justifies abhorrent behaviour. as I have mentioned before the way to stop this is to turn OTc into regulated markets with ease of entry (like the Stock Exchange)