Archive for the ‘Leadership’ Category

A review of the US monetary System – Suppliers, Dealers and Users

As Children, we should all be taught to aspire to own a commercial bank (dealer). Dealers have a very interesting and sustainable business model. Essentially, they lend money they don’t have, which creates money in the hands of the borrower. This “miracle of capitalism” is created by the fractional reserve system of the Federal Reserve. The interest paid on these loans is earnings for the commercial bank. The leverage to assets is big; the Fed requires a 10 percent reserve so that a commercial bank can loan up to ten times its asset base.

In the US, commercial banks and investment banks were divided by the Glass-Steagall Act of 1933.  After the depression is was thought that risky investment banking activities needed to be separate from the Fed-backed activities of commercial banks. Glass-Steagall also introduced deposit insurance on deposits (FDIC), further protecting the interests of depositors. The act (not FDIC) was repealed in 1999 in an effort to allow US dealers to compete on a level field with Great Britain. Margaret Thatcher’s “big bang” deregulated the UK financial system in 1986. Canada followed in the late 1980s and dissolved the restrictions for commercial and investment bank mergers. Trust companies were also deregulated. Insurance companies maintained some of their independence though Canada’s big 6 retail banks are finding ways to capture market share in the insurance business as well.

Given the extremely low cost of capital and advantaged position banks share with respect to the Fed, it is difficult to compete with dealers as a group.

The promise of Big Bang and deregulation was reduced cost of capital for customers. In addition, reduction of regulatory involvement was seen as a method of increasing competition and innovation by combining access to debt and equity capabilities. Stanley Hartt, deputy Minister of Finance for Canada 1985-88 summarizes the view at that time as “the banks felt they had to grow to survive”.

These conclusions have been greatly challenged by the financial crises of 2008-09.  Leading up to the Fall of 2008, one stop financial supermarkets were able to securitize debt, selling it off to institutional investors to raise additional cash assets. This in turn allowed for more leverage to earnings and more risk assumed. The system was clearly out of equilibrium. In September 2008, perhaps precipitated by the collapse of Lehman Brothers, the system froze. Banks would no longer lend to one another for fear of undisclosed liabilities (non-visibility) reducing the real credit worthiness of the borrowing parties and increasing the likelihood of default.

Big isn’t better, and in some cases as we have recently experienced, it is much worse. Canadian banks have faired better than most. A major contributing factor is that they didn’t get their wish about eliminating foreign ownership restrictions.  Canadian banks are limited to 10% foreign ownership. It seems to me that as a group they should be grateful for the failure in their lobby effort to have that restriction eliminated. It saved their asset base and our banks and protected them from much more of the downside of the credit crises of 2008-09. Instead, in 2009 the Canadian economy and financial system has experienced strong relative growth compared to the international competition.

Commercial banks are too big to fail because of the unique arrangement they have with taxpayers. FDIC (CDIC in Canada) insures assets to 250k (100k). If they default, the government, backed by tax revenues, guarantees the liability. This call on tax dollars creates an incentive to accept more risk, in an effort to maximize shareholder profit, since Banks are credited with the positive return to risk but are insured for losses.

For banks it is very unlikely if not impossible to reorganize under bankruptcy protection. Unlike other corporations like airlines, for banks bankruptcy is equal to liquidation.

Clearly there is something wrong with this system. The old idea of building scale to eliminate the competition appears to be in conflict with the best interests of the economy as a whole.

We could try to use a 1930s solution and disentangle commercial banks and investment banks or perhaps more realistically, the consequences of bank failures could be minimized. To my thinking the latter approach is more likely. New regulation can be introduced to reduce potential claims on taxpayers.

A group has been formed to provide recommendations on just that line of thinking. The Squam Lake Working Group on Financial Regulation is a group comprised of 15 leading academics who want to bring the system back into equilibrium. The thinking is that if the incentives of scale are reduced and the costs to society of banks failures are minimized, then a better equilibrium will be established for the financial system and by extension, the economy as a whole. The group had developed several practical solutions to improve the systemic problems. It appears the US administration is listening.

The term ‘credit crisis’ seems to imply that we can expect a resumption to normal market conditions, and economic growth, as a direct result of increased lending by banks…maybe, but things haven’t worked out that way before.

Much of the recession fighting efforts by central bankers and global political administrations is focused on a forced expansion of credit. In 2007-2008, a ceasing of credit markets was crippling to economic activity. De-leveraging of global markets resulted in a sharp reduction in economic output and a pervasive global recession. The reaction by central bankers was to create conditions where bank-to-bank lending was possible again. To a great extent, and at incredible expense,  this has been accomplished. Indeed in the past few weeks we have seen credit market spreads expand. A positive indicator, since banks are probably using their own capital to lend to clients rather than simply passing on the fire hose of cash flow from the Fed.

While resumption of a normalized credit market is a precondition to ending this recession, the evidence suggests that credit expands only after the economy has rebounded. The effect is to further fuel an already expanding economy. In every recession since 1960 real bank credit didn’t peak until several quarters after the end of each recession. While this time may be different, it is likely that the same economic principles apply today as they have the past 50 years. Banks typically tighten credit as a result of loan losses. This is a reasonable response to limit losses and participate less to the downside of an economic cycle. These normal incentives operate to limit the expansion of credit prior to some clear evidence of economic expansion. When the economy begins to expand lenders expand their efforts to capture the growing market shares. It is unlikely that policy makers will be able to engineer conditions where lenders will lead a meaningful expansion in the economy. At some point incentives should switch in favour of the consumer and creating conditions for expanded demand to replace liquidity concerns as the primary focus of economic leaders.

Here is  a related short essay by Kevin Kliessen, Economist with the  Federal Reserve Bank of St. Louis  http://research.stlouisfed.org/publications/mt/20090301/cover.pdf

The top rated banking system in the world – Canada, really?  I guess it had to happen sometime. It seems after the recent global carnage, banks that leveraged their assets the least have won. European Banks had borrowed more than fifty times their assets to increase the size of their operating business.  So a 2% loss in net operations pretty much wiped out their equity. The U.S. banks levered north of 25 times so it took a 4% net asset write off. Canada at 15 times has a 6 % cushion. It should be noted that much of the global bank liabilities are guaranteed through deposit insurance, reducing the risk. As we have recently found, relatively small, highly risky ventures can spin out of control. You and I can’t get a loan with 2% equity backing the note. If we did we might be too big to fail as well.

Last week Chancellor of Queen’s University and former Governor of Bank of Canada, David Dodge spoke at a lunch presented by the Canadian International Council (CIC). His topic -Rebuilding the Global economic and financial Order. He had a couple of insightful statements about leverage. In his view changes to accounting standards (FASB)  are adding volatility to stock markets in marking assets to market while leaving debt largely at cost. If debt isn’t repriced  as equity on the balance sheet then you get bigger reductions in earnings in recessions and larger growth in earnings in good times.  Higher highs and lower lows add risk without a corresponding increase in return since debt and equity will end up priced at liquidation value in any case. Transparency is always desired but only if  assets and liabilities ares  treated equally. Mark-to-market is really made up numbers since you only really know what something is worth when someone else pays to buy it.

Mr. Dodge is also a proponent of good regulation. He thinks that Canadian Banks may have ended up in a deeper problem without strong  federal guidelines. He concludes that upcoming G20 meetings present the best opportunity to co-ordinate meaningful global improvements in the economy.

In my opinion,  Canadian Banks would find themselves in the same position as  U.S. Banks had they been allowed to operate unfettered from regulation. For example, foreign ownership limits are federally imposed on the sector. Canadian banks lobbied to have them removed so that they might merge and invite larger interests to invest. It is lucky for them that they were unsuccessful in that effort.

I recently finished reading Outliers by Malcolm Gladwell. This current best seller is written by author of The Tipping Point and Blink. It’s a short read that is, in my opinion, worth the effort.  The central theme is success . Outliers, for the purposes of this book, are people who have achieved exceptional results in their professional pursuits compared to those who have perhaps underperformed.   There were a couple of notions that I found especially useful.  Gladwell claims that there is plenty of evidence suggesting that it takes 10,000 hours to master a profession. Based on a 2000 work year that adds up to about 5 years. He looks to the life works of masters like Mozart and Gates to demonstrate this time line. He concludes that intelligence, to a degree, plays a roll in the success, in that a minimum standard is required.  More importantly, demographics, timing and perhaps luck are the key contributors.

There is a Darwinian notion here for me. Outcomes are, to an extent, predetermined. Outliers appear continually and their impassioned exploits are rejected or rewarded based on things that are largely out of their control.  Demographics,  perhaps like natural selection, decide the timing for these mutations.  Gladwell concludes that the individual player has less to do with the outcome than we might give credit for… so I think I’ll wait for the unifying theory.

These notions can be considered when looking at our new generation of leaders.  The Jones Generation refers to that portion of the  population born between 1955 and 1964. They are the lost generation, sandwiched between Boomers and Gen Xs. President Obama and Prime Minister Harper are part of Gen Jones.  This generation had the shared experience of starting their careers in the recession of the early eighties. There  is a certain shared frustration as a result of  high expectations for success meeting 20% interest rates.  The view is that their older boomer brothers and sisters had an easier road.  Apparently, once they did manage to get a toehold on careers and families, the Joneses turned into perhaps  the greatest consumer generation of all time. It seems that as leaders the Joneses should remember some of the lessons of the early eighties. Tough times require a willingness to compete. Perhaps 10,000 hours working through a previous recession will serve as great training for this current group of leaders to succeed in the task at hand.