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Alicia Damley, CFA
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Alicia Damley has deep expertise in the financial sector. Her most recent 3 year track record (2007 thru 2009) delivered double-digit out-performance vs the MSCI global financials benchmark. Ms. Damley spent 10 years in public accounting focused on accounting and financial reporting analysis of... More
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  • Some certainty in the uncertainty - keeping sight of the investment opportunities
     

    Clarity is usually preferred over uncertainty – it helps keep things simpler. However, in recent months, uncertainty about the sustainability of global economic recovery has risen, reflected in the most recent downward revision of US growth. The effects of monetary and fiscal stimulus measures have run their course, and political dissatisfaction and turmoil have emerged. Market movements over this period have been reflecting this. While clearer data supporting resumption of the recovery is essential, all indicators are not weak. Now into the third year since the start of the crisis, reviewing what is working provides a progress indicator and more balanced perspective.

     

    First and foremost, the financial system has been stabilized. As the source of the turmoil but also the backbone to economic growth, stability is important. While overall credit growth is minimal, outright reduction in lending has not been a significant risk. Capital ratios are mostly in-line with the expected increase. No new toxic asset classes have been revealed to further weaken earnings or balance sheets. Evidence of an upward spike in credit risk is weak and is unlikely to be fueled by current loan growth trends. In the US, substantial excess bank reserves are on deposit at the Federal Reserve, which now has additional tools to further manage them.

     

    The Federal Reserve has and continues to respond to monetary, fiscal and financial sector conditions using all tools and powers at its disposal. Through timely response and considered implementation of new programs and solutions, it has been a key contributor to a more orderly de-leveraging of the global financial system. The Fed has effected its roles as the buyer of last resort. While time will ultimately judge the success of these programs, these actions have also meant that we are all some distance from the prevailing conditions and sentiment of two years ago.

     

    The corporate sector is in good form. Most large corporates hold substantial liquidity on their balance sheet as they delay new investments in the face of weak demand. Furthermore, current interest rates offer the opportunity to modify existing debt structures and lower longer term funding costs.

     

    After a number of years of gorging on debt, the private sector has been repairing its balance sheet for nearly two years. While estimates indicate this will still require at least 3 more years, it is a meaningful improvement in the sector’s flexibility and longer-term health.

     

    Economic growth for many developing markets remains strong. Recent figures for India, Indonesia, Brazil and Mexico show favorable trends. Some of this economic growth has been bolstered through a coordinated resistance to raising trade barriers and similar counter-productive measures effected during the Depression. Outright currency manipulation is also not the tool of choice, though more improvements in this area would be welcome.

     

    The size, depth and extent of this crisis dwarfs many previous events. It is abundantly clear that we have a significant number of problems (including record unemployment, low private demand, lack of credit growth), and solutions to this global financial crisis require global co-ordination (see article here). This has meant more time and complexity in crafting solutions and contributed to the overall uncertainty. Issues still remain to be resolved and solutions to some of these will prove as difficult as those of recent efforts. Hindsight shows that better options could have been implemented in some cases. But the human elements and political realities have been considerable and sometimes, intractable. Fortunately, progress has also been measurable.



    Disclosure: None
    Sep 02 12:03 AM | Link | Comment!
  • BIS III – Opportunity or threat?
     

    The new BIS III proposal, comprising of minimum capital and liquidity requirements, is the next, and likely last step, in current global financial sector reform. Given recent events, the unsurprising stated objective of this reform program is to “improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy”. The November G-20 meeting is the target date for completion of this process which requires global co-operation and discussion.

     

    These proposals constitute a sharp reversal from the general relaxation of criteria between BIS I and BIS II. In July 2009, the Basel Committee introduced guidelines for increased capital requirements on trading book positions. Key changes proposed here are: tightening of Tier 1 capital eligible instruments towards common shares and retained earnings; constraining the build-up of leverage by introducing a leverage ratio based on gross exposure; the requirement for counter cyclical provisioning; and introducting a 30-day and longer-term structural global minimum liquidity standard. Behavioral changes are also being encouraged, for example, through differentiated capital requirements for OTC vs exchange traded instruments, higher capital requirements for deteriorating counterparty credit exposure and harmonization and rationalization of use of credit ratings.

     

    The newly introduced liquidity requirements (liquidity coverage ratio and net stable funding ratio) are squarely aimed at improving funding quality and stability. Preference is for higher quality (at least AA) and longer duration instruments (>1yr).

     

    The introduction of BIS III is against a backdrop of already higher capital requirements. The proposed changes will further raise the capital to be held. For the larger banks, the (guess-)estimated negative impact on current Tier 1 ratios ranges from 300 – 500 basis points. Details reveal that regulatory guidance goes further to specify reducing discretionary distribution of earnings (as dividends, share buy-backs and staff discretionary payments) when capital buffers have been drawn down. Funding criteria likely means a race for longer-term deposits, contributing to higher cost of funding.

     

    With higher retained earnings capital, sector profitability is under pressure. Rationally, increasing lending margins, identifying new sources of revenue and lowering costs would mitigate the decline in RoE. The first is clearly difficult as de-leveraging continues and loan demand remains weak. Noteworthy though is the recent years trend of margin compression in developed markets as related transaction revenue was booked as fees in the ever extending value chain. The real and full cost of credit risk requires reassessment. New revenue sources are the immediate obvious choice despite government mandated service fee reductions in the US.

     

    Ultimately, whether the increased capital buffer proves sufficient will be determined by the source and severity of the next crisis. Right now, on a weaker economic outlook, the trend shows governments and regulators much more amenable to bank concerns on the negative impact of BIS III proposals on the banks themselves, borrowers and the risk of worsening economic conditions. The importance of global co-operation and co-ordination further complicates the development of required consensus as observed repeatedly in the recent past. Consequently, whether proposed the BIS III contributes to substantial bank sector reform is yet to be seen.

    Disclosure: None
    Jul 20 3:21 PM | Link | Comment!
  • ECB responsive, but does it alleviate underlying problems in European bank sector?

     

    In his May 31, 2010 speech (see here), Jean-Claude Trichet, President of the European Central Bank (ECB), justified the ECB’s reversal of intervening in the secondary government bond secondary market with the launch of the Securities Markets Programme, “an extraordinary action”, on May 10. Mr. Trichet re-iterated the knock-on effect of a declining and mal-functioning government bond market on the banking system and broader economy.

     

    As also stated in his speech, this neither significantly alters the urgency to address more deep-seated imbalances within some EU countries nor the need for a co-ordinated and well-functioning response to financial sector reform. Sovereign debt has preferential recognition under BIS II (and proposed BIS III) standards. Downgrades of sovereign ratings and their bonds has immediate implications for a bank’s capital position, level of write-downs, solvency and ultimately, viability. European banks own an estimated €1.2 trillion in PIIGS government debt, with German and French banks holding the largest share. The ECB’s balance sheet as of 12/31/2009 was €137.0 bn, down from €383.9 bn in 2008. Purchase of these bonds would result in an even larger expansion of the ECB’s balance sheet than the Federal Reserve’s actions during 2008.

     

    The ECB’s recognition of continuing responsiveness to worsening conditions for European banks is applauded. But these actions are reactive, addressing the manifestations of the key underlying issue – gross malfeasance in the conduct of political and economic affairs by some European countries. Not addressing this elongates the risk of unabated market volatility and delay to a normalized growth outlook.



    Disclosure: None
    Jun 03 11:29 AM | Link | Comment!
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