Tuesday, September 7, 2010

Bank Honesty is the Best Policy: the European Case

If the history of banking tells me anything, it tells me that banks are only fooling themselves if they think that they can hide bad assets and then outlast the drag these bad assets put on their performance.

Headlines read,” Europe's Banks Stressed By Sovereign Debts Regulators Ducked” (http://www.bloomberg.com/news/2010-09-06/europe-s-banks-stressed-by-sovereign-debts-eu-regulators-failed-to-examine.html) and “Europe’s Bank Stress Tests Minimized Debt Risk” (http://professional.wsj.com/article/SB10001424052748704392104575475520949440394.html?mod=wsjproe_hps_LEFTWhatsNews).

What do these people think they are doing? Who do these people think they are fooling?

Covering up a bank’s position always comes back to haunt the bank.

Now, we hear that not only have the bank’s covered up their positions, but regulators and government officials have covered up the real position of the European banks.

“Europe’s governments can’t afford to question the quality of bonds they’ve sold to banks, says Chris Skinner, chief executive officer of Balatro Ltd., a financial industry advisory firm in London. “Bankers have got Europe’s governments in their pockets, primarily because politicians cannot change the way lenders do business without undermining confidence in sovereign debt,” he says.

The secret of getting out of a financial quagmire is to identify everything, recognize and accept your problems, and then do something about them.

To me, this is one of the reasons why the restructuring of the American banking system is proceeding as well as it is. I believe that the FDIC (and others) has identified most of the problems in the commercial banking industry, and they are substantial. But, they are generally known. The FDIC, along with the Federal Reserve, is working to resolve these banking problems in an orderly fashion. The FDIC is arranging mergers and is closing banks on a regular basis and the Federal Reserve is subsidizing the banking industry by keeping its target interest rate close to zero and by maintaining massive amounts of excess reserves in the banking system.

One does not see this happening in Europe. As a consequence, clouds still hang over the financial markets as, for example, yields on 10-year Greek bonds are around 11.25 percent relative to yield of about 2.25 percent on similar German bonds. This is true on other debt issued by Eurozone countries and this risk issue also shows up in the spreads on bank bonds.

There are more questions about “when” Greece is going to default on its bonds rather than “whether” it will default on its bonds.

Economic recoveries cannot really take place until the banking system of a country is sufficiently healthy. (See my post, “No Banking, No Recovery” on the situation in the United States: http://seekingalpha.com/article/218027-no-banks-no-recovery.)

But this problem seems to go deeper. This is from the Bloomberg article.

“While they’re stuck with their government bond holdings, Europe’s banks are also still carrying much of the troubled assets they had during the 2008 meltdown. Euro-zone lenders will have written down about 3 percent of their assets from the peak of the credit crisis by the end of 2010, compared with 7 percent for U.S. banks, the IMF estimated in April. The steeper writedowns by U.S. banks are partly because they held a higher proportion of securities, the IMF said.

That doesn’t excuse the lack of candor shown by many European lenders about the unsellable assets on their books, says Raghuram Rajan, a finance professor at the University of Chicago. “European banks haven’t owned up to the large amounts of toxic debt that they hold,” says Rajan, who was chief economist at the IMF from 2003 to 2007.

“The stress tests weren’t severe enough,” says Julian Chillingworth, who helps manage $21 billion at Rathbone Brothers Plc, an investment firm in London. “Many bond investors aren’t convinced the Greeks are out of the woods.” And if the Greeks haven’t emerged from their crisis yet, then neither have the European banks that hold their debt”.

If we are going to have banking systems that are stronger and less subject to systemic risk, bankers, regulators, and public officials must realize that good risk management includes openness and transparency. Bankers, historically, have been among the leaders in securing the “cover up” of bank positions and the quality of bank assets. They do not need the help of regulators and politicians to reinforce this tendency.