Ground Zero: The Global Banking Industry
In just over two years, we have seen a realignment of the global financial services industry that has been on such a scale that only a short while ago would have been considered inconceivable. As the chart below shows, the market values of the largest banks in the US have been decimated. Citigroup – once the largest bank in the US – has seen its market value fall from over $250 billion to less than $30 billion. All of this occurred in only two years.
The realignment of the banking industry on a global basis is equally breath taking. About ten years ago, the Canadian banks were complaining that they were too small to compete against their much larger international competitors. The chart below demonstrates that this is no longer the case. Due to the substantial declines of bank share prices globally, Canada’s largest bank –Royal Bank (RBC)- now finds itself ranking seventh in terms of market value. All of a sudden, the crisis has quickly leveled the playing field to the extent that a relatively small country like Canada has a banking industry that will emerge as a formidable competitor in the global economy.
Nationalization of Global Banks. One of the unforeseen consequences of the global financial crisis – and perhaps still underestimated – is the sheer scale of government involvement in the financial services industry. For example, in the UK, the government has nationalized Northern Rock PLC, taken a majority ownership position in Royal Bank of Scotland (RBS), and owns 43% of Lloyd’s Banking Group. In addition, it has injected hundreds of billions of dollars in the form of loan guarantees in order to help kick start bank lending again. To further put this government involvement in perspective, Lloyd’s controls over a third of the UK’s mortgages and a quarter of all its savings.
However, the UK is not alone. The US Treasury department and the Federal Reserve (The Fed) have also been injecting hundreds of billions of dollars into the economy and the banking system through the use of loans to banks and guaranteeing future operating losses. These measures have been undertaken to ease concerns of banks defaulting – effectively the US Treasury will be on hand to act as guarantors. Just last week, the US government agreed to backstop the losses incurred by Bank of America following its purchase of Merrill Lynch. For its final quarter, Merrill Lynch reported losses of about $21.3 billion, thus causing Bank of America to have second thoughts about completing the merger. However, fearing the fallout of not having the merger go through, the US Treasury agreed to step in and guarantee a large portion of future losses from this purchase. The Treasury provided $20 billion in capital and a further $118billion in guarantees against future losses from the purchase of Merrill Lynch.
Low Interest Rates Are Not The Solution. In a typical economic slowdown, low interest rates usually prove to be a powerful stimulant to the economy. This time, central banks have had to rewrite the rule book. In the current slowdown, low interest rates have not worked with the same effectiveness because of the “deleveraging process”. Simply put, the deleveraging process means that consumers are paying down the debt that allowed them to enjoy rising levels of consumption during most of the decade. How pronounced is the deleveraging? Well, US mortgage debt is being paid down faster than new mortgages are being taken out, banks are hoarding cash by tightening lending standards, and businesses are reducing capital expenditures. All of this serves to slow the velocity-of-money, or the speed at which money travels throughout the economy. In a typical recessionary environment, interest rate reductions serve to speed up the velocity-of-money through consumer borrowing, investment in capital projects, and other borrowed spending.
Thus, low interest rates will not prove to be the silver bullet. As the charts below show, the ability of the economy to grow is dependent on both the velocity of money and the money supply. Since the velocity of money is not as responsive this time to the interest rates reductions, the central banks are being forced to drastically increase the money supply in order to stabilize the economy.
Now the natural question becomes, why isn’t there a quickening in the velocity of money? One of the stimulants of the velocity-of-money had been the mortgage securitization process. Mortgage securitization results when “originators” such as mortgage lenders and banks sell their mortgage loans to an investment bank, which then pool these loans into securities and sell them to investors. Dicing up millions of mortgages into tradeable securities was supposed to protect banks by spreading credit risk among a wider range of investors. But the complexity and magnitude of the securitization market helped turn the collapse of the U.S. subprime mortgage market into a full-blown financial crisis. The inclusion of subprime mortgages in the securitization process meant that the bad loans got transmitted throughout the world. To be clear, the US is not the only country to blame. From Hungary to the UK to Spain and Canada – this is a process that went on in varying degrees. As a result of this securitization process, the credit risk was spread anywhere these securitized assets were held – and that is, right across the world!
If we were to use an analogy to describe the problem it would go something like this:
The economy’s engine has stalled. The fuel is not making its way through the engine (velocity of money has fallen) so the central banks of the world are injecting fuel (money) in a more direct manner try to get the engine running again. The problem thus far has been that the Commercial banks are not distributing the money through the various lending channels. One bright spot has been that banks are again lending to one another and the financial markets are no longer frozen. At its peak, blue chip companies were paying near double digit rates for loans maturing in less than six months. These loans are used for short term purposes such as payroll or financing inventory for retailers. This part of the crisis was solved by massive intervention from central banks.
Going Forward. Given the violent upheaval in the financial sector, as investors, we have to remain objective and consider the opportunities that may be emerging in this sector. That does not mean we are ready to buy into this distressed sector anytime soon but investors should be analytical in their approach and look at this crisis to see how we may be able to take advantage of the opportunities that are arising. Recall that the US consumer became the butt of jokes and derisive comments about how Americans were too focused on consuming. Yet it was this consumption that helped the world move past the last financial crisis in 1998. It was mainly US consumption that helped pull Asia out of that crisis. Now, the US has begun the long process of repairing its balance sheet (increase savings) and one side effect is going to be less demand for foreign goods. China et al will have to decrease their own rate of savings and pick up the consumption baton. (More on this issue in our upcoming quarterly newsletter – please email email@example.com if you would like to receive a copy).
The central banks are about to embark on a concerted effort of quantitative easing. This is a process by which they will inject money directly into the banking system by purchasing assets such as government bonds and whatever else they need to in order to make the banks so flush with cash that they have no choice but to start lending again. Albeit this time with greater vigilance as to whom they are lending it to.
The preceding entry is intended for general educational purposes only and should not be construed as financial advice nor is this information intended to replace the advice of a licensed financial advisor. All readers are encouraged to review their personal financial situations and needs with a licensed financial advisor prior to making any investment decision. Although efforts have been made to validate the information presented in the above entry, Pacifica Partners Inc. can accept no responsibility or liability as to the completeness or accuracy of the information contained above.