Wednesday, December 19, 2007

Painful adjustments ahead for banking system

(John Plender in the FT) Rarely have banks engaged in window-dressing on the scale now being contemplated for December 31. With confidence still at a low ebb in a global banking system where all manner of off-balance sheet contingent claims are coming back onto the balance sheet, the imperative to hoard cash is overwhelming.

Then, on January 2, comes a new dawn. Or so runs the optimists’ prayer. With the year-end out of the way, they hope a respectable volume of lending will resume, an end to the subprime crisis will finally be in sight and bank shares will start to recover from the battering of recent months. Free in one bound, so to speak.

The trouble with this thesis is that the problems that have engulfed the banking system since mid-August were always wider than leading bankers acknowledged. Their constant references to a subprime crisis disguised the fact that risk had been repriced all across the credit markets.

Everywhere leverage is being unwound especially in the shadow banking system, where hedge funds have been at play, structured investment vehicles are in trouble and monoline insurers have a problem with the credit rating agencies.

Equally to the point, the banks’ year-end preoccupation with liquidity distracts attention from the big difficulty for 2008, namely that everyone in the financial system is capital-constrained. Also capital-constrained are households in those economies that have suffered from explosive house prices, which is where the linkage with the broader economy could all too easily precipitate recession.

This is a very wide-ranging financial crisis in which the threats to bank capital are many and various. Clearly the decline in house prices in some markets has a deleterious direct impact on bank loan books. It then has an indirect impact through the decline in the value of asset-backed paper on bank balance sheets. The funding problems of structured investment vehicles and conduits add to the pressures, since reintermediation the act of bringing them back on to the balance sheet puts capital ratios under strain.

Estimated system-wide losses of $300bn-plus are largely based on marking banks’ trading books to market. The real cash losses and defaults have yet to come. And the defaults will not be confined to the residential mortgage markets, where teaser rates are set to rise. In countries such as the UK, Ireland and Spain, lending to commercial property has been soaring as a percentage of the overall loan book. The initial yield on the property is below the banks’ cost of funds, so defaults at some point are inevitable.

The unanswered question is: what is the right level of capital for today’s financial world? Before the crisis broke, I argued in these pages that nobody could know whether the banking system had adequate capital because of the pace of financial innovation, the opacity of so many new financial instruments and the inability to measure the amount of leverage in the system.

The usual rejoinder from central bankers was that high profitability in banking over several years was a source of comfort. They have now expensively relearned the age-old lesson that high returns reflect high risks.

As Mervyn King, Bank of England governor, remarked before the UK parliament’s Treasury select committee that a painful adjustment lies ahead in which losses are revealed and new capital is raised to repair bank balance sheets.

Bullish investors look to sovereign wealth funds to act as a deus ex machina, ready and willing to turn a hand to the repair job. Yet intervention from on high is scarcely cheap an 11 per cent coupon for Citigroup’s $7.5bn preference top-up and not everyone will be eligible. There must also be a possibility that regulators contemplating today’s wreckage will wish to impose tighter capital ratios in future.

The London-based hedge fund manager Crispin Odey argues that banks that have been trading at around two times book value will do well to hold onto one times book value over the next five years. Very bearish, but I think he has a point.

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