[NYTr] Crashing Economy: Govts will wreck their currencies to save banking system

[All the News That Doesn't Fit]

Financial Times via GATA - Jan 6, 2008
http://www.ft.com/cms/s/0/6185d5c6-bc69-11dc-bcf9-0000779fd2ac.html


Governments will wreck their currencies to save banking system

Payback Time:

Banks Have Battle Ahead to Restore Financial Standing

By Peter Thal Larsen 

Early in the new millennium, as they surveyed the wreckage of the
global technology boom and the burst stock market bubble that it
had produced, the world's leading financiers marvelled at the
resilience of the 21st-century financial system.

Despite heavy losses in telecommunications and the collapse of large
companies such as Enron and Parmalat in other sectors, no big
financial institution had run into serious difficulty. This, bankers
and regulators argued, was because banks had embraced techniques
such as securitisation and the use of derivatives to pass on risks
that they would previously have held in their entirety.

This approach, dubbed the "originate and distribute" model, was
widely hailed as having transformed the banking industry into a
less risky -- and more profitable -- business.

Today those claims have been shown to be hollow boasts. The crisis
in the US mortgage industry, far from being smoothly absorbed by
the global financial system, has proved contagious, prompting a
paralysis among professional investors and a crisis of confidence
in the banking system.

But for many bankers the most shattering revelation from the turmoil
of the past six months is the extent to which risks that had
supposedly been transferred to other investors have come flooding
back on to banks' balance sheets. Far from dispersing the risks
they had underwritten, banks are being shown to have stashed loans
in complex structures that ultimately required their support.

The result is that a banking industry that a year ago looked robust
and well-capitalised has turned out to be supporting a much larger
asset base than most investors had thought. To make matters worse,
the previously hidden assets are often those whose value is the
most suspect. The subsequent correction is likely to have far-reaching
consequences for how much capital banks need, how they are regulated
and how they make money in the future.

"The financial system has become leveraged to a greater extent than
one could have guessed from looking at the balance sheets of regulated
banking institutions alone," Malcolm Knight, general manager of the
Basel-based Bank for International Settlements, the central banks'
bank, said in a recent speech. "The deleveraging process that is
now taking place in the system is, to put it mildly, unlikely to
be totally smooth."

So what will banking groups now do?

For many large Western banks, the first priority is to shore up
their capital. Banks that in recent years have been returning capital
to shareholders in the form of share buy-backs and higher dividends
are expected to start raising capital. That will help address their
exposure to obligations such as the bank-sponsored off-balance sheet
vehicles known as conduits, which had expanded to more than $1,000
billion (L505 billion, E676 billion) in assets when the crisis
struck.

The same applies to structured investment vehicles, the entities
that were among the most enthusiastic buyers of complex, highly-rated
debt securities created by the banks. These SIVs were supposed to
be independent of the banks that created and managed them. But when
the crisis hit, large banks such as Citigroup and HSBC found they
had little choice but to take responsibility for the assets.

More recently, banks have also felt obliged to bail out investors
in money market funds -- supposedly safe, liquid investments --
that were at risk of reporting losses. A dozen or so large US banks
have so far injected more than $4 billion into these funds, even
though they have no formal legal obligation to do so. Regulators
are likely to pay closer attention to these kinds of commitment in
future.

"There is going to have to be more capital injected into the system,
to support the greater level of obligations, whether they are
contingent or actual," says the chairman of one of the world's
largest banks. Quite how much capital the banks will need is,
however, a subject of intense debate. The amount will depend partly
on the size of their losses related to subprime mortgages and on
the extent to which the current squeeze triggers a broader economic
slowdown, leading to higher defaults on other types of loans.

These factors will vary in different parts of the world. For example,
the European banking industry has been less directly affected by
the subprime meltdown than their American counterparts. But on some
measures European banks have been operating with less capital than
those in the US, where regulators enforce rules that provide a floor
to the amount of capital banks must hold.

Analysts at Citigroup estimate that European banks will be forced
to absorb risk-weighted assets worth around E450 billion ($666
billion, L336 billion) on to their balance sheets as a result of
the turmoil in the industry. Depending on which measure is used,
they calculate that European banking is labouring under a capital
deficit equivalent to 5-20 per cent of the banks' market value.

Amid all this uncertainty comes another upheaval for banking: a new
approach for measuring banks' capital, known as Basel II. The
framework, which came into force in Europe this month and is due
to be adopted by larger US banks next year, is designed to improve
the allocation of capital by encouraging banks to take a more
sophisticated approach to measuring risk. But the Basel II approach
is largely based on the use of complex risk models that have been
thoroughly discredited by the recent crisis.

Indeed, the crisis has been a sobering experience for financial
regulators, who had spent much of the past five years fretting about
the hidden risks in hedge funds and other unregulated entities,
while failing to spot the risks building up in the institutions
that they were supposed to be supervising. As a result, regulators
are likely to use their powers under Basel II to force banks to
hold more capital.

"The crisis has shown that regulators have been asleep at the wheel,
not just in terms of what they have allowed to be included in capital
but also what they have allowed to be excluded from the balance
sheet," says Simon Samuels, European banking analyst at Citigroup.

Notably, the stock market is already helping to enforce this
discipline. The banks that have suffered the heaviest share price
falls in recent months have been those perceived by shareholders
to have the smallest capital cushions. This has forced some drastic
steps. In the past few weeks, Citigroup, Merrill Lynch, Morgan
Stanley, and UBS -- those banks that had suffered the heaviest
losses on subprime-related bets -- have accepted almost $30 billion
in new capital from sovereign wealth funds in the Middle East,
Singapore, and China.

Even banks that have avoided large losses are likely to find they
will need more capital. They are expected to sell assets, cut
dividends and/or issue fresh equity in order to rebuild their capital
bases. Smaller lenders may decide the best way to solve their
problems is by selling out to rivals. Fresh capital will, however,
be required not just to support existing obligations but also to
fund growth.

The credit crisis has choked off many of the markets that banks in
recent years relied on to take assets off their balance sheets.
Issuance of mortgage-backed securities has dropped sharply, while
demand for more complex instruments such as collateralised debt
obligations -- packages of loans that have been sliced to create
new securities -- has dried up completely. Many bankers think it
will be months, if not years, before they can start issuing these
securities again. If and when they do, investors are bound to demand
higher returns than before and are likely to require banks to
demonstrate confidence in the securities by keeping a greater
proportion themselves.

In short, this means that banks will be forced to fund more of their
future loans from their own balance sheet resources. The shift has
prompted some leading bankers to declare the prevailing business
model obsolete. "Previously we had the idea of moving towards a
model of origination and distribution," Alessandro Profumo, chairman
of Unicredit, one of Europe's largest banks, told the Financial
Times late last year. "This model is not there any more."

Others are less gloomy, arguing that despite the speculative excesses
of the past few years, the mechanisms for dispersing risk through
the financial system will still work. "In an environment where
interest rates are higher, there will be greater differentiation
between different classes of risk," says one leading banking
executive. "I don't think that calls into question the fundamental
technology."

Even so, it seems likely that the banking sector is facing a prolonged
squeeze. Higher levels of capital will depress returns, while any
increase in bad debts among corporations or consumers would eat
into profits. The credit squeeze has already increased the cost of
borrowing for consumers, particularly in the mortgage market.
Although companies' balance sheets are reasonably robust, an economic
slowdown would hit their prospects.

Banks face higher funding costs both in the wholesale markets and
in their retail business, where competition for deposits is
increasingly fierce. Institutions with large investment banking
arms will also be hit by a general slowdown in activity.

Meanwhile, the authorities are expected to examine the case for
exerting a tighter grip on the banking system. Chastened by the
near-collapse of institutions such as Northern Rock, the UK mortgage
lender, regulators will initially concentrate on overhauling rules
governing banks' management of liquidity risk. But a wider rethink
of banking regulation cannot be ruled out. Ever since the 1930s,
when the aftermath of the stock market crash prompted US legislators
to separate commercial from investment banking by passing the
Glass-Steagall Act, financial crises have triggered a legislative
response. US politicians have already proposed reforms of the
mortgage broking industry. In Europe, regulators are training their
sights on credit ratings agencies.

Yet regulators are also aware that any aggressive moves to rein in
the banking industry could risk exacerbating the crisis. Through
their ability to create credit, banks play a pivotal role in the
economy.

In the past few years, the banks' apparent ability to pass on much
of their risk meant the scope for creating new credit was almost
limitless. The changes already taking place in the industry have
led to tighter credit conditions, prompting central banks into a
co-ordinated intervention to supply cheap liquidity to the banks.
"A forced aggressive deleveraging of the banking system would convert
a banking crisis into an economic crisis," says Citigroup's Mr
Samuels.

Even if economic decline is avoided, banks are likely to find that
their growth rate begins to return to levels that were widely seen
as the norm before the industry began its breakneck expansion just
over a decade ago. The only bright spot for banks is the continued
rapid growth in Asia and the Middle East. But it seems unlikely
that those economies will be able to shrug off a recession in the
US.

"Opportunities in the banking industry will be more limited for the
period ahead, even after the current severe stress eases out, and
the market will be faced with -- and will have to accept -- the new
'dull' reality of structurally slower profit growth," says Sam
Theodore, managing director and head of European financial institutions
at DBRS, the rating agency.

The next 12 months will be crucial in determining whether the banking
industry comes back to earth with a painful bump or whether it can
engineer a smoother landing. Either way, it will be a long time
before any banker dares to claim that his industry is less risky
than it was before.