Regulation of Banks

There is an opportunity here to eschew heavy handed regulation.

The public are clearly incensed at the behaviour of the bankers and prop traders. The people are disappointed at the level of diligence and care that their bankers have applied in the conduct of their businesses.

The opportunity exists today for regulators to demand nothing more than disclosure that is fair, clear and not misleading, so that private individuals can decide if they want to deposit money with, invest in the equity of or trade as counterparty with, a financial institution. The public will therefore decide what is too big to fail and provide a market solution for the right size of banks.

The alternative is increased regulation, bureaucracy, inefficiency and ultimately a higher cost to the economy than is optimal.

It is sub-optimal to risk manage to the tails on an ongoing basis. As long as the system consists of a sufficient number of independent decision makers, a concept of self insurance takes force. When the number falls or the independence assumption is breached or weakened, systemic risk rises.

Another condition for a market solution to work is that agents, that’s savers, investors, counterparties, are able to make sense of the information that they are given. This is a stretch. Not many people can understand the full complexity of the modern bank. Not many people understand financial statements of any type of business let alone a bank. Education is the answer. Economic agents need to be educated in prudent household financial management in order to interpret the information and allow them to behave more rationally and predictably. Until they don’t.

The Best Job In The World

Want to find the best job in the world? Here’s how to think about it.

You want a job with maximum return to your skills as possible. You therefore want maximum return on equity, per person, in your job or field.

You really couldn’t give a toss what the return on assets is. Return on assets has efficient market limitations. Too high, and it is competed away. Too low and the industry goes the way of the dinosaurs or gets nationalized.

Let’s assume for a moment, that most activities generate roughly the same ballpark return on assets.

What you want to do is to take on a job which maximizes the dollar return on assets per person.

In other words, you want to work for a bank. Why? Leverage. You want to work in a job that levers its equity to kingdom come, maximizing dollar return on assets, per person. Assuming that return on equity faces the same limitations and bounds as return on assets, you want as much equity per person and as much assets to equity as you can muster.

This is the dilemma. If you didn’t think this way, you wouldn’t work in a bank. You would be doing something productive instead.

So where is the incentive for restraint and prudence? Not found in a bank. Its not the actual operational business that counts. Banks that lend are equally driven as banks that trade their balance sheet, as banks that underwrite, arrange or distribute.

Management is in it for the leverage.

Doctors and dentists, engineers and scientists, they make good money, they may have higher return on assets than bankers.

Doctors revenue, what? 10 million for a sole practitioner. 20 million. Transactional notional for an investment banker could be in the billions. You’d simply have to pull more teeth and lift more faces to make as much as a banker because the banker controls or works with so much more notional value of business.

Work for a big bank, not a small one. Work for a levered bank not a conservative one. Here is a concrete example why. If you are an ace trader making 20% a year on assets. If you are allocated 20m to trade, you’re cruising but you’re not bruising. If you were a mediocre trader generating 5% a year, the garden variety waste of space, but you are allocated 500m, you are really raking it in.

So, life is not fair. Go work for a bank. The curbs on bonuses may be temporary. Banks have already raised basic pay. Grab it while it lasts. When bonuses return there will be some bank in some country paying out. Join them. Tell them how much you got paid in your last job.

World Trade 2010

In the latter part of 2008, the value of world trade plummeted as availability of trade finance evaporated at the same time that global economic growth slowed drastically.

2008 saw a reversal of globalization as the developed world consumer retrenched after a protracted period of operating too low a savings rate accumulating unsustainable levels of debt. The emergency measures taken by governments to reflate their economies be it in monetary or fiscal policy has sent nominal GDP rebounding with a more moderate impact on real GDP. This caused a recovery in world trade, albeit not to pre crisis levels. The inventory cycle led by lagged destocking and restocking led to a magnified response in industrial production and world trade. The cyclical nature of a lagged transmission mechanism had already manifested in the middle of 2009 where world trade faltered again. November 2009 saw further weakness in world trade. This is further evidence that the developed world economy’s recovery is yet fragile. Aditionally, the situation in trade finance is still difficult. Bank lending remains frozen. Unless banks can find additional capital or capital relief under Basel II, they will not be deploying capital.

And yet, one should not be too quick to lose heart. A lagged transmission system creates oscillations around a recovery path. The current recovery path is interesting. The balance of trade between the US and China is a good proxy, given the volume of trade between these two countries. Since 2001, the trade balance has evolved into a US deficit cyclically correcting but trending well into deficit. The current cycle has seen a sharp correction towards balance as the crisis took hold in 2008. The recovery in 2009 saw a resumption of the US deficit but not to pre crisis magnitudes. The deficit appears to have stopped growing and appears to be in the process of drifting towards balance. As the US trends towards a net exporting position the conclusions for interest rates, the USD and inflation are most interesting.

FX transaction volumes are dominated by speculative and financial activity. Asset-liability share of FX transaction volumes are in the minority, 20% to 25% is an estimate provided by several FX hedge funds. Yet speculative transactions impact on FX tends to add volatility and not drift to the process whereas trade driven transactions tend to introduce drift. The implications are therefore for a strong USD.

There is another factor impacting the USD and that is that as world trade recovers from the doldrums, demand for USD as a trading currency increases. This is especially true from inter emerging market trade which is more likely to settle in USD. Inter developed market trade will sometimes settle in USD but is more likely to settle in the vendor country’s currency. Countries with closed capital accounts, capital controls, currency risk, and political risk will almost exclusively trade in USD.

Macro conditions are stacked therefore towards USD strength and not weakness. At the time of writing, this is a contrarian view.

Extending this thread, a strong USD worsens the terms of trade for the US potentially countering the drift in the trade balance. If the US is to drift towards a neutral trade balance, and the lack of vendor financing certainly pushes in this direction, internal pricing must adjust where external pricing cannot, suggesting deflation.

I have long argued without success or conviction that interest rates were too low to be efficient, that a low interest rate encouraged over investment as the hurdle rate for putting capital in harm’s way was too low. My argument lacked conviction because with a central bank setting short rates, it was hard to tell what a hypothetical market rate of interest would be…

A naturally strong USD affords the Fed latitude in keeping policy looser for longer. A deflationary environment is likely to keep long term interest rates lower as well.

Where does that lead? Monetary policy that is chronically loose has implications for dollar peg countries. If China does not yet have an asset bubble, it will. But it could take some time. And one can always watch in disbelief and disapproval from the sidelines, for quite a long time.

Why Equity Markets Are Weak

Its not fundamentals that are driving equity markets and responsible for the current weakness. Fundamentals were bound to weaken once the first round of inventory restocking had taken place and the benefits of cost cutting had been realized. The world economy is still weak, but in a recovery phase, and conditions have returned to normal, albeit at depressed levels.

What is driving equity markets lower is tightening of monetary conditions as central banks across the world try to normalize policy after a period of unprecedented monetary stimulus.

India and China have increased their reserve ratios, the Aussies have raised rates, even the Fed is slowing its pace of mortgage asset purchases.

US Indebtedness

Debt levels as a percentage of GDP: