In the May 5^th edition of the Economist magazine, there appears an article on China’s banks. It points to the high profitability of the banks and the low level of NPLs.

It points to a couple of sources of worry, bad local-government debt and souring property loans. Much of the debt is structured in SIV like vehicles called LGFVs. While the Economist is probably right in its economic assessment a greater threat lies in store. You only need a healthy sense of curiosity.

The Chinese should be thankful for the European shenanigans for distracting attention from some very interesting goings ons in the Chinese banking industry. If the government were forced to bring all bad loans on to the sovereign balance sheet, debt to GDP would be more than the 40% or so currently reported. That number would be in the range of 90% to 160% of GDP. Based on the creative accounting currently in use in China, at which end of that range would your guess be?

How did NPLs get from mid teens and mid twenties to low single digits in a few years? Simple. You sell the NPLs at face value to someone, like an asset management company for example. Can’t afford it? No problem. Extend a loan to said asset management company. If you look closely at the balance sheets of all the big banks you will find a bunch of bonds issued during the banking reform years by asset management companies which proceeds were used precisely to buy NPLs from the banks which now hold these bonds. How can auditor possibly countenance this practice? Why are domestic financials prepared according to PRC GAAP and audited by firms whose names are the concatenation of a Big Four and some Chinese company? Most of these bonds are delinquent but not classified as non performing but are instead euphemistically referred to as receivables. The European crisis will seem small once the truth behind the Chinese economic miracle is uncovered.

A few months ago the ECB’s long term loans to the banking system appeared to have staved off risk of default or breakup for at least as long a term as the facility. The fears of default and breakup have returned with a vengeance.

My assessment was that the LTRO was sufficient to postpone the problem for at least a year if not two, subject to a few assumptions, but that they did nothing to address the fundamental issues causing the cash flow and balance sheet insolvency of peripheral Europe. The LTROs 1 trillion EUR will at least cover the Eurozone’s 2012 maturing sovereign debt if one assumes no further government largesse is required for unforeseen circumstances. This covers it for a year, assuming that the European banks cover 100% of all new issues. If they cover half, the money will last longer, perhaps 2 years. No government largesse means everyone sticks to their imaginary budgets, and more importantly, no government or bank has been misrepresenting their financial position. These are strong assumptions.

It seems that government finances are hard to define and quantify rigorously. Some people call this accounting fraud. As the only practical prosecution (there can be many plaintiffs), is a connected party, its unlikely that any legal recourse can be sought. In times of stress, one cannot rule out accounting fraud. Even if we assume that government financials have not been embellished, there is the question of whether the proposed budgets are realistic. Austerity takes care of one side of the profit and loss. With taxation at its limits, in terms of already high marginal tax rates, it is difficult to envisage higher rates. Indeed both austerity and taxation beg the question of the elasticity of output, and thus tax revenue, to taxes and fiscal austerity.

The qualitative and quantitative variability of banks’ balance sheets, even apparently strong US banks, is also cause for concern.

When banks had large scale proprietary operations, (some would say a negligent or fraudulent misuse of funds), the riskiness of banks was indeterminate. Bank CEOs would struggle to understand the nature of their balance sheets due to their complexity. The static risk of the balance sheet presented sufficient complexity but the dynamic risk resulting from the non-linearity of the exposures and additionally, the prop traders’ trading behavior made a thorough understanding of the risk not difficult but impossible.

With the winding down of prop desks one element of balance sheet complexity has been reduced. However, this is not all. The agency business has its own complexities. Typically the agency business exists to serve clients and thus the risks undertaken on behalf of clients are either transient, or hedged away. Here the financial engineers have outdone (and perhaps undone) themselves and introduced a level of complexity that confounds the concept of risk pass through in an agency business.

As profitability falls due to increased regulation and capital adequacy requirements, the reduction of prop trading and the creep of financial oppression, agency businesses need to work harder to increase returns on assets just to maintain returns on equity. The result is more aggressive financial engineering, more complex deal structuring, mostly to camouflage more aggressive fees.

As more complex structures or payoffs are sold to clients, the resultant complex risks have to be laid off in the market. There are several ways to do this. One is to find a matching less sophisticated counterparty in a clear breach of good faith. Guess who is the least sophisticated counterparty? The theoretically robust way of laying off the risk in the market is to hedge each basic element of each product individually using its theoretical replication strategy. There is almost always one, but it may not be feasible or practical. Many replication strategies have asymptotic properties that involve zeroes and infinities and may in fact exacerbate risk by requiring inordinate notional exposures. The third way is to aggregate the risk exposures of the entire client book, and to hedge the aggregate exposures rather than the individual ones. This usually works if the risk models and systems are good and there are no unexpected deviations from model. The more complex the book, the greater the risk that either the model is inadequate for handling the individual non-linearities, or a significantly large deviation from the neighbourhood of calibration confounds the model.

Banks have in the past appeared to be in more control than they actually were. The current stressed environment and post 2008 crisis conditions may present characteristics which their models have not taken into account.

And even if they were in control, in the current stressed environment, human behaviour has taught us time and again that good faith is a rare commodity.

The bottom line is that nobody, possibly not even the management of the banks, knows what the current and near term expected positions of the banks really is. 

It this lack of information, about banks and about sovereign balance sheets, that the financial destiny of the Eurozone faces. Lack of information or lack of clarity leads to fear which can lead to capital flight. Despite most European banks passing so-called stress tests, and raising more capital, deposits have been consistently flowing out of Eurozone banks.

This hints at another purpose of the LTROs, since most of the money raised by the banks still sit with the ECB earning a negative carry of 75 basis points per annum. They need the liquidity.

For all the financial wizardry that has been deployed in search of a solution, the Eurozone is poised at the point of a limited collapse. Greece is at the door and may be forced to exit the union. If Greece is ejected, the market will surely push Portugal and Ireland to the door.

For these smaller economies, the principal members of the Euro, France and Germany, may tolerate exit. Italy and Spain are problems of a different scale and would certainly pose an existential question to the Euro. This is contagion risk.

It is interesting to consider that in the absence of a Euro, local currencies, Drachma, Escudo, Pound, would be plunging, and it is almost sure that some pundit would propose pegging these to the Deutsche Mark.

Yet we currently have currency union and discuss selective exits. Perhaps it is Germany who should consider exiting the Euro. For the Euro members, the Euro itself is analogous to the gold standard which while it provides an anchor to the value of each backed currency, takes away important policy tools. Policy tools which the ECB has attempted to recover through creative and alternative means but which have interesting and exciting side effects.

The unfolding saga of the Euro makes dramatic reading and gives everyone a lot to talk about over ouzo and beer, but a storm is brewing in a teacup, a very large red teacup half way across the world where accounting principles are all but generally accepted, the shadow banking system has grown alarmingly and the banking system has an air of fiction about it. China.

Since 2008, raising capital for a hedge fund or private equity fund has become very difficult. In the case of some would be institutional or family office investors, it has always been difficult.

Especially in the backwaters of capital. The marketer is an eternal optimist. He actually believes that the investor is interested in what he has to say, that the investor understands what he has to say, that the investor understands English, basic finance, and intends to make money through investing. These are strong assumptions individually but taken together, compound the capital raising problem.

Marketers should always begin with the first principle, which is to first do no harm. The marketer has to therefore believe in his own product. He has to understand his product inside out, and most importantly, from all the possible angles and perspectives of his target investor audience. Thus armed with conviction and understanding, the marketer has to take his product to the investor.

This is easier done than one might expect. Many investors will take a meeting quite easily. Beware these investors. They are often time wasters. The investors who have no time to waste have little time for your product. The more difficult it is to get a meeting, the more serious the prospect once you get in front of them. Alas, just because an investor is difficult to pin down doesn’t mean that they are a good prospect. Good prospects are hard to pin down.

The first meeting is important. It is here that many a deal is closed. There is a class of emotional or recreational investors who will invest on first impressions. If one is lucky, the impression of the marketer will be sufficient to close a deal in the absence of the investment professionals. Madoff was a case in point. He never met any of his end investors yet managed to, through his hapless intermediaries, raise billions in capital.

Do you send material ahead of the meeting? Of course you do. The interested and diligent investor will read this material in preparation for the meeting. If you are lucky. The bored and mischievous investor will read it in even more detail so as to make the marketer’s experience at the first meeting one he will not forget for a long time. We can discuss the quality and how to put together an investment presentation in another post.

Always be formal and professional at the first meeting. The marketer may know your boss. Very often, buy side professionals will not do the courtesy of dressing up to meet the marketer. This is a mistake. Back to the marketer. Always be formal and professional at the first meeting. Investors, like all children, are very impressed by packaging. A suit and tie are required. In my experience as a buy side investor, I have always trusted the bedraggled informally dressed and the hapless and held my guard firmly up when faced with a ‘suit’. Never mind. Play it safe, wear the suit. In Asia, business cards are delivered with both hands. This is a tradition to demonstrate that one’s hands were fully tied up and not fumbling for the dagger in the back pocket. Your counterparty will also deliver their card with both hands, if you are lucky. The more intransigent investor will not offer you a card at all. Ask for one. You may never get the chance to spam this person’s email inbox ever again so make sure you get his card.

Sit down.

Never assume that the investor before you knows what you are talking about. At the same time, asking if they know what a CDO means will insult them. You need to surreptitiously explain what you are going on about while convincing the investor that you had absolutely no clue that they have absolutely no clue what everyone is talking about. Explain the investment opportunity, the investment strategy, the history of the firm and its people, and why you think this is the best investment since free lands have been expropriated from poorly armed indigenous peoples.

Some investors will attempt to demonstrate how much smarter they are than you. Let them. If you don’t you will not close the trade. Don’t just sit there and take it, engage them. This shows respect. Don’t argue. This shows disrespect. And don’t patronize. That’s just rude. After some polite sparring, make sure you lose the argument. If you actually agree with the said investor, you need a reality check when you get back to your hotel. Take notes.

Some investors will disagree with everything you say. And I mean everything. Agreeing with them will not make them stop or help the situation. You can quickly gauge if the investor simply doesn’t make these types of investments or doesn’t like you hairstyle. Don’t leave too early, use up at least 40 minutes, then take your leave politely. Before you go, use the time to find out all you can about the investor, their likes and dislikes, what they’ve invested in before. You might be able to send a less hirsute colleague next time around.

If an investor is interested, you’ll know. The questions they ask will telegraph their intentions. An interested investor does not a trade make. There are other considerations and hurdles to clear.

Have you ever wondered why that investor who was so terribly interested in your investment product and who knew the strategy and the market inside out, and who knew all the players in the industry and who asked you to send due diligence material and who said they would follow up suddenly falls silent? Sometimes these are smart junior people whose voice on the investment team or committee is simply not sufficiently loud, and they know it. Sometimes they are smart senior people who answer to an investment committee or have a process and simply do not have the discretion or authority to make an investment.

In some markets, the people who have the authority to make investment decisions are simply too busy, or too intelligent, to make those decisions. It is common to find that a professional investment team has been hired to assess investments which they then bring to a committee of ‘wise old men’ with the ultimate authority to pull the trigger. These wise men have built their careers outside of the investment industry, either in business or politics and often both, at the same time. You get the type. They don’t trust their investment team, being old and wise. Unfortunately, they don’t even trust themselves, being at least wise enough to know that their experience and expertise lie elsewhere. The result is that these wise men only invest in brand names. Their highly intelligent investment teams will have been conditioned to the likes and dislikes of their masters. They will only seriously propose brand names to their masters. Every so often, a niche, intelligent, under-researched, glaring opportunity will pass through the desks of some hapless investment analyst. They may choose to escalate this to their investment committees. This is rare.

Marketers faced with a prevaricating, delaying, unresponsive investor should not be discouraged. Its not you, its them. It likely that the investor you face is a professional gatekeeper with limited discretionary powers, with a committee to answer to, a committee comprising very wise old men, who don’t fully trust their abilities or judgment, and who think that because they’re themselves not experts in investment, they should invest with a reputable big brand name. That’s why its so important to build a brand. Marketers faced with these types of investors should not be discouraged. They should move on. Either to a more suitable investor, or to a fund manager with a brand name. And so real talent never really makes it to the masses, institutional or otherwise. And well it should be. It just serves everybody right.

Take a small island with an open economy highly dependent on trade and intellectual property, grow the economy to the hilt, run out of ideas, grow the population to grow the economy, to the hilt, or the shoreline, and what do you find? High inflation at each level of economic output.

The open economy invites imported inflation and so a natural control variable might be the exchange rate, but what of domestic inflation caused by capacity constraints?

An ever rising disparity of income and wealth is being fuelled by differing labour capacity or supply constraints in different industries. This exacerbates the inflation problem since shelter, transportation and food account for a greater share of consumption to the lower income group and it is precisely the scarcity of land, transport infrastructure related to the scarcity of land, and food which are the main sources of inflation.

The solution to this is not wage policies or subsidies across the board or by income level. This will very likely trigger a wage price spiral since it fails to address the underlying causes of inflation and localized labour market shortages.

If the economy is operating at close to full employment and inflation is accelerating beyond economic growth, structural limitations have been met and constraints are binding. To address inflation, the economy needs to be cooled. To the extent that the inflation is imported, exchange rates can be used as a control. If the inflation is due to domestic capacity utilization limits, interest rates are the appropriate control.

Differential demand supply imbalances in the economy lead to differential pricing (or mispricing) of wages. To address wage price spiral inflation dynamics, industries facing labour shortages need to either be cooled or the specific relevant labour developed or imported. The latter approach has been operated with great economic success but has faced social and political headwinds. The former approach has to be implemented or at least explored. Industries with monopoly or oligopoly employers tend to underpay. Such industries may require wage policy or labour unionization. Industries with numerous employers paying market wages can be left alone.

Wage price inflation spirals are due to two separate yet related dynamics conspiring to drive prices higher. A credible solution needs to address both prices and wages, separately yet in a related fashion. After all, a wage is nothing more than the price of labour.

One of the most difficult issues facing Singapore is the shortage of land. This is trivially true for a tiny island. It is thus the most likely source of inflation when the economy overheats. Call it the Rent Price Spiral. Prices rise resulting in higher profits resulting in competition for space resulting in rising land prices and rental leading to higher prices. Maintaining GDP growth through the unbounded growth of the labour force is not viable in the long term, and in Singapore, is fast approaching its limits. Maintaining Per Capital GDP growth, per capital income and per capital consumption is a more logical objective.

This is easier said than done, which is why to date, it hasn’t even been said.

There is something wrong with the fractional reserve banking system. It should have become clear post 2008 but it hasn’t.

Banks at their simplest form take deposits, (borrow money) usually short term, and lend money, usually medium to long term. They also augment their short term borrowings with the issue of longer term debt instruments. So banks borrow on the one hand and lend on the other, making a margin, being the difference between the rate at which they borrow and the rate at which they lend.

For the borrower, banks provide services by seeking the capital and  aggregating it. Along the way they also provide corporate finance advice. There are costs associated with seeking capital and aggregating it, and there are costs associated with administering the business as well. What borrowers seek from a bank is the ability to provide the requisite capital at attractive terms and pricing. Banks do represent some risk to a borrower, if they unexpectedly withdraw funding or are otherwise unable to support the borrower further. With the complex array of structures through which a bank aggregates and directs capital, for example with securitizations, the risks that a bank poses to borrowers can be complex.

For the depositor or lender, the bank provides safe keeping of and interest on their money. Often the bank will provide a bewildering array of other products and services as well but these are ancillary to the primary business of borrowing cheaply from the public. The risks to the depositor or lender are simple enough. Credit risk. In the case of securitizations, the risk is transferred away from the bank, to the particular pool of borrowers. For the depositor, the risk is in the bank defaulting. As long as banks act as nothing more than intermediaries of capital, the analysis of bank’s credit default probabilities is straightforward. Banks use depositors money to lend and make a spread. The financial strength and performance of a bank are the result of its credit underwriting standards and balance sheet management. As banks have evolved and drifted into other activities, the volatility of the asset base becomes less correlated or related to its liability base. Fee income is fine as it is compensation for a stable business activity; there are no negative fees. The risk increases with trading profits which can be positive or negative and introduce uncertainty of cash flow and mark-to-market variation to the assets of a bank. The asymmetric pay-offs to traders in a bank are well documented and represent a serious agency issue to shareholders and depositors. Basically, the trading desk gambles with the capital provided by shareholders and depositors. The risk reward to the depositor is particularly poor as their upside is capped.

In a low interest rate environment, the disadvantage to the depositor is amplified. Not only is the compensation for holding cash, (lending it to the bank) low, but banks are likely to engage in more risky activities to maintain returns on equity and assets as well as to generate generous bonus pools for management.

The current environment is interesting. Interest rates are low, unilaterally depressed by most developed world central banks. It is unclear what the ultimate lenders would be happy to charge in a competitive environment to ultimate borrowers in the absence of the intermediary bank. It is safe to assume that the interest rate would be significantly higher than it is today.

Banks are unwilling to lend to private borrowers due to increased capital requirements under Basel 3 and tighter credit underwriting standards post the 2008 financial crisis. Private enterprise therefore faces a shortage of capital at current low rates of interest. Lenders or depositors face near zero interest rates, and are unable to disintermediate the banks to earn a higher return on their cash. The banks end up hoarding cash out of fear of the next liquidity crisis, (or perhaps they know something we don’t about the quality of their own balance sheets), or they invest in assets which consume little or no capital, such as sovereign bonds.

The European Central Bank’s LTROs are still not well understood even by some industry pundits. The LTRO provides liquidity and not capital. Since banks are capital already constrained, LTRO funds can only be deployed in assets that carry a zero risk rating under Basel 3 capital rules. This limits banks to investing in sovereign bonds, and rationality dictates that they invest in their own sovereign’s bonds.

Basel 3 capital rules must be one of the most effective means of crowding out private investment. Regulators beholden to governments are happy to encourage the refinancing of government debt which might otherwise struggle to find free market investors.

The result is a banking system that sweats depositors by paying them nothing for their capital, and starves the private sector of access to credit. It is hardly the picture o
f efficient free market capital allocation. The banking system has become the de facto lender of last resort to government, which is hardly the most efficient allocator of resources or producer of output.

The long term impact on economic growth must be felt.