WHO’S NEXT AFTER CYPRUS?

The Cyprus debacle seems to have taken a course towards a resolution of some sort, with the announcement last week of a bailout plan that includes, among other measures, a one-time tax levy on wealthy (supposedly Russian) depositors in Cyprus banks, even when reports are now surfacing that the Cyprus banking system has been experiencing steady capital flight for several months now, with savvy Russian depositors being tipped-off by money managers way in advance of things reaching their dramatic climax over last week. The bailout deal sets a significant precedent, and fires a warning shot towards European jurisdictions who have allowed their banking systems to become offshore parking lots for hot money, to the tune of multiples of national GDPs.

I distill 4 fundamental lessons from this episode:

1) Capital controls are back, clearly embedded in the bailout terms: Capital controls are an extraordinary breach of basic EU rules, which allow freedom of labor and capital movement. Indeed, article 63 of Europe’s internal market rules explicitly states that “all restrictions on the movement of capital between member states and between member states and third countries shall be prohibited” unless there is an issue of “public security”. But there are few signs of the EU enforcing article 63 when it comes to Cyprus, even when the capital controls proposed are currently treated as temporary measures.

2) All deposit accounts are at risk, and some euros are more equal than others: the latest plan, which will see accounts with less than €100,000 protected, has established a new template for future bank bailouts: that depositors’ cash above the “insured” amount can and will be raided.

3) “Too big to fail” still holds: Some will argue that as big savers in the Bank of Cyprus and Laiki, the island’s two biggest banks, are taking such a haircut, the “too big to fail” mantra no longer works. But in truth the banks were minnows within the euro zone. Their near-collapse tells you that the ECB will do all it can to protect banks it regards as “systemic”, but will let the others go hang.

4) EU stress tests are worthless: The European Banking Authority’s annual health check on euro zone banks at the height of the euro crisis in July 2011 revealed significant concerns about just eight banks – five Spanish, one Greek and two Austrian. The Cypriot banks – Bank of Cyprus, Laiki, and Hellenic – passed what was supposedly a grueling assessment. Bank of Cyprus chief executive officer Andreas Eliades said at the time: “The stress test results justify the group’s strategic choices and actions, and illustrate its very strong capital base even under the most extreme, difficult and adverse scenarios.” Make of that what you will.

So who’s next to follow Cyprus’ path in the euro zone? Speculations have been swirling as of late, identifying Slovenia, Malta, Slovakia, or even Luxembourg as potential next domino piece to fall. In essence, Cyprus fell into its mess due to four fundamental factors that converged at a particular point in time, namely: weak fiscal situation, large debt overhang, banking sector size too big (and too weak), and too much reliant on foreign funding. I figured if I plot those 4 dimensions based on latest data observations (2012) for a host of euro zone countries, maybe one can discern possible next targets? Below is my attempt at a visualization in Tableau software. The x and y axis are self explanatory, depicting the debt and fiscal situation respectively, the relative size of the bubbles represents the size of the banking sector relative to national GDP, and finally he bubble color represents the extent of which that banking sector is reliant on foreign deposits (the more red, the “hotter” the funding). The data was sourced from the latest IMF World Economic Outlook edition, and the ECB’s Eurostat. Voila!

Basically, we’re looking for big, red bubbles that are closer to the upper right quadrant of the chart. Cyprus is right there, along with Portugal, France, Spain, Malta, Ireland, Belgium, Slovenia, Slovakia, Austria and Hungary, to name a few culprits. Malta looks particularly worrying, but consider this: Despite the size of Malta’s banking sector, assets held by the more important banks are slightly more than twice the country’s GDP. This is half the EU average. More importantly though is that the vast majority of deposits and loans administered by these banks are domestically derived: Maltese banks have very little exposure to foreign government bonds, have more than enough cash reserves to cover their loan portfolio and adopted over the years a very conservative low-risk approach to investment.

Slovenia has had its share of rumors lately, and the chart above shows it to be on the edge of the danger zone. These fears could be well founded: Slovenian GDP is set for a deeper-than-expected 1.9pc contraction this year, compared with an earlier estimate of 1.4pc, according to official forecasts released on Friday. The revised forecast brings government predictions in line with the IMF’s gloomier verdict that that the economy will shrink 2pc this year, the most in the European Union after Greece and Cyprus. As such, Slovenia’s cost of borrowing soared to a record high on Wednesday, with yields on two-year debt tripling over the past week, jumping from 1.2pc to 4.26pc before falling back slightly on Thursday. Ten-year yields have reached a post-EMU high of 6.25pc. Add to it the Russian connection, and you’ve got yourself a self-fulfilling prophecy.

Personally, I would be nervous about Belgium, particularly after the IMF’s latest assessment, which states: “The economy has entered a second year of near zero growth amid persistent vulnerabilities. While an improvement in external conditions, even if gradual, should support the recovery, the economy’s capacity to rebound and create jobs is constrained by structural rigidities and a loss of competitiveness. The financial sector has been transformed and downsized in the aftermath of the financial crisis, but vulnerabilities remain. Combined with the fragile situation of public finances, these vulnerabilities could, in an adverse environment, undermine macroeconomic stability.” Hum, zero growth, large and weak banks, lousy fiscal, large debt overhang, and an IMF warning to boot? That’s hard numbers. Does the market agree? Belgium bond yields went lower, so maybe the market knows something I don’t, or maybe it’s just a prelude.

By the way, the Tableau visualization above is interactive and dynamic (and Hungary is hiding behind Austria, conveniently), so feel free to click on data points and bubbles and explore around, then write to me or in the comments section below and tell me which euro zone country would be next to fall to the all-new, all-improved punishing bailout treatment.

BIG BANKS GETTING BIGGER … AND THAT’S NOT EVEN HALF THE STORY

After the crisis of 2008, global finance, starting in the United States, plainly needed better regulation and supervision. Lots of institutions had turned out to enjoy taxpayer backing because they were perceived to be too big to fail. Huge derivatives exposures had gone unnoticed. Supervisory responsibilities were too fragmented. The Dodd-Frank act came into life in July 2010, and attempted to address these issues under four axes: securitisation, compensation, liquidation and systemic risk (too big to fail). Two years now since Dodd-Frank, how has the situation evolved?

Several analysts, using data from the FFIEC, recently picked up on the very verifiable story that America’s big 5 have in fact gotten even bigger compared to pre-crisis levels. see here and here. I reworked the numbers using the same source data and came up with a slightly nuanced outcome: big banks are indeed as big or even bigger than what they were prior to Dodd-Frank (depending on what your base comparison year is), but the ratio of the top 5 bank holding companies to real US GDP (most other analysts use nominal GDP) has been steadily decreasing since 2009. It currently stands at 65% of real US GDP, or $8.7 trillions (see below), compared to 68% at end-2009. So, to be fair, if we’re trying to answer the question of whether Dodd-Frank brought about positive changes to the “too big to fail” dilemma, the comparison should be between today and 2010, not 2007.

This said, I personally think that the emphasis should be placed more on the soundness and stability of a bank rather than its relative size, the simple argument being that if a bank is well capitalized, liquid, and overall sound in its credit positions, then the “fail” part of “too big to fail” would be taken care of, and the “too big” part would become irrelevant. Krugman and I seem to be in agreement, and he further adds that “the pursuit of a world in which everyone is small enough to fail is the pursuit of a golden age that never was.” Regulate and supervise, and do it right and airtight.

Speaking of banking stability and soundness, are big banks today any more solvent (and, by direct consequence, less leveraged) than they were pre-crisis?  Hardly, judging by the latest data, again from the FFIEC. See for yourself below. Granted, the Tier 1 leverage ratio is hardly a comprehensive assessment of bank stability and soundness (I should know, I’ve been drafting banking sector stability reports for the IMF for 10 years), but it is a fundamental measure of solvency, hence potential bankruptcy and failure. This is what the Fed’s stress testings are all about: will the banks have enough capital to sustain operations and pay back shareholders and creditors in severely adverse scenarios? The news was conveyed last month in the resultsof the Federal Reserve’s latest bank stress tests. As presented by the Fed, most of the news was good. Some large financial institutions were judged likely to have sufficient equity capital even if the U.S. economy were to experience a significant downturn. With that, banks such as JPMorgan were allowed to increase their dividends and even buy back shares. But there’s a problem, and it’s not a small one. If you buy the Fed’s view of what is likely to constitute stress, there is some justification for its action. But why would we let banks reduce their capital in the face of so much financial and economic uncertainty around the world (re: Europe)? We all know that lower equity at big banks means higher expected losses for taxpayers down the road: The disaster of 2008 caused about a 50 percent increase in U.S. debt relative to gross domestic product — the second largest shock to the country’s balance sheet after World War II.

On these stress tests, the Fed’s assumption in the stress scenario that Europe would have a mild recession seems too benign given the latest developments re: Spain, Portugal, Greece. How much faith do we have in these stress tests? a combined 96 percent of North American financial services professionals were “not at all confident” or only “somewhat confident” that the Fed’s stress testing addresses all of the important risks to the banking system, according to a recent Sybase survey.

So we’ve established that big banks are as big or even bigger than they were pre-Dodd-Frank, and possibly as thinly capitalized and over-leveraged as ever, but are they more prosperous?  you bet, not quite as rich as 2007, but getting there quickly and steadily. See below.

The financial system it seems hasn’t become safer since September 2008. We are not in a strong position to weather any financial storm that starts gathering on the horizon, and that should be ample cause for concern.

-Samer