The regulatory way forward seems clear – banking institutions will need to be less leveraged, compensation policies will be more constrained, balance sheets will be reduced. It is ridiculous to look for banks to be increasing lending at the moment when their very survival depends on them shrinking balance sheets until they reach the point when most of the funding of their activities comes from deposits.
Return to the banking past
There was an interesting letter in the Financial Times this week suggesting that, in the UK at least, one way forward would be to try to achieve the kind of pre-big bank model when commercial banks would be relatively safe institutions funded by retail and institution deposits and would trade in liquid markets on behalf of clients, and capital market activities would be performed by commission and fee earning stockbrokers and merchant banks.
It certainly seems clear to me that the situation we have had in recent years where banks use the implicit guarantee of state support (too big to fail) to gear up their balance sheets in order to trade for their own book and pay individuals extortionate amounts of money is not going to be allowed to continue.
I also think that the future model of financing the economy will involve new ways of disintermediating the banks – through investment funds and secured lending by pension funds and insurance companies, for example.
The macro economic consequences of all of this are clear. There is no growth in bank lending to finance consumption or investment.
The experience of the downsizing of the Japanese banking sector was negative growth in bank lending for ten years from the mid-1990s to the mid-200s. In the UK, bank and building society lending has been in negative growth territory since the second half of 2010 and recent trends point to outright declines in Euro area bank lending in the next year or so. This structural decline in bank balance sheets makes monetary policy relatively ineffective.
Credit pressures
Yes, quantitative easing can push market rates ever lower but these low rates are not reaching the consumer nor are they stimulating credit growth. Just look at mortgage rates in the UK. The yield on two-year gilts is 58 basis points. The two-year swap spread is 65 basis points. So the reference for a two-year fixed rate mortgage with no spread for the lending institution would be around 1.25%. A quick look on a comparison web site for two-year fixed rate mortgages put them at anywhere from 3% to 4.2%. What’s more, these rates have gone up over the last year while market rates have gone down.
If credit growth is going to remain under pressure because of the restructuring of the banking sector, then it is very likely that monetary policy will remain extremely easy for a long time. This scenario favours bonds. Equities could struggle while growth remains weak. The performance of the bond market so far in 2012 shows just what a robust asset class fixed income is.
Even though the environment is difficult and significant risks remain, it has paid investors to be exposed to credit and high yield.
Government bond returns are low and will remain low because of the level of yields, but the carry available in investment grade and high yield bonds, with still limited default risk on the corporate side, provides attractive returns. Year to date, investment grade credit has delivered a total return of 7%, with high yield markets somewhat higher.
The recapitalisation and deleveraging of the banking world will continue and will remain linked with the sovereign debt crisis in Europe. Banks are funding peripheral governments and having to rely mostly on the ECB for their own funding. Breaking that link will have to wait until there are concrete plans for eurozone-wide banking supervision and for the ESM to be operational to provide direct capital to banks.
It is still a long road ahead, with numerous summits to fret over.
