Stressing Out the Banks

Right now you may be wondering who the big winners from the stimulus programmes and banking bail outs have been, because it sure as hell hasn’t been you.

Well, look no further than two articles yesterday from Bloomberg News:

“Purchases of U.S. Existing Homes Probably Dropped as Credit’s Effect Waned”

That’s the story from Main Street, USA. But it’s not the full story.

Take a look at what’s happening to Wall Street, USA. Or rather Long Island, USA:

“Hamptons Home Sales Double as Wall Street Buyers Fuel Rebound”

If you don’t know the Hamptons, take a look at this link from Google Maps of Southampton, Long Island. It’s part of the playground for Wall Street’s rich and infamous.

Although we do find it amusing that the Google Streetview cars have somehow not found the time to drive up and down the expensive streets of Southampton, Long Island yet they appear to have covered every block of the not-so-well-off rust belt city of Detroit.

And I have to say, they’ve found the time to drive down your editor’s street in Frankston too! We’d have thought the Hamptons would be much more interesting for people to look at than Detroit or Frankston.

But it’s just a coincidence I’m sure.

Anyway, all those stimulus cheques and banking bailouts that were supposed to save the economy have simply ended up in the pockets of those that helped cause the mess.

While Ma and Pa Kettle have been scrimping and scratching away, or even maybe taken advantage of what they thought were generous government subsidies, the real winners are those that received the biggest handout of all – the bankers.

And now these grateful bankers are helping to stimulate themselves and the pockets of other bankers by buying their big houses from them.

All thanks to the whacking great taxpayer funded bailouts which now apparently sits at USD$3,700,000,000,000 – or to put it another way, USD$3.7 trillion.

Now granted, a bunch of that USD$3.7 trillion has gone to Fannie Mae and Freddie Mac to help them write even more mortgages to the likes of Ma and Pa Kettle.

But “helping” someone to hock themselves up to the eyeballs when they can least afford it is hardly the kind of help we think they need.

However, you shouldn’t think it’s all plain sailing for the poor banks. Last year US banks went through an emotional stress test of their balance sheets. The upshot was that most came through with flying colours. Hurrah!

Now it’s the turn of the European banks to be stressed, sorry, we mean, stress tested. Is there any doubt they will come up smelling of roses too. We can imagine it now, “Ta-da, everything’s fine, move along please, there’s nothing more to see…”

The result of the stress testing is due to be released tomorrow evening Australian Eastern Time. Although we did find it quite amusing that one of the stress scenarios doesn’t include the scenario of a sovereign government defaulting on its obligations.

That pretty much gives the game away about how European governments intend on solving their debt problems – by taxing and inflating their way out of it.

Which by itself means another win for the banks. But as Niall Ferguson wrote in the Financial Times recently:

“Long before Keynes was even born, weak governments in countries from Argentina to Venezuela used to experiment with large peace-time deficits to see if there were ways of avoiding hard choices. The experiments invariably ended in one of two ways. Either the foreign lenders got fleeced through default, or the domestic lenders got fleeced through inflation.”

The last sentence sums it up. The Europeans, like the Americans, have decided to plump for the coward’s choice – inflation.

Oh, and by the way, don’t fall for all the guff you’re hearing about the heroic new UK prime minister, David Cameron. We’ll have more on that next week…

Anyway, all this talk about the corrupt banks got us thinking. In a way, it’s a flow on from what I wrote yesterday, about creative destruction.

In late 2008 we were within a hair’s breadth of seeing the banking system – and the glorious bankers within it – destroyed.

The years of chicanery and corruption would be over and something new and, well, less corrupt could appear in its place.

If we had been unlucky then the bankers would have come up with something worse. Although frankly, it’s hard to see how that would have been possible. But not to worry, because if it was a worse system then creative destruction and market forces would eventually put paid to it too.

But if we’d been lucky creative destruction would have seen the need for something better than the old banking system to appear. And eventually that will happen, it’ll just take time. As we keep saying, the bailouts and handouts have done no more than postpone the inevitable outcome.

I mean, think about it, if you’re starting a banking system from scratch, odds are you’re gonna have to make plenty of improvements.

After all, if you’re a saver who’s just lost a bunch of savings because ANZ Bank, Commonwealth Bank, NAB and Westpac have just collapsed under the weight of excessive and manic lending to the housing market, you’ll want to make sure your money is safer this time.

Wouldn’t you?

That’s all very well and good, but what improvements?

We’ve argued previously about the case for a gold backed currency.

Simply put, the case for a gold backed currency is that the gold coins are a physical store of value. Gold is widely recognised commodity. Due to its qualities it retains its value and is easily divisible and exchangeable.

Even paper money backed by gold – providing there is a 100% reserve held by the issuer of the paper money – is preferable to a system of fiat money where like here in Australia the money in your wallet is backed by nothing more than the trust in the government and central bank.

The only problem with paper money backed by gold is when the issuers of the paper begin issuing more paper than the gold they have in reserves.

But that doesn’t mean that a gold backed currency is a bad idea, it simply means that should an issuer of paper money issue more than the gold they have in reserve then they should be charged with counterfeiting.

That, you would hope, would prevent most honest issuers (let’s call them banks!) from issuing counterfeit paper money. Furthermore, the bankers would be loathe to even try as should customers become aware that the bank is counterfeiting by issuing excess paper money there would soon be a run on the bank as depositors rush to exchange their paper notes for gold.

And the idea of individual banks issuing their own notes backed by their own reserves isn’t as crazy as you may think.

For years, until the central banks became omnipotent, this was pretty much how many banking systems operated.

Banks could issue their own notes, much like you see today in the United Kingdom where three Scottish banks – Royal Bank of Scotland, Bank of Scotland, and Clydesdale Bank – all have the ability to print their own bank notes.

The same applies in Northern Ireland where The Bank of Ireland, First Trust Bank, Northern Bank and Ulster Bank print their own notes.

Those notes are widely circulated and accepted alongside Bank of England printed notes. It’s proof that a multi bank note system can work.

However, in the case of the UK, under the current banking system, having multiple note issuers is actually pretty pointless, because in effect Bank of England issued notes act as a reserve currency for the notes issued by the Scottish and Northern Ireland banks.

When the Bank of Scotland for example, prints Bank of Scotland bank notes, it can only do so if it holds an equivalent amount of Bank of England notes.

Plus all the notes – English, Scottish and Northern Irish – are exchangeable for the same face value with no potential for one to trade at a premium or discount.

Under a private banking system backed by gold reserves this would be the same. The only difference is that should a bank begin issuing more notes than the gold reserves held, and should the market become aware of this, notes issued by that bank would begin trading at a discount to other notes, to take into account the shortfall in reserves.

And in extreme cases people and businesses may refuse to accept them. Hence the incentive for the banks not to issue more notes than reserves.

Now, getting back to the stress tests, how easy would that be to do a stress test on private banks? Two simple questions – How much gold do you have in the vaults? How many notes have you issued against the gold?

Stress test over.

Compare that to this description from Reuters about what is involved with the European bank stress testing:

“The test scenario will assume a 3 percentage point deviation of the EU’s gross domestic product from the EC’s forecasts over a two-year horizon. It will also assume a “sovereign risk shock” in which some government bond prices would be marked down further from the depressed levels of early May. The size of such haircuts has not been officially announced and conflicting reports about them suggest national regulators may not be applying them consistently. A banking source told Reuters on Tuesday that the haircut on Greek sovereign bonds was 23 percent off “current market prices”.

“Banks will be tested on how their so-called Tier 1 capital, a key measure of financial strength, bears up. The ECB wants to see if the ratio of this capital to assets stays above a minimum benchmark of 6 percent of assets in the tests; although this is higher than the 4 percent legal minimum, it is lower than most bank shareholders are happy with. Deutsche Bank, for example, now has more than 11 percent.”

As we’ve shown before, the current banking system is so complex, even top banking analysts struggle to make sense of what state the banks are in. If you don’t believe me, listen in on the next bank earnings conference call.

But to be honest we don’t know what to expect from the stress tests. We can only guess that the results will be well stage managed…

All the big UK, French and German banks will most probably receive glowing reports.

All the banks from the medium sized economies will get a tick of approval, perhaps with a small comment about something unimportant.

Then almost all of the banks from the smaller economies will get a good report card too. Again with perhaps a comment offering helpful suggestions… but nothing to panic about of course.

Finally, we wouldn’t be surprised to see one bank from one really tiny economy get the book thrown at it. Just so they can say to the markets, “Look, see, we vigorously and transparently applied the stress test and only the Bank of Whatever from the Republic of Where’s-That has any problems… but even that’s fixable.”

In other words, the word whitewash springs to mind.

The reality is, the stress test means nothing because you can see from yourself just by looking at the Tier 1 capital how insolvent the banks are.

According to the comments by Reuters above, “The ECB wants to see if the ratio of this capital to assets stays above a minimum benchmark of 6 percent of assets in the tests.”

In other words, for every $100 in assets (loans, etc) held by banks, the European Central Bank is happy for banks to have just $6 on their books. And considering Tier 1 capital can include government bonds and other securities, the actual cash reserves held by the banks is much less.

For example, as we pointed out with the Commonwealth Bank several months ago, the CBA only has around $2 of cash in reserve for every $100 deposited by customers. Despite that the banks tell their customers that all at-call deposited funds are available immediately.

Now you know the real reason why banks set daily maximum limits on things such as ATM withdrawals and bill payments and why you need to notify them if you intend taking out a large amount of cash from the bank branch.

They’ve got to make sure they can jiggle the books so there’s some cash in the till when you come a-callin’.

But already the markets are looking on the brightside on the prospects of a positive outcome from the stress tests. Quite frankly, as far as we see it, it’s just another false dawn.

It’s doing little more than adding to the volatility in the markets, and delaying what is inevitable – the collapse of an unsustainable and insolvent banking system.

The European stress tests are a sham just like the American stress tests were a sham.

We can only hope that when the banking system eventually collapses, it’s replaced by a system of sound money rather than an attempt to revive the failed experiment of fiat currencies.

Cheers.

Kris Sayce
For Money Morning Australia

Stressing Out the Banks, 8.6 out of 10 based on 13 ratings

Tagged as: bank, credit, economy, financial, inflation, mortgage, stress