“Recession’s end“, Bloomberg commentators included in their headlines on Wednesday night, while others noted that inventory reductions indicate that the economy is nearing a bottom. Green shoots, green shoots, green shoots, blah blah blah.
UBS’s senior economic adviser George Magnus is here to put an end to all this talk of plants, taking aim via his weed-whacking financial commentary this morning on banks, capital and what’s really needed to fix the financial system. Here are some excerpts:
This paper is about why it is such a slog to fix the financial system, and why we can’t really entertain ideas about economic recovery, other than short cyclical hiccoughs, aka green shoots, until it is fixed. The plot hasn’t changed since we first heralded Minsky’s financial instability as the template for this crisis, but the story evolves and the numbers change. So we will examine below where we are in terms of financial stability, and, using the just published IMF Global Financial Stability Report, highlight the key numbers that matter when it comes to three overarching, but incomplete, tasks: full re-capitalisation of banks, the swapping of debt-for-equity as part of a major debt restructuring, and the isolation of bad assets.
And here’s why we should be cautious:
There are two main reasons to remain cautious about those green shoots. First, sustainable economic expansion in capitalism requires capital formation, which we may define to include capital spending, residential building and consumer durable purchases. The mere ending of a large inventory correction, and the effects of limited fiscal stimulus measures (possibly except in China, and later this year in Japan) won’t do the trick. To get households and companies to commit to capital formation outlays, they need confidence in the stability and growth of income, profits and credit availability and affordability. Because of the exceptional balance sheet adjustments required during this de-leveraging, and the continuing dysfunction in the financial system, we can say that on all counts, we are nowhere near the point at which such outlays will occur on a scale that matters.
Second, a sustainable expansion needs a very substantial building block to fall into place. As Economic Insights has pointed out repeatedly for the last two years, the precondition for recovery is financial stability. By this we mean viable, profitable banks that do not depend on State life-support for their funding and capital needs, and two-way markets that work within the context of orderly risk premiums, and without the off-balance sheet activities of the State, booked at the central bank.
On those banking stats in particular, Magnus says that according to the IMF’s global financial stability report, and backed up by the UBS global banks team, about a third, or some $900bn, of bank write-downs have already been reported. Clearly, there’s still a way to go — about $1,500bn, according to Magnus. He estimates that since the crisis began banks have raised about $900m in capital — just about matching the writedowns so far — but, that won’t be enough.
Like the US banking stress tests, Magnus sees the need for more tangible common equity, which is more loss-absorbing and more acceptable to investors evaluating counterparty risk, in his view. But if banks brought forward to today their loss provisions for the period 2009-2010, their tangible common equity would be wiped out (possibly, something that has been unsurprisingly discovered by the stress tests). To meet a tangible common equity-to-tangible assets ratio of 4 per cent, for instance, banks would have to raise almost $900bn according to Magnus, about one third of which would be for US banks alone.
Here are his numbers:
And here’s his fairly firm conclusion:
Financial stability, then, in the way we have defined it, remains elusive. In an especially sharp and possibly protracted economic recession, or even a period of positive GDP growth in which de-leveraging and rising unemployment will continue for some time, it will be difficult for banks to extricate themselves from the negative loop between a weak economy and loan losses. This simply underscores the need for the authorities to step up and take on adequate and comprehensive re-capitalisation and bad asset removal programmes — unencumbered by political constraints. The antithesis, after all, was the signpost in Japan in the 1990s to zombie banks — a phenomenon that observers at the time and subsequently hailed as something that ‘we’ would never repeat.
Related links:
Stress test pass rate: 68% - FT Alphaville
US U-turn on tangible common equity – FT Alphaville
Stress test: Tangible common equity – Option ARMageddon