Transcript
Speaker: Hello and welcome to another joint venture podcast.
Speaker: Yeah, more people talking.
Speaker: After the success of the one we did a few weeks ago, looking at commercial property in the financial sector, we thought it would probably be worth revisiting the topic of what's going on in the financial sector, how healthy it is or otherwise.
Speaker: Particularly in light of some recent information, we're seeing a virtually unprecedented decline in the deposit base of the US banking system.
Speaker: In real terms, deposits are falling at their fastest pace since the Great Depression, which I guess is a fairly catchy statistic in itself.
Speaker: In nominal terms, it's a virtually unprecedented decline.
Speaker: It's very rare that you see the deposits in the US banking system actually declining.
Speaker: A number of reasons for that.
Speaker: Part of it is quantitative tightening.
Speaker: Also,
Speaker: The banks have been losing customers to the money market mutual funds over the last three or four years.
Speaker: But all of this does add up to a more difficult environment for the banks, and one that we know is influencing their behaviour and could become, I think, one of the important features of the year.
Speaker: Now, before we start, I've got to say, as always, this isn't tailored investment advice.
Speaker: This is just for general information.
Speaker: Hopefully it will be useful, but there's no stock or sector recommendations embedded in this.
Speaker: It's very much our view, our personal views of what's going on in the industry.
Speaker: But I'd like to introduce Ben, involved in banking for many years, both at JP Morgan and briefly, I think, at HSBC, now at
Speaker: Henderson Rowe as head of investments.
Speaker: And I think it would be fair to say Ben is an expert in banking.
Speaker: So hopefully we can give you something useful.
Speaker: As I say, we're seeing this unprecedented decline in deposits and not just all deposits, but certainly particular types of deposits that are important to the bank's funding models.
Speaker: And I thought we'd start by asking Ben what that meant.
Speaker: Hello Andrew, thank you for having me on again.
Speaker: So I was also at Credit Suisse First Boston, which then dropped the first Boston, became Credit Suisse, and now from the grave I see it's crawling back again.
Speaker: That is also an interesting case study in banking and multi-divisional businesses that may not have the best reasons to be glued together.
Speaker: In terms of the deposits, they need to be seen in the wider context that we've effectively had a decade of quantitative easing and that inflated the amount of cash in the financial system.
Speaker: And by virtue of nearly all the financial systems that you deal with, the banks are the ultimate repository for that.
Speaker: So we've had this huge buildup of deposits and liquidity over the last few years.
Speaker: We obviously had an enormous buildup with regards to COVID particularly.
Speaker: A lot of investors and savers and just average consumers in the US had their savings built up and they started to run those down.
Speaker: At the same time, you're getting quantitative tightening and you're finally beginning to get other alternative assets for people to redeploy their cash into.
Speaker: It's important to consider, though, it is very hard to destroy cash.
Speaker: So one of the things that always kind of annoyed me was where people say, oh, there's lots of cash on the sidelines.
Speaker: Well, the reality is there's always cash on the sidelines.
Speaker: The cash doesn't disappear.
Speaker: You're just changing it from a holder of an asset who was holding something else, and they've decided to accept net cash for the pricing.
Speaker: The key thing to remember is where the cash is, how liquid it is in terms of is it tied up with regards to other assets and how it could be moved around in the system.
Speaker: And I think that's the beginning of the fundamental shifts that we're starting to see now with a bit of quantitative timing coming back in.
Speaker: It is interesting in that context, just in the world of economics, that if you were to go back 20 or 30 years ago, the world was enthralled by what was known as the credit counterparts identity, which
Speaker: in a practical sense, meant the only way you could destroy money was giving it to the government or exporting it or using it for debt repayment.
Speaker: But very much just changing the ownership of deposits didn't change very much if it was just moving things around in the private sector.
Speaker: And I've certainly noticed that all that has been forgotten over the last few years.
Speaker: And the discussion of quantitative easing, discussion of quantitative tightening seems to miss a lot of that.
Speaker: So
Speaker: I'm on something of a crusade to try and bring back the credit counterparts analysis, because I think it is absolutely vital to what's going to happen this year.
Speaker: I couldn't agree more.
Speaker: A lot of this stuff goes around in cycles.
Speaker: I think it was Keynes that talks about something about often people are beholden to some long dead economist.
Speaker: And one of the things that I would say about quantitative easing is you've got a lot of similarities with some of the problems you had about 200 years ago with regards to the Bank of France debacle.
Speaker: And
Speaker: The modern term for it now is something along the lines of, I think, the neutrality of money.
Speaker: But the reality is money isn't neutral.
Speaker: It will often flow.
Speaker: And what they discovered in pre-revolutionary France, that when they effectively embarked on what was an early example of quantitative easing, the people closest to the money were the aristocrats or the financiers.
Speaker: They were able to buy these assets.
Speaker: The assets were inflated in value.
Speaker: And by the time the money sort of filtered around to the system, to the bottom end of society, the people that finally received it just found out that asset prices had gone up.
Speaker: A really simple behavioral example of that that I see repeatedly is house prices.
Speaker: I bought my house.
Speaker: Oh, look, it's gone up in value.
Speaker: Brilliant.
Speaker: Well, actually, everybody's house went up in value.
Speaker: So apart from the fact that you need to live somewhere, you only really get to monetize that at the end of it.
Speaker: So it's called monetary neutrality now, but historically they used to call it the Cantillon effect.
Speaker: And I think over the last decade, you've seen that element of that.
Speaker: You've seen that growing disparity between rich and poor.
Speaker: People who owned asset prices did very well.
Speaker: And now we're getting the final stage of it.
Speaker: a bit like history repeating itself, that the people are working out that far too much money has been printed, people can't buy houses in many countries relative to average wages, and you've got this sort of general disparity and destruction of their living standards.
Speaker: Yeah, and history does rhyme in that.
Speaker: I mean, if you create excess money balances, I mean, as I never tire of telling people the US might have created 20% more money in its economy, but its economy couldn't produce any more in 2021 than it could in 2019.
Speaker: All you simply had was more money chasing the same number of goods.
Speaker: That was probably the easiest forecast for inflation you could make.
Speaker: And it was straight out of the textbook.
Speaker: First equity prices, then house prices, then the general price level.
Speaker: And I suspect in 10 years' time, the economics text will be talking about the folly of 2020.
Speaker: But for the banking system, and I think this has been...
Speaker: I wouldn't say disastrous, but it seems to me highly disruptive.
Speaker: I mean, large US commercial banks seeing their balance sheets forced to grow by a fifth in a relatively short space of time is incredibly disruptive in a way I don't think the central banks really thought about before they enacted these policies.
Speaker: I couldn't agree more.
Speaker: For banks, obviously, money is raw material.
Speaker: So the perception is if you vastly increase the amount of raw material and you give it at zero cost, it's got to be positive for them.
Speaker: But the reality is because of how regulation works, no, it isn't.
Speaker: So in the United States system, you've effectively got three prong sort of model to approach.
Speaker: regulation works along the lines of this effectively free model.
Speaker: So there's your sort of internal model which is effectively how banks would see the risk themselves and how much capital they think they need.
Speaker: Then you get a sort of standardized model which is pretty much as the name suggests this is kind of the risks as the regulator would see it and they apply it pretty much uniformly across a number of institutions to kind of get around
Speaker: just to see about modeling issues or particularly whether there's one issue or another or one asset or another that a bank might have an overly favorable or negative view about it.
Speaker: And then the final one that you get is effectively the leverage ratio, which is a really crude measure of banks' balance sheets.
Speaker: And the leverage ratio is effectively as simple as this is how big your balance sheet is in gross size.
Speaker: And it doesn't differentiate between whether it's cash that you're holding at the Federal Reserve or it's highly risky junk rated emerging market loans.
Speaker: They are all treated the same and you have to hold a certain amount of capital for that.
Speaker: So when you grossed up the bank balance sheets by pumping all this cash into the system and it ultimately being the end repository for a lot of this stuff started to appear on their balance sheets, it grossed their balance sheets up and put them under enormous capital strain and therefore basically put them under pressure in terms of hitting their earnings.
Speaker: So we have had that unique phenomenon over the last few years of
Speaker: certain banks trying to shrink their balance sheets, trying to give money back to customers.
Speaker: But ultimately, it's been a bit of a drag.
Speaker: And there's been different ways to deal with that.
Speaker: Another one would be to take perhaps more risk than you would have comfortable with to offset the fiscal drag that you've got on the other side of the kind of calculation through the leverage ratio.
Speaker: It's meant to be a backstop.
Speaker: But in many cases in the QE world, it actually became the main binding constraints.
Speaker: particularly I suspect for those institutions that still wanted to do buybacks.
Speaker: If you're looking to buy back your own stock and reward shareholders, having a larger balance sheet was really kind of counterproductive.
Speaker: Oh, absolutely.
Speaker: And the regulator generally prefers buybacks.
Speaker: So I know they're quite controversial.
Speaker: But the advantage of a buyback from the regulator's perspective is a dividend is effectively fixed.
Speaker: I know we can cancel it.
Speaker: But the concern they always have is the moment the dividend gets cancelled, people see it as a sign of weakness.
Speaker: And that's exactly what generally tends to happen.
Speaker: You've cancelled your dividend.
Speaker: There must be a problem.
Speaker: Banking is, after all, a confidence game.
Speaker: It is absolutely a confidence game.
Speaker: And the issue that you've got with buybacks is they are usually approved long after the bank's made its earnings.
Speaker: It's been signed off.
Speaker: The regulators agreed to it.
Speaker: But it's viewed as much more discretionary.
Speaker: So if you have to kind of raise more capital, do something like that, or basically try and keep the balance sheet within a certain sort of range, the regulator is happier with the buyback concept than they are with the dividend concept.
Speaker: So what do you think the banks did with the proceeds of QE?
Speaker: I mean, my sense is, yes, there was some domestic lending, there was some emergency lending to the corporate sector during the dark days of the pandemic.
Speaker: But I sense a lot of the money was actually recycled simply into financial markets, both domestically and abroad.
Speaker: And I think we're going to touch on this in subsequent podcasts, but an awful lot of money, I think, has found its way
Speaker: into global capital markets, an awful lot of dollars.
Speaker: And if anything, and this is obviously a bigger topic, I'd kind of argue that the Fed's response to the pandemic has actually increased the dollars role in global finance, because that's where a lot of the QE money was recycled.
Speaker: Do you think that gels with reality?
Speaker: Yeah, I totally agree.
Speaker: It's obviously an enormously complex topic, and I'm grossly simplifying, but I would...
Speaker: highlight a couple of points.
Speaker: First of all, there are different classes of banks.
Speaker: And by that, I mean at the top you get this kind of premiership division of banks, which are called the GSIBs, the Globally Systemically Important Banks.
Speaker: And they are perceived because of their business models, because of their interconnectivity, because of what they do, moving money across markets or very, very connected to capital markets themselves.
Speaker: They are required to have much higher capital levels.
Speaker: So I think when you're talking about cash being injected into the US system, absolutely.
Speaker: But some of the main engine of how that cash gets recycled globally is
Speaker: will go through those GSIBs.
Speaker: I think if we were talking about some of the community banks or some of the more regional banks in the United States, it's a very different experience.
Speaker: They simply don't have those options to start injecting the cash into wider markets.
Speaker: The second point that I would argue, and this is a useful topic when I see things talking about central bank digital currencies, but pretty much all the financial systems, national financial systems, are very much bespoke.
Speaker: And in the United States case, capital markets are far bigger and far more important than they are in most other developed countries.
Speaker: I think crudely the banking system is around sort of 35% of
Speaker: of all that kind of financing activity that goes through.
Speaker: So again, by design, when you push cash into the US financial system, there is a higher propensity for it to go into the capital markets, because that's the nature of their financial system.
Speaker: When you look at the UK, for example, it's something closer to 80%.
Speaker: So that sort of spillover effect is less important.
Speaker: And the other thing is, obviously, the dollar is the world's reserve currency, which I don't think people fully appreciate exactly what that means and how important it is.
Speaker: But if you are going to start doing transactions around the world, pretty much always there's a dollar leg to it one way or the other.
Speaker: And also, you could actually earn money in the dollar.
Speaker: I mean, in a world of euro rates in Japan and Europe, there wasn't really much point being a Japanese or European bank.
Speaker: So...
Speaker: Certainly in the European banks, and we've talked in the past about trying to scale the size of the Japanese banks' dollar books, but...
Speaker: I think it's pretty apparent even a few days or a few weeks after the pandemic began, the Japanese and European banks were borrowing trillions of dollars to build dollar lending books of their own.
Speaker: And I think that was the big stimulus for emerging markets.
Speaker: We tend to think about the US imported stuff as the lockdown ceased and that provided a boost to the emerging markets.
Speaker: If you look at the performance of their stock markets, the performance of their property markets and domestic demand, it's pretty apparent a lot of that was driven by borrowed dollars.
Speaker: And that's a two-edged sword, of course.
Speaker: It's all right when you borrow them and use it to stimulate your economy.
Speaker: But if the US banks start asking for the money back, unwinding that can be painful.
Speaker: And I think we've seen a bit of that over recent quarters.
Speaker: I totally agree.
Speaker: One of the things that people don't consider is banks fund predominantly in their own native currency.
Speaker: So it's great that you want to build a dollar lending operation, but the question has to be asked, where did those dollars come from?
Speaker: And essentially, you've got one of three choices.
Speaker: One is good old-fashioned, trying to track them through deposits.
Speaker: And those deposits can be onshore and offshore.
Speaker: Obviously, onshore US deposits, it's a much deeper market because it is their home market.
Speaker: The offshore dollar market is often called the euro dollar market for historical reasons.
Speaker: That's generally more corporates and potentially some of the larger wealth management operations.
Speaker: So you've got to convince them why they shouldn't keep their dollars in Bank of America and put their money in, for example, ING.
Speaker: Some firms will do it because they've got a relationship because ING is their house bank and they'll have dollar revenues.
Speaker: I'm picking ING at random, by the way, so please don't read too much into that.
Speaker: The second way of doing it is issuing bonds in dollars.
Speaker: And again, international investors pick those up.
Speaker: And then the final element is exactly as you described, you get it through the financial system.
Speaker: And there's a number of ways of doing that.
Speaker: And interbank financing is one of the key metrics.
Speaker: And that is a market that has changed a lot over the last decade because of the GFC.
Speaker: But effectively, you take your Japanese yen and one way or the other, you have to convert it into dollars.
Speaker: But there is a price for that.
Speaker: So whether you're getting it directly off an American bank, you're getting off an American investor, offering them higher pickup.
Speaker: But there are a number of different channels for that.
Speaker: The key thing to remember all of that is they are, for the most part, not particularly sustainable and sticky ways to do it.
Speaker: If you've grossly overborrowed in the dollar market, yes, you'll have some core customers that will always have dollars for it, but you've probably had to pay a rate in a world where obviously you've had all this money printing to attract those dollars on board.
Speaker: So the first question I would have is how sticky they would be once financial conditions tighten.
Speaker: The second element you've had is obviously the wholesale markets, or I should say the fixed bond markets have been difficult over the last 12 months.
Speaker: there's been a bit of a reopening with the rally.
Speaker: But again, if capital is getting more scarce, you're going to have to pay up for that.
Speaker: And again, you're somewhere at the mercy of whether those markets are open to finance you.
Speaker: And then the final one is, if you're an American bank or some of the other investors, if you can park your cash at home at four and a half or maybe we go to 5%, why do I want to mess around lending monies overseas?
Speaker: Yeah, I think, you know, in many senses, having built your dollar book, you become a distressed borrower the minute somebody doesn't want to lend to you.
Speaker: And the thing I think, and certainly on my side of the fence, that really worries me, a few years ago when I first started looking into this topic, you have a conversation with the Bank of France who, you know,
Speaker: How do you treat this stuff in the balance of payments data?
Speaker: The simple answer came back, we don't.
Speaker: We don't bother trying to measure it.
Speaker: It's just sort of washed out somewhere in the balancing item.
Speaker: Now, they have improved on that.
Speaker: They have started to even think about repos.
Speaker: But so many countries don't monitor this stuff, and it is difficult to monitor.
Speaker: Some of it appears as...
Speaker: If you have a subsidiary borrowing dollars and transferring them back to your home country, that can appear in the direct investment account.
Speaker: All of this means that despite probably being, if not the largest, one of the largest credit markets on the planet, we know very little about it.
Speaker: In particular, the central banks know very little about it.
Speaker: And in December, we had the BIS treating us to the news that
Speaker: there's the equivalent of 30% of global GDP in short-term FX debt, but they don't know who owns it.
Speaker: And I think this is a real, this, and that sort of old adage, it's what you don't know that catches you out.
Speaker: Um,
Speaker: This is something that the central banks don't know.
Speaker: And I'd argue quite strongly that the central banks only really think about the funding markets when they play up.
Speaker: So you're thinking December 18, September 19, during the global financial crisis and for a few days during the pandemic.
Speaker: Central banks sort of realised there was a problem here and they had to react to it.
Speaker: And yet they haven't really looked into the size of these markets and how they work.
Speaker: And I think that that is a potential fragility in the system.
Speaker: I couldn't agree more.
Speaker: I think the expression is something along the lines is what you don't know, what is not what will get you.
Speaker: It's what you think you know for sure, but just ain't so, as the expression goes.
Speaker: When that came out, I saw a lot of people in the analyst community say, oh, no, no, no, this stuff is all fine.
Speaker: It's all matched.
Speaker: There's no problems with it.
Speaker: Don't worry about it.
Speaker: And I think
Speaker: That's a classic example of what you think you know for sure, but just ain't so.
Speaker: The reality is when you look at it up close, when you've actually worked in a treasury operation, when you've actually seen the plate spinning that kind of effectively goes on in terms of kind of taking collateral down, rematching it.
Speaker: Ultimately, going back to your earlier point, as you said, it's a bit of a confidence trick.
Speaker: So the key thing is, what is your ALM, Asset Liability Management?
Speaker: So what are your assets and what are your liabilities and what rate do they roll off and what flexibility do I have?
Speaker: So if my funding rolls off quicker than my assets to the point you're making distressed sort of lenders,
Speaker: they will have a problem.
Speaker: They will have to start selling those assets down or they'll have to start paying up and then you potentially get yourself pushed into a negative funding position relatively quickly.
Speaker: Now, post-GFC, there's been an enormous amount of regulation to focus on this because obviously it was one of the key ways.
Speaker: In fact, probably the biggest way that a firm will fail is through liquidity, not credit losses.
Speaker: There's a good book by an author called Richard Vague
Speaker: with a scary title, something along the lines of the next great financial crisis.
Speaker: But Veig is a banker and he focuses very much on the fact that this is how the real world works and this is how economists view it.
Speaker: And it's a different thing.
Speaker: It's a highly stylized way of looking at things.
Speaker: And it really kind of glosses over a load of these issues.
Speaker: As we know, central banks have become increasingly dominated by economists.
Speaker: And they've taken these kind of simplified views of the world in there about how money works, how banking works, and they fail to take into account the actual real sophistication of it.
Speaker: So a good example of that was just prior to the Icelandic banking crisis.
Speaker: They commissioned a high profile economist to write a big report saying why everything was fine.
Speaker: And 18 months later, it wasn't.
Speaker: And in a former life,
Speaker: We had a meeting with a former, very senior, well-known central banker who had a reputation for sophistication and insight.
Speaker: And we asked them the question about how do you deal with this?
Speaker: And their answer was along the lines of, well, it's too difficult, so I exclude it from my models.
Speaker: Great.
Speaker: Well done, you.
Speaker: Yeah, I could take issue with the way monetary economics is taught and indeed practiced in so many places.
Speaker: I wish life was so simple that a bank has reserves of X so it can have loans 10 times X or whatever the ratio is supposed to be at that moment in time.
Speaker: If only life was so simple.
Speaker: The trouble is we live in a credit financed system and the British had their independent committee on banking.
Speaker: which was dominated by people that I felt shouldn't have been anywhere near it.
Speaker: And they came out with some quite ludicrous suggestions along the lines of effectively turning most of the banking system into investment trusts, where they were largely capitalised by equity and had very little opportunity to lend money.
Speaker: And my first thought on that is, A, it demonstrates you really don't understand how the economy works, and B, if you get what you want, I think you'll have fighting and riots relatively quickly when people find out how hard and how expensive mortgages will be.
Speaker: So it's a system.
Speaker: I've got a lot of sympathy with investment trusts as a structure, but not in that context.
Speaker: I'm a huge fan of investment trusts, and I think one of the things we'll see play out over the next two or three years is the fact that open-ended vehicles that have been used to absorb vast amounts of this surplus liquidity are going to have enormous problems when people try to pull their money out.
Speaker: So a lot of, for example, the ETFs, I think, is a sensible idea around, say, highly liquid,
Speaker: certain indices and assets, but I think once you're starting to move into, say, credit products or other relatively illiquid asset classes, you've got much bigger issues on those lines.
Speaker: You raised a point earlier, which I think is worthwhile just bringing up, that there are a couple of key dates that are always worth looking at.
Speaker: One is you write the year-end funding squeeze, and that's essentially because everybody piles through the door, they present these set of accounts to their auditors.
Speaker: and they have to demonstrate that they've got sensible funding, not just their auditors.
Speaker: In some cases, they're regulated depending on how sophisticated the regulator is.
Speaker: Some monitor the banks frequently and repeatedly.
Speaker: Others, a few come to mind instantly out of the large developed world, shall we say, pay relatively less attention.
Speaker: But the key thing is if they've done dollar lending, they have to show they've got dollar funding.
Speaker: So from September, October, you start to get this kind of big demand for financing in dollars.
Speaker: for the year-end effect.
Speaker: The other one where you tend to see it because of the growth of their financial system over the last years in dollar borrowing is the Japanese around March, because again, they have their accounting year-ends towards the end of March.
Speaker: So that's less important, but another one that we tend to see.
Speaker: And these are big numbers, and I've...
Speaker: On average, you've seen an 8% decline in the offshore books of the French banking system every December.
Speaker: And in a bad year, it can be 15%, 20%.
Speaker: Now, the French banks are pretty significant in global markets.
Speaker: And to shrink their offshore books 8% in a matter of a fortnight doesn't normally come without casualties.
Speaker: And I think the central banks are having to adapt to that world of realising there is a
Speaker: a real seasonality in credit flows and funding requirements.
Speaker: And I think in a market sense, it's even possible to game that a little bit.
Speaker: Oh, absolutely.
Speaker: So without naming names, but if you recall certain US brokers before they reinvented themselves as banks while under considerable duress used to have year ends.
Speaker: around the end of November.
Speaker: In fact, one of the survivors has changed itself, so it's gone back to that.
Speaker: And that's because they effectively arbitrage that.
Speaker: While the mainstream financial system is doing it, you've got your balance sheet, you can gross this thing up, you can warehouse it.
Speaker: It's nice earnings.
Speaker: Yeah, no, I think...
Speaker: It's a sort of arcane detail in the system, but I think an incredibly important one is why we do get these funding crunches.
Speaker: And I'd go so far as to suggest it was the fact that we were facing one of those just after Thanksgiving that led the Fed to effectively suspend its quantitative tightening and actually give us some fairly dovish guidance for a period of time.
Speaker: Now, there may have inadvertently kicked off a little liquidity boom with that, but...
Speaker: This is becoming a constraint for policymakers.
Speaker: And I think I wrote this morning, it's not impossible that we could see the Fed prepared to be much more hawkish at the beginning of the quarter.
Speaker: But as it gets towards the end of the quarter, knowing that particularly the French and Japanese banks have to parade before their regulators and convince everybody they're solvent, and they start to withdraw from markets at the tail end of a quarter, that's going to start setting a sort of seasonality, as it were, in
Speaker: in central bank land in talking and indeed in the management of liquidity.
Speaker: I agree.
Speaker: I think that while the system prior to 2008 was too lax, and that's a complex discussion in its own right, I think they've potentially over tightened things since then.
Speaker: And the two
Speaker: key points for me is one is I think they've introduced this much higher degree of rigidity and the other thing is you've pushed which will come at the cost of liquidity as well around key times and therefore you can see the central banks being forced into stepping into the markets around these stress periods where potentially there would have been private sector solutions.
Speaker: Yeah I think it's you know
Speaker: not best practice that the Europeans, particularly the French, seem to look at the banks at a point in time and cause these periodic liquidity crunches instead of looking at the behaviour of the banks over the average of the quarter.
Speaker: One single snapshot has got to be a recipe for instability and I can only hope they move away from that.
Speaker: Well, I suppose I hope they move away from it.
Speaker: No, in fairness, for the GSIBs, there is much more of a
Speaker: operation now about regularly monitoring their balance sheet so you've got a better idea about those sort of swings but the intent and how regulators would see that and actually what happens today today is a different matter so that's one.
Speaker: The other thing I'll just point out as well just my earlier point about the second key point is a lot of the risk hasn't gone away it's just been injected into markets and it's found people that are less well regulated and as we could see
Speaker: Over the course of the British pension fund problems, there was a couple of institutions there that had been busy providing bank-like services in the good times.
Speaker: And the moment that there was a liquidity strain, they are not able to warehouse risk.
Speaker: And they were basically punching clients out of their trades when the margin calls came up.
Speaker: Because the margin was taking too long to turn up, they can't warehouse it.
Speaker: Now, they are big, relatively sophisticated institutions, but they are not banks.
Speaker: There is a whole host of new actors with much higher degrees of leverage that have attached themselves across various points of financial markets.
Speaker: I'll be interested to see how they perform over the next three to five years.
Speaker: Which sort of leads us on to, we've talked a lot about the world under QE and the expansion of balance sheets, a little bit onshore, a little bit offshore.
Speaker: In theory, at least, we're entering a world of quantitative tightening.
Speaker: In the US, as I sort of indicated in the introduction, in theory, quantitative tightening will now ramp up.
Speaker: At some point, the debt ceiling will be raised and there'll be some bond issuance.
Speaker: Both of those will tend to withdraw deposits.
Speaker: They actually do take deposits out of the private sector.
Speaker: You do take money out of the system through those, credit counterparts analysis.
Speaker: And as that happens, we are going to see the banks, I think, facing more of a squeeze on their deposit basis.
Speaker: And we're seeing some tightening in credit standards.
Speaker: But how do you think the banking system will react to that?
Speaker: We focus on the US because it's most important.
Speaker: Again, if you sort of divide them into two categories, I think the broad majors, the US GSIBs, will be broadly fine.
Speaker: They tend to have excellent liquidity, and they will probably be able to reprice their loans more attractively and be able to step in.
Speaker: These are the banks that historically would have been called the money center banks.
Speaker: And there's a reason for that.
Speaker: So in terms of this is where the money flows back to the center and they're very well attached to that.
Speaker: I think you've got bigger structural problems when you step away from them into some of the regional and much lower down type banks.
Speaker: I think they are going to be very pushed to keep their deposits.
Speaker: You've also got all the foreign actors in the US system that source deposits.
Speaker: And I think they're going to come under pressure as well.
Speaker: And the final thing is if quantitative tightening is going to come through, then the large kind of transformer banks, again, sort of G-CIF money center operations that would be prepared to pump liquidity into capital markets in exchange for high quality collateral are likely to ask for higher rates to do that simply because rates have gone higher and there are potentially more attractive things to do with their money, such as buying relatively short dated US debt.
Speaker: So
Speaker: I think most of the moving parts are in place for quite a horrible squeeze.
Speaker: And I suspect, given the Fed's previous behaviour, it will be forced to exactly what we've seen so far, suspend QT.
Speaker: I don't think QT is the sort of one-way street.
Speaker: There's part of me that takes the Fed at its word and then you run the numbers for what that's going to do to the deposit base, to the money supply, the background inflation we've got.
Speaker: And you're looking like a chapter from Milton Friedman.
Speaker: And the impact on the economy, I think we're already seeing.
Speaker: I've been investigating today.
Speaker: We've seen this tightening in credit standards.
Speaker: It's not, I think...
Speaker: that severe yet and although the corporate borrowing data has slowed down it's not at a danger level yet and we're certainly not seeing a rise in defaults and late payments to small companies but I think if we were to have three six months of QUT all that would change those tighter credit standards would be really quite stringent
Speaker: we probably would see some parts of the corporate sector struggling to fund the inventory build that they're currently experiencing, unintentional inventory build.
Speaker: And we probably do start to see some small companies simply finding they're not getting paid and facing an extra central crisis as a result.
Speaker: So I think
Speaker: All the focus in the media tends to be on what the price of money is.
Speaker: But if money or credit simply stops being available, I think that's much more likely to give you that dramatic outcome.
Speaker: So the existential crisis for small companies, some of these foreign banks that maybe have used short-term dollars to fund long-term property investments in an emerging market.
Speaker: I mean, all of those guys...
Speaker: probably would stand higher yields up to a point, but what they can't stand is an interruption in the flow, let alone a full-on debt deflation.
Speaker: If the ultimate lender wants their money back, then I think the system can't clear.
Speaker: It would simply fail.
Speaker: And that's why I suspect QT will probably start and then end this year.
Speaker: I wouldn't be surprised.
Speaker: The only caveat I would add is I would expect problems to occur
Speaker: overseas before you see it domestically in the US, if you're talking about tightness.
Speaker: And I couldn't agree more that people focus on the cost of money, but they don't pay as much attention to what Keynes used to call tightness.
Speaker: And I think we're potentially heading into that tight world.
Speaker: And the other thing is, this money was oven spent.
Speaker: It is supporting assets.
Speaker: If you think of the world as a giant global asset liability
Speaker: sort of balance sheet, if you're trying to drain out one side of it, somebody's going to have to end up paying more as they attempt to roll their debt over.
Speaker: So great, debt's been issued, it's been used for purposes, more leverage has been put in, but effectively it's going to become more expensive to do that.
Speaker: So I still think it's early days for the US economy, but if you're looking at
Speaker: The financial markets, I suspect there's a reasonable chance that something falls over in the euro dollar markets before you start to see really difficult problems in the US.
Speaker: We always talk about liquidity.
Speaker: And I'm busy doing my Yacht Master Certificate at the moment, and the tide changes in the periphery first.
Speaker: And I think that's equally true of financial markets.
Speaker: Some of these offshore financial centers, where you have seen a lot of
Speaker: borrowing of dollars at relatively short duration to acquire illiquid, long duration assets in emerging markets, normally in the local currency.
Speaker: That
Speaker: I think if we see any stringency at all, any tightness at all, then problems emerge.
Speaker: We saw a bit of that last year.
Speaker: We saw places like Hong Kong losing a lot of foreign exchange reserves.
Speaker: Now that pressure has come off over recent months, I think because the Federal Reserve has deliberately and perhaps unintentionally allowed
Speaker: dollar conditions to ease a bit over the last few months, certainly since Thanksgiving.
Speaker: But if we do see some stringency as QT ramps up again, then I think some of these people are in a very exposed position.
Speaker: I couldn't agree more.
Speaker: And Hong Kong is interesting because you're also running effectively a fixed rate.
Speaker: So it puts you in a more difficult position than where perhaps you've got a dirty peg or a float.
Speaker: then as you rightly point out there's the issue where potentially reserves have to be drawn down to finance it.
Speaker: Now often those reserves have been parked elsewhere so one way or the other somebody's getting deprived of funding
Speaker: So if you're just looking at HKMA, which is incredibly well run, I fully accept that, but their reserve parking, their liquidity funds are somebody else's funding elsewhere in the system.
Speaker: So if they're drawing it down to basically support effectively the peg, then somebody else in there is finding that actually the funding they were previously benefiting from is disappearing.
Speaker: And often that isn't actually a Hong Kong bank, it's somebody else in Asia Pacific.
Speaker: Yeah, that's even in the South Pacific.
Speaker: And just on Hong Kong, I mean,
Speaker: The world has got so used to this inflation of money, inflation of credit, and I think Hong Kong is a big example of that.
Speaker: I lived out there in the 1990s, but it's an economy that's more than twice as indebted as it was at the time of the Asian financial crisis.
Speaker: It doesn't have a lot of nominal GDP growth.
Speaker: It needs a constant injection of credit to keep asset prices rising, to keep some sort of nominal expansion in the economy to maintain the solvency.
Speaker: You
Speaker: You just stop growing.
Speaker: I think that represents quite a threat for Hong Kong, what has clearly got a difficult time for a number of reasons.
Speaker: So we saw a lot of commentary about the Hong Kong dollar coming under pressure six months ago, and it certainly did when US financial conditions were tight.
Speaker: They've eased, the pressures come off, but I don't think that stops the pressure coming back on if the Fed does push ahead with quantitative tightening.
Speaker: Yeah, I absolutely agree.
Speaker: And I am sceptical that the Fed will push through.
Speaker: I don't think this is a sort of late 1970s Paul Volcker type Fed.
Speaker: So I think there is a chance that they are likely to falter if financial difficulties start to appear.
Speaker: The other question is,
Speaker: What kind of problems would cause them to stop now if it's the Hong Kong financial system potentially falling over or somewhere else just picking at random?
Speaker: To my mind, that's going to be very, very hard to explain to their political overlords why they've stepped in to support it for financial stability reasons.
Speaker: So I think there is a chance that you would need an obvious clear threat to the US financial system before they would step in.
Speaker: And offshore financial centers, places that have avoided paying for whatever arbitrage to the world's financial system, Hong Kong's not necessarily one of them, but some of the other centers that, shall we say,
Speaker: get used for reduction of taxes, but obviously are heavy users of US dollars for various reasons.
Speaker: I cannot see any of them being potentially supported by the Americans when they've still got quite high level of domestic inflation.
Speaker: And why should they?
Speaker: They decided to basically arbitrage to that.
Speaker: They decided to get themselves involved.
Speaker: I think it's problematic for them if these liquidity conditions tighten.
Speaker: The other key thing that's worth pointing out as well is the dollar does have, the Fed does have various swap lines.
Speaker: And this is another thing that I always hear that, oh, don't worry, there won't be a problem.
Speaker: the Fed has swap lines with the Bank of Japan or the Bank of England or the ECB?
Speaker: Yes, it does.
Speaker: And they should be viewed as an overdraft.
Speaker: So when they get drawn down, the Fed's usually not particularly happy about that occurring.
Speaker: And depending on the local regulator, they're even less happy that they've had to step in, borrow money off the Fed, and then inject it into their local banking system.
Speaker: So quite often, you will get a call from your local regulator asking why you've done this, and please make it go away as soon as possible.
Speaker: So like I say, there's a range.
Speaker: Some are more relaxed when they, to my mind, shouldn't be.
Speaker: But it's not something you can use as business as usual.
Speaker: You cannot carry on borrowing down on this line and effectively using the Federal Reserve to finance your balance sheet and undercut US institutions who are following the rules.
Speaker: No.
Speaker: I mean, going back to your point, would the Fed react to a problem in an offshore financial centre?
Speaker: Probably not.
Speaker: Would it respond to European, Japanese or some other non-US bank being caught up in that storm?
Speaker: Again, probably not unless there was a genuine counterparty risk that probably...
Speaker: threaten the integrity of the US financial system.
Speaker: And I think that's probably the greyer area.
Speaker: If one of the US money centre banks has lent dollars to one of these foreign banks that gets itself into a degree of difficulty, I think the Fed would take notice of that.
Speaker: They're all very well saying this is collateralised borrowing, but I think the Fed would be starting to think about 2008 at that point.
Speaker: Yeah, I suspect it would.
Speaker: But I mean, the first recourse would be the local central bank, and then you've got the government.
Speaker: So we're talking about a liquidity issue.
Speaker: I think for a lot of the GSIBs, they're in pretty good condition.
Speaker: There is, again, a range.
Speaker: I know they're all meant to be following the same rules, but there are different interpretations.
Speaker: But most of the main GSIBs have got access to, shall we say, a friend-sured central bank.
Speaker: The obvious two outliers would be Hong Kong and the PBOC obviously do not have any kind of swap line with the Federal Reserve and I can't see any circumstances where they'd be granting one either.
Speaker: I think the State Department would probably view that as an opportunity rather than something that they would give away.
Speaker: It's beyond my pay grade.
Speaker: Certainly geopolitically, I could imagine Washington wishing to exploit that situation were it to arise.
Speaker: I guess the question is, and I fully agree from what I see on a more macro level, that the
Speaker: The major US money centre banks look well placed.
Speaker: In fact, we've seen most of them limit their asset growth over the last 12 months to ensure that they could cope with this drying up deposits.
Speaker: It is the fringes of the financial system that I guess are vulnerable, those regional banks.
Speaker: And that may have implications for parts of the US economy that we could...
Speaker: have a us that looks like it did a decade or so ago we have pockets of strength and pockets of weakness and on average it looks a bit weak looks all right but actually the the range of experiences across the us becomes quite large and certainly that was a feature posted the gfc we might be moving into that that type of world again um i think both i agree with that that i think there will be some regional differences but
Speaker: I wouldn't underestimate the amount of fragmentation because of the GFC and how that risk has moved into other financial market participants.
Speaker: The obvious candidate there would be some of the activities of the private equity shops, which have obviously immensely expanded.
Speaker: The other thing as well for all the big US banks, which I'd view as pretty sound, but one of the things you've got to remember as well is how they book assets.
Speaker: And you've got three effective classifications for that.
Speaker: So you've got the trading book.
Speaker: So that's mark to market, as we all know.
Speaker: So any losses immediately go through the P&L statement.
Speaker: You've got hold to maturity, which is the one that the other one that sorry, you've also got available for sale, I should point out and available for sale is
Speaker: exactly as it says.
Speaker: You don't necessarily market to market for the P&L.
Speaker: You do market to market, but it goes through the balance sheet, so it comes off your capital base.
Speaker: But the one I think that's worth looking at, and I think it's worth going through the big US banks and pretty much any banks' statements over the last quarter, but if you have a look at the hold to maturity, where they have parked those assets and they do not have to mark those to market,
Speaker: as long as they don't sell them.
Speaker: Now, there are some good reasons for doing that.
Speaker: You sometimes have some very long term obligations.
Speaker: You can buy those bonds.
Speaker: You match them today.
Speaker: There is a mismatch between how the kind of accounting treats and the economic situation or the economic reality.
Speaker: And that was always a problem that I've had at previous firms that do you
Speaker: hedge yourself or kind of protect yourself for the best economic sense, but it might not look great on the accounting side of things, or do you do it that makes the balance sheet look good, but it's not actually a great economic hedge because of the two moving parts.
Speaker: But the one thing I would flag about hold to maturity, have a look at some of the real values in there.
Speaker: I mean, there are some significant impairments, even with the biggest US banks in there about where they are now currently valued.
Speaker: And while it doesn't come off your capital base, it will be a consideration in your internal capital model.
Speaker: Those losses are real.
Speaker: They will unwind over time when the liabilities come off.
Speaker: But you are aware they are problematic.
Speaker: And that has occurred already.
Speaker: I wouldn't have thought that was just a problem for the US banks.
Speaker: I mean, the European Central Bank has that problem.
Speaker: And I presume the commercial banks would as well.
Speaker: Yeah.
Speaker: There's some pretty spectacular bond holdings in Europe that may not be worth what they once were.
Speaker: I couldn't agree more.
Speaker: So in many cases, you've had five, 600-year lows in interest rates.
Speaker: So maybe we're still hanging around in half a millennia's time for this stuff to come good again when the market comes around for its other super low cycle.
Speaker: I do think there's a risk that we will see a bit of disflation just because of how supply chains work.
Speaker: But I do think that it's unlikely that we are going to get sustained low rates again at the level that we're seeing.
Speaker: So those losses, to my mind, would be pretty much permanent.
Speaker: Yeah.
Speaker: I think I once wrote a slightly tongue-in-cheek report about from here to eternity rather than maturity for some of these bond holdings.
Speaker: Yeah.
Speaker: If you get enough of a tightening in the short end of the curve and we have enough quantitative tightening, then some of this stuff does start to get sold and has all sorts of implications, which I guess is one reason why the central banks can't really push.
Speaker: But then how cognizant of the risks are they?
Speaker: That one remains to be seen.
Speaker: You could certainly see an accident occurring, although we...
Speaker: We're obviously hoping that doesn't occur and that these things just sit on the balance sheet forever and are forgotten and are just a sort of limit on, as the Japanese banks have proved, a limit on their ability to do anything but then actually bankrupt you.
Speaker: Hopefully the central banks won't force that particular issue.
Speaker: Yeah, absolutely.
Speaker: I mean, the reality is they're following the rules.
Speaker: That's what the rule says.
Speaker: But it does, shall we say, weigh on your considerations when you know that you've potentially got some of those issues that are going to take some time to roll off.
Speaker: So I agree.
Speaker: Look, there's various different ways how you'd get a kind of unwind in the financial system.
Speaker: One is that asset liability mismatch, that funding costs have gone up.
Speaker: You've got a portfolio of securities that maybe aren't held to maturity.
Speaker: But one way or the other, your financing costs have gone up quicker.
Speaker: You've mismatched that.
Speaker: And now you're forced into basically a liquidation because you're being pushed into a negative carry.
Speaker: position, so negative sort of return on your assets relative to the spiralling financing costs.
Speaker: Another feature in 1994, and we know what that did for the bond market.
Speaker: Oh, yeah, absolutely.
Speaker: I mean, and the other one as well that you raised earlier on, if you're sitting in a regime that has allowed you to basically
Speaker: accumulate enormous FX type liabilities, then potentially as the central bank draws down on its reserves, again, you're going to have this kind of almost like negative feedback loop that the assets that you hold are going wider because your foreign exchange reserve central bank is having to liquidate those assets at the same time, which is pushing things wider.
Speaker: And you and I both know
Speaker: 97 and Korea is an interesting example of a number of, shall we say, sins of international finance.
Speaker: But the other thing is as well is people often look
Speaker: at the reserves at these central banks and go oh yeah it's fine look they're in there they're held in treasuries sometimes they are but there is a tendency where your local financial system comes under pressure to start parking your reserves in those local banks which obviously serves for funding for them so effectively you start to get double counting.
Speaker: There's certainly some footprints of that in Asia that are that proved problematic last year and may may well haunt us I think if we
Speaker: If we do see a lot of US Treasury bond issuance, then some of those features are going to come back to home, particularly the Asian financial systems.
Speaker: Again, Latin America seems less exposed to that.
Speaker: But I suspect there's more than a few dollar bonds in Asia's foreign exchange reserves that aren't actually foreign assets.
Speaker: I would generally agree with your view that if you were going to put things on a risk spectrum,
Speaker: Latin America tends to be a lot more good old-fashioned credit risk and a lot less of that ALM mismatching.
Speaker: Europe tends to act as a transformer in terms of that they're able to basically suck up a relatively large amount of dollars because of relative credit rating and stability of currency and will often then finance some other parts of the world that perhaps US banks are less willing to do or know less well.
Speaker: But if you tend to look for the biggest mismatches and the biggest problems, I'd say Asia Pacific has a lot of them.
Speaker: I certainly think that.
Speaker: Certainly the data is supportive of that.
Speaker: And I think that adds to maybe a conclusion we're groping towards that if we do do quantitative tightening, it probably won't be for very long.
Speaker: We don't probably therefore get the big clear out.
Speaker: And we may not have finished chasing QE and QT.
Speaker: We thought maybe inflation might have been the end of that model, but perhaps it wasn't.
Speaker: I'm more skeptical they'll be able to go back to QT while you've got inflation.
Speaker: And we're obviously beginning to see things come through.
Speaker: But I could certainly see a scenario where the bond issuance starts to come through, as we've discussed offline previously.
Speaker: That generally causes a sort of repricing of the curve because the US economy hasn't just collapsed as some indications.
Speaker: Forward curves would suggest that people are expecting it to do.
Speaker: So the issuance just causes the curve to back up.
Speaker: The general squeeze on dollars basically causes people to sell US treasury bonds and the quantitative tightening further puts pressure on things and the problems occur elsewhere.
Speaker: My concern would be is unless they've extinguished
Speaker: inflation in that domestic US economy, I think you'd probably get the example of if they had to step back in, there'd be a general sort of market reaction of, oh my God, they're not serious about this.
Speaker: And we're looking at something that looks a bit more like the 1970s or late 1970s.
Speaker: Could well be right.
Speaker: I certainly think bonds could be an interesting market to observe and certainly trade this year.
Speaker: Something else I was working on this morning was looking at US economic surprises and the average temperature compared to the seasonal norm.
Speaker: That does seem to matter.
Speaker: It was pretty cold before Christmas.
Speaker: I suspect some of the stories of the US's demise at the end of the fourth quarter might actually have been, it was damn cold.
Speaker: It seems to be warmer now, and we're seeing cinema and theatre tickets and restaurant air travel.
Speaker: All of that has picked up a bit in the last few weeks.
Speaker: So I think rumours of the US recession might still be a bit advanced, and that just adds to this.
Speaker: confusion for the federal reserve you're responding to short-term data you're responding to fears of a funding crisis persistent inflation in the service sector as an economist i guess you probably wanted to run a central bank one day but i don't think i'd be wanting to run the federal reserve right now no there's not many central banks i think i'd want to run in the current uh regime i think as a former colleague put it to me uh
Speaker: everything on the run up to the GFC with the commercial banks going crazy and everything since the GFC has been the central banks largely going crazy.
Speaker: So we are going to have some kind of corrective action.
Speaker: I know I've mentioned it to you before, but for anybody listening in, there is a good read by a Wall Street Journal journalist called Christopher Leonard, and it's called The Lords of Easy Money.
Speaker: And it just talks about the Federal Reserve over the last 10, 15 years.
Speaker: But what's really useful is he tracks back to the late 1960s and going through the 70s and previous examples of monetary type financing and how it blew up in the Fed space and what they had to do after that.
Speaker: And it's just interesting talking about
Speaker: the expression, those who fail to read their history are doomed to repeat it.
Speaker: And there is a strong whiff of that about what's been going on in the last 10 years.
Speaker: You've repeated some of the mistakes that have happened in the 60s and 70s.
Speaker: There is a reason... Accelerated it since the pandemic, I think.
Speaker: But on the subject of accelerating, we're probably out of time.
Speaker: Yes.
Speaker: We...
Speaker: Looking forward to doing some more of these podcasts.
Speaker: I think we've got pensions and endowments and emerging markets in the sites.
Speaker: And so please, please hang on for further postings.
Speaker: And thank you very much, Ben, for your time.
Speaker: Thank you, Andrew.
