Six Triggers for the Next Financial Crisis

Banks are much safer now than before the financial crisis. Or are they? Certainly, if focusing simply on increased capital and liquidity requirements, and closer regulatory supervision. Yet close questioning of bankers, and regulators past and present, throws up six possible triggers for a crisis.

1. CYBER-SECURITY. Imagine this scenario. A cyber-attack closes down a bank for a week; panicked depositors unable to access their funds form queues on the streets; the regulator is forced to close the bank permanently in a bid to avoid contagion; the strategy fails as queues form at other banks on (fake) news of their vulnerabilities. A former member of the Basel Committee on Banking Supervision believes this could be the most likely spark to trigger the next financial crisis. Another scenario is a cyber-security attack into any part of the wholesale infrastructure, say the estimated $542 trillion derivatives market, which would cause widespread panic as the global system shut down.
   
   In the words of an investment banker with knowledge of the subject: “Of course banks spend lots but as their IT departments are full of contractors and senior management is clueless, the spend is wasted. Their systems are weak, they don’t talk to each other, and are very vulnerable.  It’s impossible to trace where an issue has happened and to fix it.”
   
   Only big banks will be able to afford the enormous amounts needed for proper cyber-security. “Banks need military grade cyber,” asserts the former regulator. New ratings will emerge for a financial institution’s cyber safety. Those with anything less than triple AAA could find themselves frozen out of the wholesale markets. The inevitable consequence is consolidation: small banks will be gobbled up.

1. TOO BIG TO FAIL. An ongoing theme in this column, on which I have been proved wrong. So far. Writing about The Precariousness of JP Morgan Chase in 2014 and suggesting readers should sell, was an abysmal stock recommendation. Yet further consolidation of the financial system in countries from Spain to the US – an outcome of the financial crisis and of the ensuing regulation – has concentrated the risk. The taxpayer will more likely have to bail out the giants, notwithstanding the tough regime for Global Systemically Important Banks (G-SIBs).

1. RISK CONCENTRATION. Risk is also more concentrated now due to “significantly greater harmonisation on, for instance, the risk weighting of assets, the prudential rulebook and accounting standards…it means if something goes wrong, it goes wrong for everybody!” notes the Non-Executive Director of a bank. She points out that in 2008 it was the diversity of standards which helped reduce the problem in some countries. France, for instance, did not apply mark to market accounting, and Canada applied heftier capital standards.
   
   In the 2018 harmonisation recipe, lending to the real economy for investment has generally fallen, while another mortgage bubble in residential property has been created.  There has been a sharp drop in the diversification of business models. Excessive to overvalued property could yet again be the catalyst. Even more so if interest rates increase, unplanned for and unaffordable for many owners. We have raised a generation who think that interest rates of 2% are customary, notes a Dutch former regulator.
   
   Geographic shrinkage is another element in risk concentration and the lack of diversification. Regulatory bias has promoted more domestic exposure: banks like Citigroup of the US, or Unicredito of Italy, sold many of their foreign businesses post-crisis.

1. GEOPOLITICAL JEOPARDY. Italy is a likely suspect. The country could blow up on the back of its bankrupt banks and the unstable government’s argument with Brussels, amid recent evidence that Italian households are no longer willing fools ready to finance government spending by buying its bonds. If Italy goes, so would the euro.
   
   There is also the more obvious imbroglio of Brexit and its unforeseen consequences, however much the Bank of England provides public reassurance on this front. Or China’s debt burden…The list is long.
   
   During the 2008 Beijing Olympics, at the height of the US financial instability, Russian officials made a top-level approach to the Chinese and suggested that together they might sell big chunks of their US Treasury holdings. The Chinese declined. The answer might be more nuanced today, amid heightened political tensions.

1. JUDICIARY RANDOMNESS. A term first heard at a meeting of the G-30, this refers to multimillion fines which fall on banks after scandals such as mortgage abuse in Spain and product mis-selling in the UK. Danske Bank’s recent €200bn money laundering disgrace forced the newly nominated Chairman to speedily reassure the markets that the bank was not facing “an existential crisis” – and that is even before the US Department of Justice’s criminal investigation has reached a conclusion and consequent fine.

1. REGULATORY MICRO-MANAGEMENT. The financial crisis put paid to the idea of principles-based regulation. However, the sharp pendulum swing to prescriptive rules-based regulation isn’t working either. To state the obvious, regulators are not bankers.
   
   “The jerks presume to tell us how to do our business, in extreme detail…you come to Treating Customers Fairly (TCF) – the man from the government has this 100% wrong, “complains an executive board member of a British bank. As he points out, “we are now obliged to treat disparate people the same – [despite the fact that] nature was not fair in how it handed out its gifts.”
   
   Form-filling and ever-larger compliance departments are the curse of the post-crisis world. “We have to write a ton of repetitive stuff for the regulator year after year which nobody can read, understand or apply usefully,” notes the banker. The real issue with “this stupid charade” is the resulting risk blindness – either complacency that every risk is covered or an inability to see the forest fire because measuring every inch of the trees is the new normal.

There are other possible catalysts to a financial crisis: from the pile up of debt; to shadow banking; to climate change; to the unimaginable. Two overarching factors could make the next crisis even worse than the last one.  The public’s trust in the financial system, high before the crash, is being continuously eroded from its low base with a repetitive litany of scandals, greed and technical incompetence – examples abound such as Goldman Sachs’s reported Malaysian corruption and TSB’s IT chaos.

Meanwhile, the international cooperation visible in the financial crisis, and ably described in former US Treasury Secretary Hank Paulson’s book On the Brink, is entirely absent. The idea that the Trump government would coordinate action to save the world is risible.

On this cheery note, Robinson Hambro wishes its readers very Happy Holidays

Homage to Spain

Why recent local elections don’t change the investing scenario

All politicians are required to get out and “press the flesh,” as shaking hands with voters is dubbed. As my flesh was being pressed by Carmen,* my mother’s longstanding masseuse, the results of last Sunday’s local elections in Spain seemed a fit subject for discussion.

Mention the governing Partido Popular (PP) and her strength redoubles with indignation at the constant revelations of corruption in its midst. She pays little attention to the party’s labour reforms and austerity measures, which allied to a low oil price laid the seeds for this year’s recovery. GDP in 2015 is forecast at 2.8%, the fastest growth since the crisis in 2007, although unemployment at 24% remains high (if overstated due to the immense black economy). Exports are shooting through the roof on the back of a weak currency and the private sector’s restructuring.

Mention the opposition Partido Socialista Obrero Espanol (PSOE) and her outrage at the revelations of their corruption – less than the PP only because they have been in power less in the last twenty years – turns into the pummelling of a 25-year old. Not one knotted muscle remains untouched.

Podemos (We can) is the only party that almost makes the massage gentle and ineffective. Almost. The new protest party had to tiptoe back from its flattering embrace of Venezuela’s leaders and bankrupt political system, as its poll ratings plummeted. Spaniards may be fed up with the corruption of the main parties and with a recovery that has yet to be felt beyond the confines of the privileged. A number of them were willing to use their votes in the elections this week to punish the two behemoths of old by voting for Podemos and its other incarnations and sympathisers. But it is doubtful that this will be repeated in national elections.

When a year and a half ago Podemos was at its height, gaining 28% of the intention to vote poll, there was a whiff of concern in the Circulo Empresarial de la Competitividad which groups together top executives from the 17 largest multinationals in Spain, including Telefonica and Santander. The elite business group reportedly opened its collective wallet to support another protest party, Ciudadanos (Citizens), as a counterweight. This was a small, pro-business Catalan-based party which advocated the autonomous region remaining part of Spain.

Ciudadanos has now spread out on a national scale and won over 6% of the vote. It would have won more seats if it had put up more candidates. Carmen, whose family was on the side of the Republicans in the Civil War, sees it as little more than a mini-PP. The pressure intensifies and any tennis elbow I thought I had disappears under her disapproving strokes.

________________________________________________________________________________________

Carmen is 70 years old. Her power reflects that of her generation in Spain. But where she is stepping back from her metier, giving me a massage in memory of old times, too many of Spain’s oldies are clinging on to power.

Over 50% of the Presidentes (Executive Chairmen) of the Ibex-35, the Spanish equivalent of the FTSE-100, are over 65 years old. One, Francisco Gonzalez of bank BBVA, has just re-taken the CEO title as well. Another, Emilio Botin of Santander, gave up his role only on his death.

“We have spent too many years with our bums ensconced in our chauffeured cars,” says a 65-plus year old Spanish tycoon over drinks at the Ritz Hotel.

Despite the intransigence of the over 65s, renovation is happening in the political class. Forty-seven year old King Felipe VI, known as the best-prepared Borbon king in history, took over from his father Juan Carlos I at the end of last year. Alberto Sanchez, a photogenic 43 year old, is the leader of the PSOE. Cuidadanos is headed by fresh-faced 36 year old Albert Rivera, while Podemos’s 37 year old leader Pablo Iglesias sports a rather last-century ponytail.

Only 60-year old Mariano Rajoy, who continues to deny knowledge of massive illegal payments by his party treasurer, Luis Barcenas, clings to power. His party garnered only 27% of the votes versus 38% in 2011. Unfortunately, the abysmal results came too late for him to step aside before general elections due in late autumn.

________________________________________________________________________________________

The outcome of May 24th means the end of the bipartite system that governed Spain from the advent of democracy 38 years ago and the beginning of endless horse trading between all the parties. In September, there will be elections to the Catalan parliament, and six months from now, general elections. A similar panorama will probably unfold.

Investors who have sold Spanish shares are panicking unduly, for economic policy will remain within a narrow band of the acceptable for three reasons.

Firstly, even in a local election where voters were understandably angry and more likely to experiment, the PP and the PSOE ended up with the most votes. In a general election, that is even more likely to happen. Either of the mainstream parties will need to govern in coalition with Ciudadanos or informally supported by them. A condition of supporting the PP may well be Prime Minister Rajoy’s disappearance and substitution – no bad thing. The distance between the centre-left PSOE and the radical left is as wide as the Grand Canyon; that between PSOE and Ciudadanos is infinitely narrower, and thus Podemos will probably be left out in the cold at a national level.

Secondly, Spain is centrist. Moderation, aspiration and consumption are three words that ring true for the majority.

Last, but not least, Spain’s economic policy is mainly decided in Frankfurt by the European Central Bank and in Brussels by the European Commission.

A couple of years ago, in November 2013, this column advocated investing in Spain. We were right and prices have since gone up. But they have further to go.

*Carmen is not her real name.