Ring fencing Banks – no silver bullet

It sounds like a great idea; separate the investment part of banking from the retail part. So a financial meltdown in the more risky arm of the bank would not put at risk ordinary current (check) account customers. The devil is in the detail.

The reason for the financial crisis was a lack of liquidity based on short term loans that some investment banks used to make a profit on or tide them over. The credit crunch prevented that, and they become insolvent. The second part of the crisis was defaults and the inability to create new debt as a successful business model as in the good old days – because it was now too risky.

The second part features in people’s minds more then the first. Some banks did make bad loan decisions but equally some just had a poor business model to finance their deals; with no risk assessment to take into account changes in the financial market. Ring fencing retail arms was not the issue here; with the exception of Northern Rock there was no run on retail banks in the UK. Other banks like Royal Bank of Scotland or Halifax survived through mergers or public financing.

The benefit here is that an investment arm cannot take down it’s retail arm to bail it out. In essence this should mean that your savings are safe if over the threshold that the government guarantees (wait for detail to see). Peace of mind but this does not address the global financial meltdown that happened.

Capital ratios of 10% – higher than the international standard – addresses the issue of getting money quickly (liquidity) when needed. However, in addition scrutiny of operations of investment banks need to be effective – or at the least the deterrent of bankruptcy must be real. Perhaps the added stick of legal repercussions for not following good banking practises. Not fines but white collar crime incarceration. May focus the mind …

The ring fencing may end one arm subsidising the other in good times too. This will increase costs on customers by reduction in real interest rates on savings, charging for normal current accounts (when public mood can stomach it – it will happen if the banks can get away with it). How investment banks insure themselves too may result in less dividends and returns.

It is a first step in saying that an investment arm will be allowed to fail. The question is the cost on the banking customers, and whether if a domino shock effect on banks happened the over burden tax payer could be saved from bailing them out. The questions we need to ask is how will oversight be better more effective. The real solution is to allow them to fail, and not be able to get so big without adequate safeguards for that possibility.

More on the government’s response to reforming banking system here – ahead of the Chancellors’ Mansion Speech.

The Credit System, Money and the Economy

What is money? Well the answer to that will help to understand the current credit crisis, and how the money markets effect the real economy.

To appreciate that, this video Money as Debt may help to give the background which is really easy to follow.

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Interest cuts coordinated – but stockmarket does not rebound

Interest cuts coordinated – but stockmarket does not rebound

If liquidity is a problem in the economy, then a cut in interest rates is a good idea. A coordinated move by six central banks made a cut of 0.5% today – a surprise in the UK where the decision was thought to be made on Thursday when the Bank of England’s monetary policy committee was due to meet. The question though is why did this take so long in coming – this was an obvious first step to take, which could be done quicker than injecting money back into the system. It would have been a signal to the market that central bankers were taking concerns over an economic downturn seriously.

However stock markets are still falling – the FTSE falling by 5% today, the Dax by nearly 6% and Dow Jones at the moment a modest 0.16% gain. Bankers are looking for governments to step in to buy shares, to help market capitalisation – effectively so that they have the funds for the financial system. The domino effect on business and consumers is very real, but the government’s must not write a blank cheque on this. While depositors need to know their funds are secure (to prevent runs on banks), those banking models that put a bank effectively out of business need to be allowed to go under, managed only so that they do not impact on banks which are struggling because of the financial crisis – not due to bad loans. Toxic debt should not be taken completely at face value.

In other major developments:[source BBC News]

• The UK government unveiled a package of measures aimed at rescuing the banking system which could add up to £400bn ($692bn)
• European and US stock markets fell as investors remained unconvinced that the co-ordinated rate cuts and bank rescues would solve the financial crisis.
• All UK savers with accounts in the closed Icelandic internet bank Icesave were told they would get all their money back.
• The Treasury arranged for more than £3bn of UK savers’ money held with Icelandic banks Kaupthing Edge and Heritable Bank to be transferred to ING Direct UK.
• Iceland’s prime minister said he hoped to find a “mutually satisfactory solution” to the loss of UK Icesave deposits after Prime Minister Gordon Brown threatened to sue Iceland to recover the money.

The big interest cuts cuts should have been made sooner. One factor that helps is that it will make the cost of borrowing cheaper. Something which governments with budget deficits need. The only other problem is that with little money going around government borrowing so much will crowd out private sector investment. That however is less of a concern then a banking system that is seized up.

It may seem like socialism to some. Yet there is no need to reward failure or to encourage risky loans. The problem is that the market is usually better at picking winners than governments are. Decisions by central governments have to be done on the basis of what is best for their economy – bringing stability and confidence back into the system. Raising the amount of deposits secured by the state was a positive step.

The question is why it took so long for national governments to act on the levers that they readily had at their disposal. That lack of confidence in handling the credit system crisis is one reason why stock markets are not rallying quickly. The confidence in the world economy is bleak, not helped by a wait and see attitude that for example the UK government has shown on a “case by case” mentality. The government finally announcing measures that make available £400 billion ($692bn) to allow the credit system to flow again as the banks have stopped lending to each other is welcome.

The key points of the plan are:[source BBC News]

• Banks will have to increase their capital by at least £25bn and can borrow from the government to do so.
• An additional £25bn in extra capital will be available in exchange for preference shares.
• £100bn will be available in short-term loans from the Bank of England, on top of an existing loan facility worth £100bn.
• Up to £250bn in loan guarantees will be available at commercial rates to encourage banks to lend to each other.
• To participate in the scheme banks will have to sign up to an FSA agreement on executive pay and dividends.

The failure of macro economic policy lies squarely with elected governments – that enjoyed the good times but did not heed the warning signs till a crisis hit the system. Voters being kicked out of their jobs will have their revenge when election time comes. Much of the pain could have been softened if governments had taken action sooner.

Governments guranteeing banks – 100% uncertainty

Uncertainty - effecting the economy

DON’T PANIC!

However, when there is more to fear then fear itself and uncertainty that is easy to say. When governments start sending mixed signals the problem of confidence, let alone knowing what is going on with full information, makes rational decision making problematic – adding to the financial crisis.

Ireland guaranteed deposits 100%. This infuriated other member states of the EU, because it put pressure on them to do like wise – exacerbated by capital going to Irish Banks. Yesterday the German Chancellor appeared to state that the government would back savings also by 100%. That is significant – Germany has more savings then any other country. The British Government could not get specifics on the German policy.

If the UK followed suit that would mean guaranteeing funds in excess of a trillion pounds – money which the government does not have. This weekend like last saw bankers loosing time off as a scramble to sure up liquidity and governments buying stakes in banks:

• The German government was forced to salvage a 50bn euro ($69bn; £39bn) rescue package for Hypo Real Estate
• Denmark and Sweden both increased the amount of protection depositors in their banks receive
• Iceland said its banks had agreed to sell some of their overseas assets and was trying to persuade the trade union pension funds to repatriate some of their funds too
• The individual actions came after EU leaders decided at a summit on Saturday not to attempt a pan-European solution
• France’s BNP Paribas said it would take a 75% stake in Fortis. [BBC News]

The worry is domino dancing, with a collapse not just spreading in the banking system in one state but in others as well. In an interdependent world, and single market Europe seems unprepared for quickly speculation is impacting on confidence as they chase after one crisis after another. Rather then providing confidence and stability, this is reacting to events as they unfold.

Before the financial crisis an economic downturn was happening. The situation with banks is going to confound the problem. As well as people and businesses finding it more difficult and costly to get finance there is the added problem. Redundancies are going up and the costs of living are rising. It does matter to us ordinary people on Main Street because what was already a difficult situation is being made worse. There will be less tax payer’s money for public investment – borrowing will be more expensive for the government in these times – and for the type of spending that gets an economy through downturns when the private sector starts delaying investment and scales down production.

As an economist it can be difficult to not sound excited at what is happening. Suddenly everyone is concerned about the economy and what is going on, and what sort of regulation should be in place.When times are good people take it for granted and any muttering of lack of oversight or weaknesses are shouted down as regulation that would strangle the goose that lays the golden egg. The irony as always is such public and government concern and scrutiny of what is going on happens too late when the horse has already bolted.

On that panicked horse are in for a bumpy ride.

Stock markets are once again down suggesting it will take more to calm the beast:

MARKET DATA – 11:36 UK

FTSE 100	4712.02down	-268.23	-5.39%
Dax	5480.26down	-316.77	-5.46%
Cac 40	3845.83down	-234.92	-5.76%
Dow Jones	10325.38down	-157.47	-1.50%
Nasdaq	1947.39down	-29.33	-1.48%

Congress backs $700bn bail out – McCain ain’t dead yet

Could John McCain have pulled ahead, and distanced himself from Bush, by opposing the bill? Polls have Obama leads 50% to 42% having gained during the crisis.

Despite a majority of Republicans being against the bill, it passed by 263 – 171. $100bn in new tax breaks helped move enough Republicans (101 still voted against 91 in favour).

It also included tax breaks to help small businesses and to boost alternative energy, expanded the child tax credit and extended help to victims of recent hurricanes. (BBC News)

Has John McCain lost a beat by not opposing the Bush plan? 45% of people oppose the plan, though a similar number say they are confused by it. The mood however seems to have been blowing in the we need to do something, this is something, therefore we must do it, at least on Capitol Hill with the sweeteners above sealing the deal.

Further financial instability would have started hitting main street, with businesses unable to get credit for the next business transaction or investment to increase production. The question though is that the bill by a way to stabilise the economy without rewarding the mistakes made by the banks.

In Europe however the situation could potentially be worse. In the US 96 cents was lent for every dollar in deposits. In Europe the figures are 1.40 Euros lent for every 1 Euro (The Economist). The only thing we can say is that the worse is not over.

It has only began. This may not even work. In the long run we are all dead. Economists are not the sort of people to always look on the bright side of life. The only thing we can hope for is that this measure calms the markets, makes the bank loosen up and let credit flow again to ease the monetary system.  It is bad enough with businesses lacking custom without their banks not providing finance for decisions, because of their bad loans and lack of funds.

Ultimately animal spirits of the movers and the shakers will decide if this measure succeeds or fails. With people flocking to Ireland with their savings with the government saying that it will guarantee all deposits made that reassurance needs to be global in nature.

It is time for governments of the world to show that globalisation is not just about the allocation of resources, but independent nation states working together on interdependent issues affecting the economy. A free for all could end up in being a free fall.

McCain ain’t Dead

He ain't dead yet. Worse case scenario it happens in the White House. An Obama landslide is premature.

Meanwhile I have been saying that Obama needs to get to 10% by mid October to be safe from McCain making up ground in the closing stages of the campaign. With Gallup having him up by 8% and Rasmussen by 6%. Over the economic meltdown Obama has pulled ahead while McCain has floundered. Would Obama have followed if McCain had attacked the Bush plan? He could have appealed to Democrat leaning voters who are against the bail out. That decision may well come back to haunt McCain, even if he consoles himself that he was doing the right thing for America.

While Obama is on his way to victory, if his camp are really claiming that it will be a landslide that is premature. Victory yes, but in the closing stages McCain will come back  His support is underestimated while Obama’s is overstated – the only poll that counts will wither bear this out or not, the real question is by how much and whether McCain can come back in the final furlong.

With close states going to the current leader, Obama wins 353 to 185 in the electoral college that decides the Presidency (see blog linked below for explanation and how far this has moved from before the economic meltdown). However Obama has narrow leads in 85 of those votes. A 3% swing to McCain in those seats (well within margin of error) makes it 268 to 270 in McCains favour.

If Obama can keep Ohio worth (2.0% lead) worth 20 votes and Florida worth 27 votes (3% lead) then he will win. But calling it a landslide now is almost begging for my analysis to come and bite you in the ass. I want it to be true, but the numbers cannot be taken for granted. Just a 3% swing at the moment would out McCain in and that is so easily possible that if I was a Republican I would be making my base feel that they have to come out and fight while making Democrats feel they can stay at home in key states, it is a done deal.

Democrats need to be talking up the fight rather than being assured and complacent. It is there to be lost and will not take much. There is no prize for winning opinion polls and loosing the only poll that counts – the election. If McCain can get the Democrat controlled congress blamed for the current crisis …

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Obama 273 McCain 265 – which State will decide it?