Banking Profits: A Mirage, Not a Miracle

The banks contribution to the economy has been overstated

THE huge sums earned by banks and their employees over the past 30 years is a recurring puzzle. How has finance done so well for itself and why haven’t its returns been competed away?

Andrew Haldane, the executive director for financial stability at the Bank of England, has co-authored another incisive contribution to this debate in a chapter of a new book* published by the London School of Economics on July 14th. Analysing the recent performance of the banking industry, he concludes that it has been “as much mirage as miracle”.

Mr Haldane and his colleagues start with a statistical oddity. The fourth quarter of 2008 almost saw the meltdown of the global financial system, with banks’ share prices falling by an average of 50%. Yet according to the British national accounts, the same quarter witnessed the fastest-ever increase in the contribution of the financial sector to the country’s economic growth.

That suggests there is something wrong with the calculations. The standard measure is gross value-added—the output of an industry minus the costs of production. That is a pretty easy sum to calculate when it comes to manufacturing. In finance, however, a lot of the gross value-added comes from making loans. Economists calculate this by measuring the difference between the rate charged on loans and a “reference rate”, which is pretty much the risk-free rate.

The consequence of this approach is that when interest margins rise for corporate borrowers, as they did in late 2008, the gross value-added of the banking sector appears to go up. But without adjusting for risk, this measure of the finance sector’s economic worth is meaningless. What really matters is whether the interest margin properly reflects the risk of default. As Mr Haldane comments: “A banking system that does not accurately assess and price risk is not adding much value to the economy.” That is a particular problem given that it seems clear the banks systematically underpriced risk in the period leading up to 2007.

You can look at the numbers in a different way. Was the finance industry using a larger share of the nation’s resources? In the British case, the industry’s share of labour and capital has been on a declining trend since 1990. Combine the gross value-added figure with the declining share of resources, and you might assume finance has enjoyed a productivity miracle over the past 20 years. This miracle could explain the very high returns on equity achieved by the banks and the very high wages given to bank employees (an international, not just a British, phenomenon).

But if the value-added figure is driven by a mistaken assessment of risk, a quite different picture emerges. Mr Haldane suggests that banks increased risk-taking by pursuing three different strategies: using more leverage, both on and off the balance-sheet; holding more assets on their trading books, where capital charges were lower and rising asset prices boosted profits; and writing “out-of-the-money” options, in other words selling insurance policies that offered steady returns in good times but disastrous losses in especially difficult times.

These greater risks brought little economic benefit. In the same book Adair Turner, the head of the Financial Services Authority (Britain’s soon-to-be-restructured regulator), points out that only a minority of bank activity concerns the channelling of savings to businesses investing in productive assets, what you might call the classic raison d’être of banking.

Instead, lending is dominated by the residential- and commercial-property cycle. These cycles are self-reinforcing: more lending pushes up property prices, which encourages more lending. At the margin, the property cycles might lead to the construction of better buildings, but such modest benefits are outweighed by the accompanying financial and economic instability.

The financial industry has done so well for itself, in short, because it has been given the licence to make a leveraged bet on property. The riskiness of that bet was underestimated because almost everyone from bankers through regulators to politicians missed one simple truth: that property prices cannot keep rising faster than the economy or the ability to service property-related debts. The cost of that lesson is now being borne by the developed world’s taxpayers.

* “The Contribution of the Financial Sector: Miracle or Mirage?” by Andrew Haldane, Simon Brennan and Vasileios Madouros. Taken from “The Future of Finance: The LSE Report”, July 2010

Published in The Economist

A Life Assurer's Worst Nightmare - Incorrect Assumptions

Like the sub-prime crisis faced by banks, the risk of people living for up to 20 years after retirement seems to have crept up on an industry using historical data to calculate people's chances of an early death.

Pension funds and insurers say the mounting burden of protracted pension payments is concentrated on a small group of providers: them.

Global private sector liabilities for pensions are at about $25 trillion (R180 trillion), according to a January Pensions Institute report, which cited estimates that every extra year of life expectancy at age 65 adds about 3 percent to the value of some UK pension liabilities.

Several factors - the market crash brought on by subprime lending, new solvency rules for insurers due in 2012 and the stampede of baby-boomers to retirement age - are adding urgency to providers' efforts to spread their exposure.

If that seems like a small group, the evidence is it's the population segment most likely to grow. There are about 450 000 centenarians in the world today and experts estimate that there could be 1 million by 2030.

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Why China Insists on Controlling its Currency

U.S.-Chinese relations have become tenser in recent months, with the United States threatening to impose tariffs unless China agrees to revalue its currency and, ideally, allow it to become convertible like the yen or euro. China now follows Japan and Germany as one of the three major economies after the United States. Unlike the other two, it controls its currency’s value, allowing it to decrease the price of its exports and giving it an advantage not only over other exporters to the United States but also over domestic American manufacturers. The same is true in other regions that receive Chinese exports, such as Europe.

What Washington considered tolerable in a small developing economy is intolerable in one of the top five economies. The demand that Beijing raise the value of the yuan, however, poses dramatic challenges for the Chinese, as the ability to control their currency helps drive their exports. The issue is why China insists on controlling its currency, something embedded in the nature of the Chinese economy. A collision with the United States now seems inevitable. It is therefore important to understand the forces driving China, and it is time for STRATFOR to review its analysis of China.

An Inherently Unstable Economic System

China has had an extraordinary run since 1980. But like Japan and Southeast Asia before it, dramatic growth rates cannot maintain themselves in perpetuity. Japan and non-Chinese East Asia didn’t collapse and disappear, but the crises of the 1990s did change the way the region worked. The driving force behind both the 1990 Japanese Crisis and the 1997 East Asian Crisis was that the countries involved did not maintain free capital markets. Those states managed capital to keep costs artificially low, giving them tremendous advantages over countries where capital was rationally priced. Of course, one cannot maintain irrational capital prices in perpetuity (as the United States is learning after its financial crisis); doing so eventually catches up. And this is what is happening in China now.

STRATFOR thus sees the Chinese economic system as inherently unstable. The primary reason why China’s growth has been so impressive is that throughout the period of economic liberalization that has led to rising incomes, the Chinese government has maintained near-total savings capture of its households and businesses. It funnels these massive deposits via state-run banks to state-linked firms at below-market rates. It’s amazing the growth rate a country can achieve and the number of citizens it can employ with a vast supply of 0 percent, relatively consequence-free loans provided from the savings of nearly a billion workers.

It’s also amazing how unprofitable such a country can be. The Chinese system, like the Japanese system before it, works on bulk, churn, maximum employment and market share. The U.S. system of attempting to maximize return on investment through efficiency and profit stands in contrast. The American result is sufficient economic stability to be able to suffer through recessions and emerge stronger. The Chinese result is social stability that wobbles precipitously when exposed to economic hardship. The Chinese people rebel when work is not available and conditions reach extremes. It must be remembered that of China’s 1.3 billion people, more than 600 million urban citizens live on an average of about $7 a day, while 700 million rural people live on an average of $2 a day, and that is according to Beijing’s own well-scrubbed statistics.

Moreover, the Chinese system breeds a flock of other unintended side effects.

Read STRATFOR's Full Article Here

Effects of Uncertainty on Investing

Humans don't like ambiguity. This is demonstrated in the experiment Hersh Shefrin discusses where subjects are offered either a guaranteed $1000, or a 50/50 chance at $2000. Consistently, fewer than 50% of respondents prefer the gamble for $2000, even though the expected values (i.e. the average value of the result if it were conducted many times) of both offers are the same.

What if the 50/50 odds in the above experiment were instead unknown? This adds even further uncertainty to the situation, and results in even fewer people willing to gamble on the $2000.

Shefrin calls this phenomenon "aversion to ambiguity", and on Wall Street it results in downward pressure on the prices of securities with uncertain outlooks. In order to avoid uncertainty/ambiguity, humans will stay away, even if the odds are favourable (i.e. downside risk is low, upside potential is high).

In his book, Shefrin argues that this ambiguity aversion is the reason for government intervention, even when it is not needed. What would have happened had the government not bailed out the banks? Nobody really knows, but the fact that the outlook was uncertain made the government want to intervene, even at a high cost, in order to avoid the uncertain situation.

As Mohnish Pabrai notes in his book, risk is not the same as uncertainty. Uncertainty can drive down the prices of assets/securities, even if downside risk is low. By capitalizing on situations where uncertainty is high, but risk is low, the investor can put himself in a position to earn above-average returns.

Courtesy Barel Karsan