The Fed’s Policy Mechanics Retool for a Rise in Interest Rates

It’s easy to take for granted the Federal Reserve’s ability to raise interest rates. Even among the legions who doubt that Fed officials will pick the ideal moment to start increasing rates for the first time since 2008, few question the Fed’s technical competence. The central bank has a long history. The engine is known to work.

So it may come as a surprise to learn that the old engine is broken. When the Fed decides that it’s time to “lift off” — perhaps this week, but more likely later this year — it will be relying on a new system, assembled from spare parts, to make interest rates rise.

There is a general agreement among economists and market analysts that the Fed’s plans make sense in theory. A team led by Simon Potter, a former academic who now heads the Fed’s market desk in New York, has been testing and fine-tuning the details by moving billions of dollars around the financial system.

But markets have a long history of scrambling the best-laid plans.

“If something is going to go wrong, I haven’t been able to figure out what, but there’s a lot of reason for caution,” said Stephen G. Cecchetti, the former chief economist at the Bank for International Settlements. “We’ve never done this before.”

The stakes are huge. The Fed is in charge of keeping economic growth on an even keel: minimal unemployment, moderate inflation. It tends to operate conservatively and to change very slowly because when it errs, the nation suffers.

Yet the Fed has found itself forced to experiment. The immense stimulus campaign that it started in response to the 2008 financial crisis changed its relationship with the financial markets. It has pumped so many dollars into the system that it cannot easily drain enough money to discourage lending, its traditional approach. Instead, the Fed plans to throw more money at the problem, paying lenders not to make loans.

The Fed, embedded in the banking system, has also concluded that working through the banks is no longer sufficient to influence the broader economy. It plans to strengthen its hold by working directly with an expanded range of lenders.

Fed officials have repeatedly expressed confidence that the plan will work. “The committee is confident that it has the tools it needs to raise short-term interest rates when it becomes appropriate to do so,” Janet L. Yellen, the Fed’s chairwoman, told Congress earlier this year, referring to its policy-making body, the Federal Open Market Committee.

And if the new approach does not work at first, Mr. Potter said in a recent speech, then his team of monetary mechanics “stands ready to innovate” until it does.

Freezing, Not Draining

The markets desk at the New York Fed has put monetary policy into practice since the mid-1930s. In the decades before the Great Recession, the desk exercised its remarkable influence over the American economy through its control of an odd little marketplace in which banks could come to borrow money for a single night.

The Fed requires banks to set aside reserves in proportion to the deposits the banks accept from customers. The reserves can be kept in cash or held in an account at the Fed. Banks that need reserves at the end of a given day can borrow from banks that have a surplus. Before the crisis, the Fed controlled the interest rate on those loans by modulating the supply of reserves: It lowered interest rates by buying Treasury securities from banks and crediting their accounts, increasing the supply of reserves; it raised rates by selling Treasuries to banks and debiting their accounts.

As the crisis hit in 2008, the Fed pressed this machine to its limits. It bought enough securities and pumped enough reserves into the banking system to drive interest rates on short-term loans to nearly zero. The federal government now pays about a dime to borrow $1,000 for one month. Companies with good credit pay about a dollar to borrow $1,000 from money market funds and other investors.

But the Fed didn’t stop there. It kept buying Treasuries and mortgage bonds to eliminate safe havens, forcing money into riskier investments that might generate economic activity. As a byproduct, the Fed kept expanding the supply of reserves.

One result is a banking system almost comically awash in money. In June 2008, banks had about $10.1 billion in their Fed accounts. The total is now $2.6 trillion. Picture all of the money in June 2008 as a single brick; the Fed has added 256 bricks of the same size. On top of that first brick, there is now a stack five stories tall.

Bank of America, for example, had $388 million in its Fed account at the end of June 2008. Seven years later, at the end of June 2015, it had $107 billion. The bank could double in size and double again and still have more reserves than it needs.

To switch metaphors, the old monetary-policy machine sits at the bottom of a lake of excess reserves. The Fed would need to sell most of the securities it has accumulated before short-term rates would start to rise. Selling quickly could roil markets; selling slowly could allow the economy to overheat. So the Fed decided to find another way.

Instead of draining all that excess money, the Fed decided to freeze it.

Paying Banks Not to Lend

For the last seven years, the Fed has encouraged financial risk-taking in the service of its campaign to increase employment and economic growth. By starting to raise interest rates, the Fed intends to gradually discourage risk-taking.

The straightforward part of the plan is persuading banks not to make loans.

In a serendipitous stroke, Congress passed a law shortly before the financial crisis that let the Fed pay interest on the reserves that banks kept at the Fed. Written as a sop to the banking industry, it has become the new linchpin of monetary policy.

Say the Fed wanted to raise short-term interest rates to 1 percent, meaning that it did not want banks to lend at lower rates. Because the glut of reserves is so great, the Fed could not easily raise rates by reducing the availability of money. Instead, the Fed plans to pre-empt the market, paying banks 1 percent interest on reserves in their Fed accounts, so banks have little reason to lend at lower rates. “Why would you lend to anyone else when you can lend to the Fed?” Kevin Logan, chief United States economist at HSBC, asked rhetorically.

This is not a cheap trick. Since the crisis, the Fed has paid banks a token annual rate of 0.25 percent on reserves. Last year alone, that cost $6.7 billion that the Fed would have otherwise handed over to the Treasury. Paying 1 percent interest would cost four times as much. The Fed has sent roughly $500 billion to the Treasury since 2008. As the Fed raises rates, some projections show that it may not transfer a single dollar in some years. Instead, the Fed will pay banks tens of billions of dollars not to use the trillions it paid them previously.

At first, Fed officials thought that paying interest to banks would establish a minimum rate for all short-term loans, exerting the same kind of broad influence as the old system. It soon became clear, however, that rates on most such loans remained lower than 0.25 percent. Even banks that needed overnight loans found they could borrow more cheaply. The average rate in July was 0.13 percent — about half of the Fed’s new benchmark rate.

The rest of the financial system is also awash in cash, and lenders — like money market mutual funds — put downward pressure on interest rates as they fight to attract borrowers.

And here’s where the Fed’s plans got a little less orthodox.

The Fed lacks the legal authority to pay these lenders a minimum interest rate on deposits, as it does to the banks. But two years ago, Lorie Logan, one of Mr. Potter’s top aides, suggested the Fed could achieve the same goal by borrowing from these companies at a minimum interest rate.

The resulting deals, known as overnight reverse repurchase agreements, signal a significant break from the Fed’s history of working through only the banking industry.

“We’re pushing more activity out of the regulated banking sector, and so monetary policy has to take account of the unregulated sector,” said Jon Faust, an economist at Johns Hopkins University who until recently served as an adviser to Ms. Yellen, and before that to her predecessor, Ben S. Bernanke. “The world is changing, and I think the bigger risk is not changing along with it.”

When liftoff arrives, however, the Fed plans to place this machinery inside the familiar language of the old system. It is likely to announce that it is raising the federal funds rate, the interest rate that banks pay to borrow reserves, from its current range of 0 to 0.25 percent to a new range of 0.25 to 0.5 percent. The Fed does not plan to emphasize that this rate is now a stage prop or that the real work of raising rates will be done outside the limelight by its new tools.

Mission Control

On weekdays at about 12:45 p.m., the New York Fed’s trading portal, known as FedTrade, plays three musical notes — F-E-D — signaling that Mr. Potter’s shop is open for business. So begins another day of training camp, another test of the Fed’s plans to borrow money from nonbank financial companies.

The Fed’s traders sit at terminals in a converted conference room. Along one wall are five chairs and five sets of computer monitors beneath five historical photographs of the trading desk: men answering phones, men writing bids in chalk on a long board and, in the most recent photograph, from the 1980s, a glimpse of a woman in the background. On another wall is a screen that links the room in New York by videoconference with a backup trading room at the Chicago Fed.

Potential lenders — a preapproved group of 168, including a bevy of money market funds and the housing finance companies Fannie Mae and Freddie Mac — have 30 minutes to offer the Fed up to $30 billion each. At 1:13 p.m., a warning message starts blinking red. At 1:15 p.m., the Fed closes the auction and accepts up to $300 billion in loans at an interest rate of 0.05 percent.

During two years of experiments, the Fed team has adjusted the rates it pays, the amounts it accepts and the time it enters the market, among other variables. Mr. Potter and his lieutenants have also held lunch meetings with investors on the other side of the portal to solicit advice and complaints.

The size of the program poses the most obvious risk. Fed officials limited daily borrowing to $300 billion because they didn’t want to freeze more money than necessary. They also worry about exacerbating market downturns by giving investors a new place to flee. These concerns were heightened by reports that some investment companies were interested in creating money market funds that would be advertised as the safest place to park money — because the money would be parked at the Fed.

Last year, at the end of September, shortly after the cap was imposed, lenders offered the Fed $407 billion on a single day. Demand was so high that instead of asking for interest, some lenders offered to pay the Fed to take the money. The Fed ended up borrowing at zero percent and turning away $107 billion in loans.

A cardinal rule of central banking is that you don’t starve financial markets during panics, and the Fed has been leaning in the direction of doing more. It has already announced that it is willing to borrow at least $200 billion through a parallel program at the end of September this year, for a total of $500 billion. It has also suggested that it may raise the cap during liftoff. “My sense is we’re better off making sure we can maintain control,” James Bullard, president of the St. Louis Fed, said in a recent interview.

Unpredictable Reactions

“This is where the nutty people on the bond-trading desks have control,” joked Alan Blinder, a former Fed vice chairman, when asked if the Fed’s plan would work.

Mr. Blinder’s point was that markets ultimately determined the cost of borrowing money, particularly for longer-term loans like mortgages and corporate bonds. The Fed can be precise in its planning, but the market is unpredictable in its reactions.

Fed officials have emphasized that they do not want the liftoff to surprise investors. “This has probably been the most telegraphed 25-point rate hike in history,” said Wayne Schmidt, chief investment officer at Gradient Investments in Arden Hills, Minn. “I think when they actually do something, it will be more of a nonevent.”

But there are at least three reasons markets are becoming less predictable.

The rise of an interconnected global financial system has weakened the Fed’s influence over interest rates. When the Fed last raised short-term rates, beginning in 2004, officials were surprised that long-term rates failed to rise because foreign money was pouring into the housing market and other domestic investments. This time, there are plenty of warnings that the weaknesses of other developed economies could once again make it harder for the Fed to raise domestic interest rates.

“Financial market conditions have come to depend increasingly not only on developments at home but also on developments abroad,” William C. Dudley, the president of the Federal Reserve Bank of New York, said in a February speech in which he cautioned the Fed’s control over those conditions had been “loosened.”

The Fed’s audience also increasingly consists of computer programs that will start buying and selling securities before people have time to read the first words of the Fed’s policy statement, creating the potential for new kinds of chaos.

On Oct. 15, for example, automated trading programs drove up the price of 10-year Treasuries in a burst of buying so intense that a government report later found the machines bought more than 10 percent of the securities from their own firms. Then, just as quickly, the computers turned around and drove prices back down.

The 12-minute spree was among the largest price movements ever seen in one of the world’s most liquid markets, yet the government report found no clear cause.

Finally, investors say regulatory changes are keeping some large traders on the sidelines, making it harder to buy and sell, even in the highly liquid market for Treasuries. That can exacerbate market movements because when people are in a hurry to buy or sell, they tend to chase the best available offers. “The depth of the market is not what it used to be,” said Tad Rivelle, chief investment officer for fixed income at TCW, a Los Angeles investment firm that manages some of the world’s largest bond funds. “You can get the same trades done, but it takes more time.”

Other observers, however, urge a broader perspective.

“People are very concerned about those 12 minutes last year,” said Mr. Cecchetti, now a professor of finance at the Brandeis International Business School. “I’m very reassured by the fact that there were only 12 minutes.”

Moreover, Mr. Cecchetti said that removing some liquidity was a good thing because much of that liquidity was a result of public subsidies for the banking system that had encouraged undue risk-taking.

“Does it mean that there’s going to be more high-frequency volatility? Sure,” he said. “It means the Simon Potters of the world are going to have to be much more careful about what they’re doing. But that seems to me to be kind of O.K.”

Volcker’s Messy Lesson

Mr. Potter has worked at the New York Fed since the late 1990s, but he spent most of his career there in the research department before taking over the markets desk in 2012. He became more involved in the practical side of the Fed’s work during the financial crisis. In a 2012 speech at New York University, Mr. Potter said the experience — particularly during a four-week period at the peak of the crisis — had impressed upon him the limits of theory, the need to understand what investors are thinking and the value of flexibility in policy making.

“For economists who did not have the opportunity to observe the panic up close as I and most of my colleagues had, the developments in this four-week period must have been bewildering, given how widely events on the ground and theory diverged,” he said.

That perspective may come in handy. The last time the Fed shifted the basic mechanics of monetary policy was in the early 1980s, when Paul Volcker was its chairman. That campaign is remembered as a triumph of central banking. Mr. Volcker succeeded in driving inflation down toward modern levels, ending a long period in which governments had floundered helplessly to prevent rising prices.

But Mr. Faust, the Johns Hopkins economist, says the messiness of Mr. Volcker’s triumph is often overlooked. The Fed’s initial plans did not work and were revised and did not work and were revised again — and still didn’t work.

He said the Volcker episode was a reminder that monetary policy is not figure skating. The Fed is likely to flail, he says, but it will be measured by its success in getting interest rates to rise, not by the grace of its performance.

“If you’re into the internal plumbing, I suspect there will be times when that looks messy because this is new,” Mr. Faust said. “But central banks can raise interest rates, and they will. And as long as that happens, from the standpoint of the broader economy, everything is fine and the rest will be forgotten or become a footnote of history.”

Source: http://www.nytimes.com/2015/09/13/business/economy/the-feds-policy-mechanics-retool-for-a-rise-in-interest-rates.htmlhttp://www.nytimes.com/2015/09/13/business/economy/the-feds-policy-mechanics-retool-for-a-rise-in-interest-rates.html

Fed risks using wrong tool to tighten

The Federal Reserve has been sending strong signals that it is preparing to raise interest rates for the first time since 2006. As the Fed prepares for lift-off, its operational framework and large balance sheet may pose challenges to market functioning.

The Fed’s balance sheet has increased from roughly $1tn at the end of 2007 to well over $4tn at present. This stems from about $3.4tn of purchases of US Treasuries and other bonds under the Fed’s quantitative easing programmes. This took such assets out of market ownership to reside on the Fed’s balance sheet.

This is important because market interest rates are effectively determined in the collateral market, such as the repo, or repurchase market, where banks and other financial institutions exchange collateral (such as US Treasuries, mortgage securities, corporate debt, equities) for money.

Financial agents that settle daily margins may post cash or collateral; this forms the core of the financial plumbing. Such “pledged” collateral is generally received by banks not only via repo markets but also from securities lending, prime brokerage agreements with hedge funds, and derivative positions. The largest suppliers of pledged collateral are hedge funds; other sources include insurers, pension funds, central banks and sovereign wealth funds.

The repo rate is an important market signal and should move in tandem with the fed funds rate; hence the need to have good plumbing.

In 2007, the collateral market was $10tn in size; now it is only $6tn. A further reduction lies ahead, threatening to rust the financial plumbing, as the Fed prepares to raise interest rates.

There are two ways the Fed can tighten monetary policy to control interest rates once it has raised them. The first is to use and expand its so-called reverse repo programme, which soaks up large sums of money from non-banks such as money market funds, but does not release collateral from the Fed’s balance sheet back into the market.

The second is to sell US Treasuries, which similarly mops up cash while also supplying collateral.

The reverse repo programme is currently capped at $300bn per day, but the Fed may raise this cap to ensure reverse repos mop up enough cash to maintain a floor on interest rates. Reverse repos work by persuading non-banks to remove dollars deposited with banks and place them with the Fed, in exchange for collateral such as Treasury bonds. So the Fed becomes the new counterparty to the non-bank, while the bank gets “balance sheet space” as the deposits move to the Fed.

Crucially, this process does not release collateral to the market as the operational structure of the reverse repo facility puts practical restrictions on the reuse of collateral. Thus, none of the collateral within the reverse repo programme can be used to post at central clearing houses, in the bilateral derivatives markets, in the bilateral repo market or delivered against short positions.

The consequence of a sizeable reverse repo programme would be that money becomes scarcer as it is drained from the market, thus raising the repo rate, while collateral becomes proportionately more abundant and therefore cheaper. Thus, by targeting the size of the programme, the repo rate can be made to track the fed funds rate; however, this will result in the repo rate not being a market rate.

A better option would be to keep the reverse repo programme size at its present level and sell US Treasuries . These bonds could be sliced and diced for repos and related collateral usage. While the Fed can control the amount sold, collateral gets reused, which is not under the Fed’s control, so the repo rate may not equate to the fed funds rate. However, selling of US Treasuries can be fine-tuned, to reduce a large wedge between two rates.

It is crucial to ensure that the market plumbing does not get rusty through the use of a large reverse repo programme. A deep and liquid collateral market provides price signals (like the repo rates) that would be weaker under a large programme.

For effective monetary policy transmission, all rates should move in sync with the fed funds rate and this requires good plumbing.

Manmohan Singh is the author of Collateral and Financial Plumbing and a senior economist at the International Monetary Fund; views are his own and not those of the IMF

Source: http://www.ft.com/intl/cms/s/0/0d72eaa8-885f-11e5-9f8c-a8d619fa707c.html

China’s Stimulus Quagmire

Even with Monday’s 7.6% decline, China’s stock market is on a historic tear, having risen more than 50% over the past year. Yet much of this investor frenzy is based on three flawed premises: that China’s decelerating growth necessitates stimulus, that such stimulus will reduce borrowing costs for firms, and that lower borrowing costs will incentivize spending and ultimately jumpstart growth.

New data from my firm’s China Beige Book—the largest private study of China’s economy—belie each of those assumptions. Our data make it clear that China doesn’t desperately need to stimulate its economy, that its recent attempts to lower interest rates via stimulus have done the opposite, and that if Beijing opts for large-scale stimulus anyway, it won’t work as intended.

Market participants often seem to misunderstand what China’s slowdown means. While the economy has continued to decelerate broadly, important components—including profit performance and the labor market—have shown overall improvement since 2014’s second-quarter nadir. In the just-completed fourth quarter, China Beige Book data on sales, profits and job growth all looked a bit better, as they had in the third quarter. This is a tentative rebound, to be sure, but it is hardly the gloom and doom narrative that most commentators (glued to older data) have now accepted as gospel.

Recent “stimulus” measures, including November’s cut to the benchmark lending rate, haven’t reduced borrowing costs for firms. The opposite has happened. Since last year’s second quarter, according to our data, the cost of capital has risen across the board—for bank loans, shadow-bank loans and especially bonds.

Perhaps most frequently overlooked: Firms still don’t want to borrow. The share of firms applying for and receiving loans dropped again in the fourth quarter, to the lowest levels we have recorded since beginning to survey in the first quarter of 2012. Since then, the share of firms borrowing has now dropped by more than half.

Crucially, firms don’t want to spend either. In the fourth quarter, growth in capital expenditure ticked down for the fourth straight quarter, also notching our survey’s all-time low.

Even the fourth quarter’s best performers—services firms—are caught in the wave: In multiple regions this quarter, including those that house the critical cities of Shanghai, Guangdong and Chongqing, services firms saw improved revenue growth, yet the proportion that hiked capital expenditures dropped anyway, in some cases dramatically. If firms don’t want to spend, monetary stimulus is a lost cause.

Plummeting crude-oil prices are a reason for optimism, given that China is a huge net consumer of energy. Our data track a steady pattern of disinflation in the Chinese economy since the first quarter of 2013, with sales prices, wages and material-input costs all continuing to rise, but ever more slowly. With the impact of cheap oil yet to be felt, 2014’s disinflation could become outright deflation in 2015.

Producer deflation is much better for an economy than consumer deflation. But with the economy slowing, Japan undertaking record quantitative easing and the eurozone headed in that direction, any sort of deflationary headwind may make it awfully hard for Beijing to resist another large stimulus of its own.

Here we get to the critical takeaways for investors: China’s slowdown may create the illusion that China has little choice but to stimulate, but our data show otherwise. Yet even if such stimulus is ultimately enacted, it simply will not work as intended.

Firms haven’t been interested in borrowing or spending on new projects for a year now. It is possible that low enough interest rates could change their behavior but to date rates haven’t been pushed downward by easing measures.

Instead, what companies are most likely to do if more liquidity is injected into the system is jump deeper into the roaring stock market. Already some of the inflows into stocks have come from the floundering property sector that Beijing has tried to stabilize.

If more firms move capital into stocks, the result won’t be more growth but rather more out-of-control prices for equities. And the structural impediments that are slowing China down will remain untouched.

Source: http://www.wsj.com/articles/leland-r-miller-chinas-stimulus-quagmire-1421688876

Vietnam Loses Glow as a Market Darling

Until a few years ago, Vietnam was one of the world's hottest emerging markets. Now it faces an urgent task: fix a beleaguered banking system or watch its economy continue to slip behind faster-growing neighbors.

Piles of bad loans following the financial crisis have dragged down growth in Vietnam and left banks weakened and reluctant to lend.

The government recently acknowledged that nonperforming loans—many made to inefficient state-owned companies—could be as high as 10% of the banking system, substantially higher than reported by individual banks. Fitch Ratings analysts think the number is as high as 15%.

A record number of firms are declaring bankruptcy, and in the sprawling urban areas encompassing Hanoi and Ho Chi Minh City, the landscape is littered with stalled construction projects as builders run out of cash or put on the brakes as demand for condominiums and office space dries up.

Vietnam fought off rumors in recent days that it was seeking an International Monetary Fund bailout for its banking system. An IMF spokeswoman said no requests for aid had been made. State Bank of Vietnam Deputy Gov. Le Minh Hung said in a statement on the government's website that the country had no intention of seeking a rescue.

However, the IMF and others have been advising Vietnam on how to implement a domestically financed bailout that would restore its banks to health. In its latest economic review the fund said that "quick and comprehensive action" was needed to solidify weak banks and put the economy on more solid ground.

Fears over Vietnam's banks intensified in August when one of the country's most prominent tycoons, Nguyen Duc Kien, was arrested for allegedly improperly lending money to real-estate projects. Efforts to reach Mr. Kien, who now runs a number of private investment funds and owns Hanoi's main professional soccer club, have been unsuccessful. Stocks dropped in the days following the arrest, and the Ho Chi Minh Stock Index is down 18% since the beginning of May.

Vietnam shares fell 2.2% Monday, led by selling in property-related stocks after state media reports suggested real-estate developers are trying to cut prices to boost sales of apartments.

Song Da Thang Long Joint Stock Co. is among the local developers that have struggled. In July it secured an additional loan of 300 billion dong, or around $14 million, from the state-owned Bank for Investment and Development of Vietnam to help complete its sprawling, 13-tower U-Silk City development in Hanoi's suburbs. The project began in 2009 at the height of Vietnam's property boom but quickly fell victim to the subsequent property slump and soaring interest rates.



Some question whether this cash injection is enough to keep the project alive, and Song Da Thang Long's stock price has fallen about 60% in the past six months. Chairman Nguyen Tri Dung has said the firm is trying to arrange additional credit lines with other lenders. He couldn't be reached for comment.

Economists warn that Vietnam has entered a dangerous cycle where banks, saddled with bad debts, are unwilling to lend, making it harder for businesses to invest. That feeds into slower growth, which in turn makes it harder for companies to pay back loans, again harming the banks.

The result is that Vietnam's economy is likely to grow below its potential for years to come, unless stronger steps are taken to clean up the banks, economists say.

"I don't think there's any quick fix to a problem like this, as you see in the West. It takes time to work through a solution" to a banking crisis, says Gareth Leather, an economist at Capital Economics. He figures Vietnam's economy will grow at closer to a 5% rate in coming years than the 8% the country enjoyed through much of the previous decade. Although higher than growth rates in the West, 5% is considered slow for a developing Asian country like Vietnam and might not be fast enough to generate sufficient jobs to keep its growing population employed.

The government this month revised its forecast for 2012 growth down to 5.2% from 6% previously.

Vietnam's leaders have acknowledged that a fix is needed. Prime Minister Nguyen Tan Dung in March approved a three-year restructuring plan for the banking sector designed to strengthen the country's largest banks and encourage a series of mergers among smaller lenders, but officials appear uncertain about how to put the blueprint into effect.

Plans to launch a "bad bank" to buy up distressed assets have been discussed, but a foreign investor familiar with government discussions say implementing such a solution is being delayed by Hanoi's lack of expertise in managing a modern banking system.

People familiar with government plans say there are proposals to let foreign banks increase stakes in domestic banks from the current cap of 20% in some instances to as high as 49%. Another plan would allow majority stakes, but with a time limit of five years, after which the foreign banks would have to divest.

Government officials didn't respond to requests for comment.

It isn't clear if foreign banks will be interested in increasing their commitments without having the influence of being a permanent majority owner. There are more than a dozen foreign banks with stakes in domestic banks, including HSBC Holdings PLC, Australia & New Zealand Banking Group Ltd. and Société Générale.

Many of the foreign banks are dealing with troubles at home, and are said to be reluctant to double-down without assurances of more control over local partners. One foreign banker said at least some of the foreign banks are looking to exit Vietnam at the right price, rather than put more money in.

While the banking situation has deteriorated, Vietnam has tackled other problems by taming double-digit inflation and stabilizing its currency, in part through interest-rate increases. Vietnam has relatively little foreign debt and its trade deficit has shrunk this year.

Some think the government might be able to afford to run a bailout of its banks by itself. The government's debt-to-GDP ratio is about 44%, and the annual budget deficit has fallen to less than 4% of GDP last year from 9% in 2009, well below levels of financially strained economies in Europe.

But because of the large role the state plays in industry, the government has so-called contingent liabilities to back up debt in state-owned institutions. Fitch Ratings figures those liabilities equal an additional 10% of Vietnam's $125 billion GDP.

In the meantime, investors are waiting for more action to resolve the banking situation. Louis Nguyen, chief executive of Saigon Asset Management, which invests in a broad range of Vietnamese companies, said his firm tried to launch a fund last year in conjunction with a large Vietnamese bank to invest in problem loans.

But the fund was put on hold when he found the banks were unwilling to acknowledge problems on their books and sell loans at any sort of discount to their face value.

Source: http://online.wsj.com/article/SB10000872396390443779404577643220089349912.html?mod=googlenews_wsj

Some European Companies Try Bonds to Raise Cash

Among the midsize, family-owned companies that power the German economy, it has long been an article of faith: credit comes from the friendly local banker, not from cold and distant capital markets.

Andreas Dombret, a member of the executive board of the Bundesbank, said the sale of debt by companies was “limited in scope” but a “welcome response” to tighter lending by banks.

 

So Peter H. Leibold was breaking from the norm last year when he decided to finance the expansion of his company, which makes wood pellets for heating and energy generation, by selling corporate bonds. The company, German Pellets, raised more than 80 million euros ($102 million).

Now he is a convert. 

“The advantage of a bond is that you can raise a large amount from a completely different group of investors,” said Mr. Leibold, the founder and chief executive of the company, which is based in Wismar, on the coast in northern Germany. 

Corporate bonds — essentially, interest-bearing i.o.u.’s that companies sell to whomever is willing to buy — have long been an essential borrowing tool for companies in the United States. 

But in Europe, borrowing from banks, whether local ones or big multinationals, has traditionally been the preferred way to raise money. Just 9 percent of corporate credit in the euro zone comes from debt markets, according to the Bundesbank, Germany’s central bank, compared with 64 percent in the United States.

But as the euro zone’s financial crisis has forced many banks to hoard cash and curtail lending, more European companies are turning to bond markets. If the trend continues, it could not only begin reversing the Continent’s longstanding preference for bank credit, but also make the region less prone to banking crises.

There might be resistance, however, from European regulators, who regard such borrowing as a form of shadow banking that they cannot control. In addition, bank lobbyists might fight what they see as competition. 

“People are afraid of a financial system not based on what they know, which is financial intermediation by banks,” said Nicolas Véron, a senior fellow at Bruegel, a research group in Brussels. 

The fears are not unfounded. The propensity of banks in the United States to turn loans into securities that can be sold to investors arguably helped create the subprime mortgage crisis. 

But later on, there was an upside: the practice meant that the fates of companies in the United States were less coupled to those of banks. Not so in Europe, where the problems of credit institutions remain a grave threat to the rest of the economy. 

“Euro-area firms are particularly vulnerable to reduction in bank credit because of their greater reliance on banks for funding,” the International Monetary Fund said in a report last month. 

Companies’ tapping of euro zone bond markets has surged this year, more than doubling to $107 billion in the first quarter, according to Dealogic, a data provider. For the first time since 2009, bond issues surpassed syndicated bank loans as a source of financing for larger companies. 

When even large European banks are cutting back on risk, bond issues enable companies to raise money from investors outside the euro zone who are less affected by the crisis. 

It remains unclear, though, to what extent debt markets can fill the vacuum left by troubled European banks. Bond markets might not help the thousands of smaller companies that form the backbone of the euro zone economy but are too small to attract investors’ attention. 

“The corporate sector in Europe still comprises mostly small- and medium-sized enterprises that will continue to rely on bank loans,” Andreas Dombret, a member of the executive board of the Bundesbank, said in an e-mail. 

The countries that need credit most desperately are also the ones with the highest proportion of small firms least able to gain access to debt markets. Companies with 50 employees or fewer employ 68 percent of the work force in Italy and 62 percent in Spain, according to Goldman Sachs. Those figures compare with 40 percent in Germany. 

“For smaller firms in particular, the fixed costs can simply be too high, rendering a bond issuance uneconomical under all circumstances,” Dirk Schumacher, an economist at Goldman Sachs in Frankfurt, wrote in a report last month. 

But the experience of German Pellets, which had sales of 275 million euros ($350 million) last year and has 500 employees, suggests that bonds could be an alternative for at least some midsize companies.

Mr. Leibold said that it initially had taken some effort to explain to investors why wood pellets were an interesting business. The pellets are a source of renewable energy and are cheaper than oil or natural gas, he told them. 

Mr. Leibold, who founded the company in 2005 after he saw wood pellets being made by small operations in Sweden and realized there was an opening for a mass producer, says his sales are rising — even in Greece — as people and companies look to cut costs. 

Eventually, investors came around. The company used the money it raised to make several acquisitions and build new manufacturing plants, including one in Woodville, Tex., that is to employ 250 people when it is completed later this year. 

German Pellets also continues to draw on traditional bank financing, Mr. Leibold said. But the bond market provides a diversity of fund sources, without the drawbacks of a stock listing. Like many European entrepreneurs, Mr. Leibold expresses an aversion to going public. 

The company reflects his spirit and that of his colleagues, he said. 

“If German Pellets was listed on an exchange, it would change the company from that day on,” he said.

While there has been no broad effort to curtail debt issues, regulators at the European and national levels are now scrutinizing so-called shadow banking. That is a broad category that includes hedge funds and other activities outside the traditional banking system, as well as corporate bond issuance. 

In practice, corporate debt is typically handled within the banking system, with banks earning hefty fees for marketing the bonds. But because the business is dominated by large investment banks, the concern by some regulators is that smaller institutions have trouble competing in that market and could lose revenue as a result. 

Mr. Véron of Bruegel said central bankers might also worry that a shift from traditional banking could make it harder to control interest rates — their main policy tool. 

“The European Central Bank sees a need for more credit,” he said. “At the same time they are concerned about losing the monetary policy transmission channel.” 

For all that, though, officials do not seem to be terribly concerned. 

Mr. Dombret of the Bundesbank said that the sale of debt by companies was “limited in scope” and a “rational and welcome response” by companies to tighter lending by banks in many parts of the euro zone. 

Risks that banks will be bypassed “seem to be rather low at this stage,” he said, but he added that the Bundesbank would “continue to monitor this area.” 

Mr. Leibold of German Pellets, for his part, said he was happy with his bond experience and planned to tap debt markets again. But he was not sure bonds would work for all companies. “You need a story for investors,” he said. 

Source: http://www.nytimes.com/2012/05/19/business/global/credit-flows-through-a-new-channel-for-europe.html?_r=1&ref=global

Ngân hàng loay hoay tìm doanh nghiệp vay vốn

Tìm cách cho vay để bớt đọng vốn Phó tổng giám đốc một ngân hàng nhỏ cho biết ngân hàng ông hiện vẫn có đến 1.000 tỉ đồng dành riêng để cho vay doanh nghiệp. Mức lãi suất dao động từ 18-20%, tuy vậy ông cho biết trong cả tháng qua nhân viên tín dụng đã tìm kiếm khách hàng để cho vay nhưng không được là bao. Theo vị này, với mức lãi suất như trên nếu so với ngân hàng có vốn nhà nước hay ngân hàng nước ngoài thì không thể cạnh tranh, trong khi đó, các doanh nghiệp có hồ sơ tốt thường liên hệ với các ngân hàng trên để vay. “Cũng có một số doanh nghiệp có nhu cầu nhưng khi xét hồ sơ thì không đủ tiêu chuẩn”, vị này cho biết. Ông cho biết thêm số tiền trên hiện đang dùng để đầu tư ngắn hạn và chờ để cho doanh nghiệp vay. Với chỉ tiêu tăng trưởng tín dụng trong năm nay được Ngân hàng Nhà nước giao là 8%, ông còn cho rằng chưa chắc ngân hàng sẽ đạt được mức tăng trưởng như trên trong năm nay. Giám đốc khối khách hàng doanh nghiệp một chi nhánh tại TPHCM của Ngân hàng Quốc tế (VIB) cũng cho biết, trong thời gian này, ngân hàng ông đang tìm doanh nghiệp để cho vay, và tranh thủ giải ngân vốn. Tuy vậy, để tìm được doanh nghiệp đủ khả năng là không dễ vì các rủi ro đến với doanh nghiệp trong thời gian này là rất cao, khiến cho ngân hàng nếu không thận trọng thì nợ quá hạn sẽ gia tăng. Đa phần các báo cáo tài chính mà doanh nghiệp chuyển đến đều được ngân hàng xem xét kỹ càng và giải ngân đúng theo nhu cầu chứ không theo số vốn đề nghị của doanh nghiệp. Hiện tại VIB đang đưa ra nhiều gói hỗ trợ cho doanh nghiệp xuất nhập khẩu, thực phẩm đồ uống, với lãi suất ưu đãi, thấp hơn 1,5 điểm phần trăm so với mức cho vay thông thường. Từ đầu tháng 3, Ngân hàng Phương Đông cũng triển khai cho nhân viên tín dụng tại các chi nhánh về việc tích cực mời gọi khách hàng vay vốn. Ngân hàng này cũng đã giảm lãi suất xuống còn 18%/năm cho các khoản vay trong vòng 1 năm. Theo nhân viên tín dụng của ngân hàng này, việc xét cho vay sẽ được thực hiện tỉ mỉ và cân nhắc hơn, để tránh tăng thêm nợ xấu cho ngân hàng, trong khi việc thu hồi nợ trong điều kiện hiện tại rất khó. Theo thông tin từ OceanBank, ngân hàng này đang áp dụng các chương trình ưu đãi đối với các doanh nghiệp, hợp tác xã, hộ gia đình, cá nhân… hoạt động trong lĩnh vực nông nghiệp, nông thôn, lâm, ngư nghiệp, diêm nghiệp… nhằm phục vụ phát triển nông nghiệp, nông thôn với lãi suất thấp hơn 2- 3%/năm so với biểu lãi suất cho vay thông thường tại OceanBank. Đồng thời ngân hàng vừa quyết định dành một gói tín dụng ưu đãi trị giá 500 tỉ đồng với lãi suất cho vay khoảng 17%/năm cho một doanh nghiệp ở phía nam. Trao đổi với Thời báo Kinh tế Sài Gòn Online, chuyên gia tài chính Lê Xuân Nghĩa cho rằng, hiện tại vốn ở các ngân hàng đang dư thừa, không tìm được khách hàng vay. Điều này đã dẫn đến nhiều ngân hàng bỏ tiền mua trái phiếu chính phủ, kỳ hạn dưới 5 năm với lãi suất khoảng 11%/năm. Theo số liệu của Công ty chứng khoán Bảo Việt, tính đến hết ngày 9-3, tổng giá trị giao dịch toàn thị trường của trái phiếu đạt 47.575 tỉ đồng, trong khi cả năm 2011, con số này chỉ là hơn 73.000 tỉ đồng. Bảo Việt cũng cho rằng ngân hàng thương mại là đối tượng chủ yếu mua trái phiếu trong thời gian qua. Trong buổi họp báo công bố giảm lãi suất huy động ngày 13-3, Thống đốc Ngân hàng Nhà nước Nguyễn Văn Bình cũng cho biết, tính đến ngày 8-3, tỷ lệ tăng trưởng tín dụng đã giảm 1,27% so với cuối năm 2011. Thống đốc Ngân hàng Nhà nước lý giải rằng do yếu tố mùa vụ trong sản xuất kinh doanh ở kỳ nghỉ Tết Nguyên đán và tiếp đó, nhu cầu vay vốn còn hạn chế khiến cho dư nợ tín dụng giảm. Lãi suất vay giảm chưa đáng kể Trong khi ngân hàng đang tìm mọi cách để mời gọi doanh nghiệp vay vốn, thì trong buổi tọa đàm về tiếp cận vốn ngân hàng do Thời báo Kinh tế Sài Gòn tổ chức vào hôm 12-3, đa phần các doanh nghiệp tham dự đều cho rằng lãi suất hiện vẫn còn cao, nếu vay kinh doanh thì không có lãi. Đại diện các doanh nghiệp có mặt cho rằng mức lãi suất huy động giảm 1 điểm phần trăm, dẫn đến việc lãi suất cho vay giảm 1-2 điểm phần trăm tại một số ngân hàng chưa phải là mong muốn của doanh nghiệp vì mức giảm này không đáng kể. Theo bà Lê Thị Kim Thư, Giám đốc Kinh doanh Công ty Owtex Thiên Hòa , mức lãi suất trên dù giảm vẫn quá cao đối với doanh nghiệp, và mức lãi suất hợp lý mà công ty có thể chấp nhận được vào khoảng 8%. Bà Thư cho biết, hiện tại việc vay vốn chủ yếu để duy trì sản xuất, đảm bảo công ăn việc làm cho công nhân, không dám nghĩ đến lợi nhuận. Vì cái khó của doanh nghiệp hiện nay là tiêu thụ hàng, nếu tăng giá thì tồn kho sẽ tăng nên công ty cũng không dám đưa tất cả chi phí vào giá bán. Trong khi đó, ông Phan Văn Dũng, Tổng giám đốc Công ty cổ phần Thép Hữu Liên Á Châu, cho biết việc lãi suất cho vay được giảm xuống 1 điểm phần trăm thì sẽ giúp công ty ông tăng thêm được 5% lợi nhuận trên vốn chủ sở hữu. Vì vậy, việc giảm lãi suất là rất quan trọng, nhưng ông Dũng cũng cho biết, khi lãi suất giảm xuống còn 12% thì doanh nghiệp mới có thể có lãi. Còn ông Nguyễn Trí Kiên, Tổng giám đốc Công ty Túi xách Minh Tiến, cho rằng hiện tại doanh nghiệp nhỏ có ba cái khó: tiếp cận được vốn ngân hàng, được vay với lãi suất thấp và có thêm các chính sách hỗ trợ của Chính phủ để vượt qua những khó khăn hiện tại. Ông Kiên nói mức lãi suất trên đang bào mòn lợi nhuận của doanh nghiệp. Theo ông Kiên, vấn đề quan trọng hiện nay là nhà nước nên điều chỉnh dòng vốn chảy vào các doanh nghiệp sản xuất, kinh doanh, các nơi tạo ra giá trị thặng dư cao cho cả nền kinh tế. Lãi suất giảm mới chỉ đến được với doanh nghiệp lớn còn doanh nghiệp nhỏ và vừa dù cho nằm trong đối tượng ưu tiên cho vay vốn vẫn chưa được hưởng. “Như vậy, liệu việc giảm lãi suất có tạo ra tác động tích cực cho nền kinh tế hay chưa, trong khi doanh nghiệp nhỏ và vừa đóng góp một phần không nhỏ trong việc tạo ra tiền cho nền kinh tế và công ăn việc làm cho xã hội”, ông Kiên đặt câu hỏi. Ông Võ Thanh Liêm, Tổng giám đốc Công ty TNHH Nguồn Sinh Thái, cho biết hiện tại doanh nghiệp “thở đến đâu hay đến đó”, không dám mở rộng sản xuất vì không có vốn. Nếu phải vay vốn ngân hàng với lãi suất 17- 18% thì xem như hoạt động kinh doanh sẽ không còn mang lại lợi nhuận. Ông Liêm cho rằng, hiện tại doanh nghiệp phải tái cấu trúc mình để tìm được vốn, nhưng ngân hàng cũng phải xây dựng đội ngũ thẩm định dự án cho chuyên nghiệp, chính xác, trung thực thì mới mong vốn rót vào đúng chỗ, không ảnh hưởng tiêu cực đến cơ cấu nợ của ngân hàng, và ngân hàng sẽ mạnh dạn cho vay hơn. Source: http://www.thesaigontimes.vn/Home/taichinh/nganhang/72983/Ngan-hang-loay-hoay-tim-doanh-nghiep-vay-von.html

Buttonwood: Pausing for breath

IT IS known as the “reflation trade”. The theory is that rich-world central banks will do whatever it takes to revive their economies, even if that means tolerating a period of above-target inflation. As a result, investors feel an incentive to buy “real assets”, those linked to nominal economic growth (notably equities) or to rising prices (commodities).

From October 4th to March 1st, the MSCI World equity index rose by 21.4% and the S&P GSCI commodity index rose by 23.8%, vigorous rallies by any standard. Bullish sentiment was driven by a sense that quantitative easing (QE), the creation of money to buy assets like government bonds, had become a competitive sport.

America and Britain had been in the vanguard but in September the Swiss central bank pledged to create sufficient money to peg the franc against the euro; and in February the Bank of Japan added {Yen}10 trillion ($128 billion) to its asset-purchase programme and unveiled a target inflation rate of 1%. For its part the European Central Bank has lent more than €1 trillion ($1.3 trillion) in three–year loans to banks, in what is widely seen as a case of QE by the back door.

But the reflation trade took a bit of a dent on February 29th when Ben Bernanke, the Federal Reserve’s chairman, gave no hint of a third round of QE in testimony to Congress. Admittedly, there was a bullish underpinning to Mr Bernanke’s speech: a better performance by the American economy means there is less need for further action. Nevertheless, the Fed is seen as “pump-primer in chief” by many in the markets. Gold fell by $100 an ounce after Mr Bernanke’s statement.

A setback was probably inevitable after such a strong rally. A bigger question, however, is whether the rationale behind the reflation trade makes any sense.

Central banks have undoubtedly expanded their balance-sheets during the crisis. Back in 2008 the monetary base of the euro zone (in effect notes and coins plus reserves held at the region’s central banks) was around 10% of GDP; the equivalent figures for the Federal Reserve and the Bank of England were in the 4-6% range. Now the monetary base in all three places is between 16% and 18% of GDP.

However, expansion of the monetary base does not necessarily lead to growth in broad money, which measures the supply of credit to businesses and consumers and which ultimately drives inflation. Money-supply growth still looks sluggish in Britain, Japan and the euro zone (see chart). Only in America does it look robust.

The problem is that many banks remain unwilling to extend credit given the need, among other things, to shore up their capital. Figures show that total euro-zone lending to households and non-financial firms has declined in recent months, despite the ECB’s actions. Dhaval Joshi of BCA Research says that “banks have destroyed money just as fast as the ECB has created it.” Jennifer McKeown of Capital Economics concludes from the data that “bank lending remains extremely weak, suggesting that a lack of credit will continue to hold back economic activity.”

In short, the reflation trade may be based on a false premise. The rally may well have been driven by a lifting of the intense economic gloom that enveloped the markets in the autumn of 2011 and a sense that the European authorities had removed the immediate threat of a banking collapse, while simultaneously halting the rapid rise in Italian and Spanish government-bond yields. But now that investors have paused for breath, they can see that the economic outlook is still pretty murky. On March 5th, for example, China lowered its growth target to 7.5% (see later story); survey data on activity in the euro area’s services sector were also weaker than expected.

Furthermore, the markets are starting to lose a key source of support. As the global economy emerged from recession in 2009, profit margins surged thanks to falls in borrowing costs and weak wage growth. But European profits are down by 7% compared with the previous year, according to HSBC. Even in America, which is doing rather better, Bank of America Merrill Lynch is expecting corporate profits for S&P 500 companies to grow by just 6.4% in 2012, down from 14.8% last year.

It all looks remarkably like 2011, when an early-year rally also ran out of steam. So long as the yields on other assets like bonds and cash are so low, it is hard for stockmarkets to collapse. But those yields are so low because central banks are frightened about the economic outlook. That makes it very hard for a bull run to be sustained.

Source: http://www.economist.com/node/21549966

The mortgage market: Home truths

SOMETIMES it takes the interaction of powerful forces for things just to stand still. So it is with Britain’s housing market, which lenders expect to remain characterised this year by low levels of transactions and stable prices. But, quietly, the property market is being transformed.

The forces bearing down on housing are obvious enough. Home sales have fallen sharply since the start of the financial crisis, to around half their 2007 levels. That reflects greater conservatism on the part of lenders—“We don’t assume that home prices will go up, a mistake everyone made in the past,” says one—and of borrowers worried by an uncertain economic outlook at home and endless euro-crisis headlines. Household demand for secured credit fell in the last quarter of 2011, according to the Bank of England.

A slump in volumes has not led to a slide in prices, however. House prices are down by less than 10% from their peak, still well above The Economist’s definition of “fair value”, which is the long-run average ratio of house prices to rents. Prices in America, by contrast, have fallen back to fair value. A shortage of housing supply has helped sustain prices, as have low interest rates: two-thirds of British mortgage-holders are on variable-rate loans. A big rise in unemployment would unsettle this equilibrium, but only if joblessness bites among homeowners rather than, as now, among young people without mortgages.

“This is a broadly flat market and likely to stay that way for the next 12 to 24 months,” says Chris Rhodes of Nationwide, the country’s biggest building society. Regulators are determined to stamp out the speculative element of the market, which helped drive prices up before the financial crisis. The Financial Services Authority is currently consulting on proposals that would require lenders to assess the impact of future rate rises on borrowers’ ability to repay, for instance. That would make it much harder for ordinary folk to take out interest-only mortgages.

A flat market does not mean an unchanging one, however. Parts of the market are livelier than others, and none is more energetic than buy-to-let lending, in which private landlords buy houses to rent out. This sector also suffered during the crisis: gross advances fell from £45 billion ($90 billion) in 2006 to around £13 billion now. But lenders are expecting growth of 10-20% in the buy-to-let segment this year, and are scurrying to beef up their presence in this area.

Some of the rise in renting reflects credit constraints, particularly on first-time buyers. But this cannot explain everything. The proportion of loans allocated to first-timers has remained steady throughout the crisis as parents have stumped up down-payments for their offspring. Loan-to-value ratios are creeping up again. And numbers of first-time buyers and buy-to-let loans are not necessarily mirror images—both were growing just before the crunch, for example (see chart).

Rather than being just a cyclical effect, the growth in demand for private rentals fits into a broader pattern. Loans for first-time buyers were on a downward path well before the crisis, because of high house prices. Meanwhile, immigration and rising numbers of single-person households have driven demand for rented accommodation. “Growth in the private-rental sector is hard-coded into the UK market,” claims John Heron of Paragon Mortgages, a specialist buy-to-let lender.

But so is the aspiration eventually to buy one’s own home. For most people, the housing market still offers a stark choice: rent or take on lots of debt for a house purchase. That could change, however. Castle Trust, a yet-to-be-authorised lender in Britain backed by JC Flowers, a private-equity firm, plans to offer savers investment products tied to a national house-price index. It will use the money it raises to offer mortgage products where borrowers do not pay interest in return for handing over a slice of their equity to the firm. If prices rise, some of the capital gains are shared with the lender; so are a proportion of losses if prices fall.

The marriage of housing and financial innovation may look like an ugly match in light of the crisis. But ideas like these could yet prove one of its lasting legacies.

Source: http://www.economist.com/node/21543558

In Europe, a Conflict Over Bank Capital

LONDON — Europe’s banks and regulators are at odds about how financial institutions should increase their capital reserves.

Authorities want European banks to tap existing shareholders and reduce employee bonuses to find a combined $147 billion to increase their core Tier 1 ratios, a measure of a firm’s ability to weather financial shocks, to 9 percent by June. Citigroup estimates that Europe’s financial institutions, minus the Greek banks, had raised at least 40 billion euros, or $51 billion, as of the fourth quarter of 2011.

Banks, however, would prefer to sell or write down unprofitable operations, as well as adjust their balance sheets, to free up cash to meet the new requirements.

One solution could be to increase capital reserves through rights offerings, which allow existing shareholders to buy new stock at a discount. But volatility in the financial markets amid Europe’s sovereign debt crisis has damped investor interest.

Many banks are waiting on the outcome of the Italian bank UniCredit’s 7.5 billion euro rights issue, which closes at the end of this week. After initial investor skepticism, market participants say the Milan-based bank, which must raise almost 8 billion euros by June, is now expected to gain shareholder backing for the multibillion-euro capital increase.

“Everyone is looking at the UniCredit deal as a litmus test for future capital raisings,” said a senior investment banker from a leading bank in Europe, who spoke on the condition of anonymity because he was not authorized to talk publicly.

If other options are not attractive, some banks may eventually turn to local governments for a helping hand. Last year, the European Union created the European Financial Stability Facility, a 440 billion euro fund that can be used to shore up firms’ capital reserves.

Banks will soon find out what regulators think of their plans. Financial institutions, including Deutsche Bank of Germany and BNP Paribas of France, had to submit their recapitalization strategies to national regulators by Friday. The European Banking Authority will review the plans in early February, and regulators have the power to veto any capital-raising plan they don’t agree with.

Much of Europe is expected to enter recession this year, so authorities are likely to reject capital-raising efforts, like cutting lending to businesses, that reduce support for the European economy.

The banking authority has called on banks to raise the money through cuts in shareholder dividends and issuance of new stock. It has warned that the sale of any operation, particularly in banks’ home markets, that hurts business lending won’t be allowed.

“Regulators are asking for the impossible,” said Etay Katz, a banking regulatory partner at the law firm Allen & Overy in London. “They want banks to keep lending to the real economy, and there’s an expectation banks will have to swallow the bitter pill of offering new equity at times when investors’ appetite is negative.”

Nonetheless, some banks have been following authorities’ demands. Société Générale must raise 2.1 billion euros, and announced last November it was slashing bonuses and scrapping its 2011 shareholder dividend to meet the new regulatory requirements. It also plans to cut almost 1,600 jobs in its investment bank unit and has offloaded billions of euros of sovereign bonds to reduce its exposure to euro zone debt. As of the end of September, Société Générale’s core Tier 1 ratio stood at 9.5 percent.

Not every European bank, however, can rely on its own earnings. Many midsize banks, especially in Southern Europe, face deteriorating local economic conditions and rising customer defaults. In Spain, for example, authorities say the ratio of bad loans to bank lending has hit a 17-year high. And the European Union expects the country’s economy to grow a mere 0.7 percent this year, compared with 1.5 percent for the United States.

“The outlook is mostly negative for banks in countries like Spain, Italy and Portugal,” said James Longsdon, managing director in Fitch Ratings’ financial institutions group, in London.

Other banks are hoping the sale of so-called noncore assets in overseas markets will help to increase their capital reserves. The fire sale could be enormous. The European financial sector is expected to sell or write down more than $1.8 trillion in loan assets during the next decade, according to the consulting firm PricewaterhouseCoopers. That compares with just $97 billion from 2003 to 2010.

Last week, the Royal Bank of Scotland, which already has met the European Banking Authority’s capital requirements, sold its aircraft leasing business to a consortium of Japanese companies for $7.3 billion. Ireland’s nationalized Anglo Irish Bank also has offloaded $3.3 billion in commercial real estate loans in the United States to Wells Fargo. In all, the Irish bank wants to cut nearly $10 billion in American loans as part of a government requirement to reduce its assets and trim its operations.

Potential buyers, including American private equity firms, are lining up to take advantage, though analysts say the amount of assets up for sale will depress prices. That could reduce the impact on banks’ capital reserves. Local European politicians also may block deals that they believe will hurt domestic consumers.

“Banks may be restricted on deleveraging within Europe,” said Simon McGeary, managing director for European new products at Citigroup in London.

Banks also are restructuring their balance sheets to squeeze out extra capital. In a move known as liability management, banks can improve capital levels without raising additional funds. The strategy involves buying back or exchanging hybrid securities — investments that pay dividends like bonds, but can be converted into equity — at a discount from investors.

Under accounting rules, financial institutions can then book the difference between the original face value of the securities and the current discounted price as a profit toward core Tier 1 equity.

The strategy has been popular. Morgan Stanley estimates financial institutions, including Commerzbank of Germany and the Lloyds Banking Group of Britain, will raise a combined 8.7 billion euros by buying back, or exchanging, hybrid securities from investors.

The adjusting of companies’ balance sheets also includes so-called capital optimization, which involves tweaking banks’ back-office systems to free up funds to meet the capital requirements. Credit Suisse estimates that Spanish banks, which must raise a combined 26.1 billion euros, could free up more than 3 billion euros by fine-tuning how they use capital without raising any new funds.

“The only way for banks to succeed is to be more efficient with the limited capital available,” said Steve Culp, global managing director of the risk management practice at the consulting firm Accenture in London.

Banks, particularly in struggling southern European economies, may eventually have to turn to government bailouts. Deals already have been announced. In December, the National Bank of Greece and its local rival Piraeus Bank sold a combined 1.4 billion euros of shares to the government to increase their core Tier 1 ratios.

“There’s no magic bullet to this problem,” said Karl Goggin, a banking analyst at NCB Stockbrokers in Dublin. “The market has a finite appetite for banking stocks, so governments may have to step in.”

Source: http://dealbook.nytimes.com/2012/01/24/in-europe-a-conflict-over-bank-capital/

Hose and dry: The ECB fills banks with funds

WHEN economists think of the financial system, it is usually as a frictionless conduit through which money flows to areas of the economy where it is most needed. A better analogy right now might be of a hosepipe with a knot tied in it. The European Central Bank (ECB) is pumping unprecedented amounts of money into one end of the pipe, but how much of that will find its way to the parched real economy is another question entirely.

Start with the liquidity flowing into the euro-area banking system. On December 21st the ECB made available an eye-popping €489 billion ($628 billion) in three-year loans to more than 500 banks across Europe. The money was released in response to an almost total freeze since July in the bond markets that are an important source of long-term funding for banks. Demand for this ECB funding was much higher than expected, signalling just how much stress there is in the system.

The ECB had previously tried to ease pressure by offering one-year loans to banks. Yet this had done little to encourage them to lend to companies or people, since the money banks owed the ECB would have to be repaid before they were due to be repaid by their customers. A shortage of longer-term funding also contributed to an increase in the riskiness of the whole financial system, since banks were being forced to rely ever more on short-term financing that needs to be rolled over.

The flood of money being pumped into banks by the ECB goes a long way towards easing these funding pressures. Analysts at Morgan Stanley, an investment bank, reckon that the new facility adds about €235 billion in additional funding to the banks (since some of the money is being used to replace shorter-term loans) and takes the central bank’s total lending to the banking system to €979 billion. More important is the fact that it only has to be repaid in three years, which takes the average maturity on ECB loans to about 21 months, up from a mere ten weeks before the auction.

This should help insulate most large banks from turmoil in the funding markets. But not all will be protected. Although the ECB has essentially made an offer of unlimited funds, banks are still constrained in how much they may borrow by the quality of the collateral that they are able to hand over. This is because their collateral is subject to an initial “haircut”, or reduction in value. A portfolio of relatively safe government bonds might attract a small haircut, whereas one consisting of loans to small businesses might be reduced in value by 40% or more. A bank focused on this area of business, as many of Europe’s smaller savings banks are, might thus only be able to borrow 60% of the value of its outstanding loans.

A second constraint is that if the collateral the ECB holds falls in value, then banks need to post more. This also happens if there are credit downgrades on the bonds posted as collateral. The ECB’s haircut on sovereign bonds that are rated above “A-” is just 1.5%, but if they fall another notch this jumps up to 6.5%, Morgan Stanley notes. Weak banks in peripheral countries remain vulnerable to a downward spiral in which their holdings of government bonds are downgraded and fall in value, forcing them to come up with ever more collateral to keep borrowing from the central bank. It was this sort of collateral spiral that felled MF Global, a bust American broker, in its ill-fated bet on euro-area government bonds.

Now that banks are getting funding, the big worry is whether they will do more than merely hoard it. The early signs are not encouraging. Over the Christmas weekend bank deposits at the ECB rose to a record €412 billion. That partly reflects a traditional year-end rush to tidy up banks’ balance-sheets but also nervousness about lending directly to others.

Banks also have to present plans in January showing how they will raise an extra €115 billion in core capital to meet a new threshold imposed by the European Banking Authority. This capital shortfall has already prompted asset sales by banks, which would rather shrink their balance-sheets than tap shareholders. The ECB’s auction may make a credit crunch less severe, but it is not enough to avoid one.

Source: http://www.economist.com/node/21542187