The brave new world of QE Infinity….

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“If the only tool you have is a hammer, every problem looks like a nail”! Abraham Maslow. 

That may well sum up the current predicament of Bernanke and many of his counterparts in Europe with interest rates at record low for about four years now.

After launching Quantitative Easing 1 (known as QE1) of US$1.65trillion and QE2 of US$600bn, to stave off deflation, Fed has now launched QE Infinity to boost employment. It has committed to buy $40bn of agency mortgage-backed securities every month until the labour market improves. An open ended commitment (as he has not been specific on unemployment targets) besides promising to hold the ultra-low rates until mid-2015.

It signals that he is prepared to hold an accommodative policy stance even if economy gains strength and has moved away from the deflation argument. But before we get to analyse the merits and effectiveness of QE Infinity, let’s understand the theory of behind benefits of QE and why some economists seem to worship it.

How does QE work?

QE is an unconventional emergency tool of monetary policy that the Central Banks can use to boost the economy by pumping liquidity into the system. The Central Bank generates fresh amounts of electronic money to encourage lending to businesses. Specifically, the Bank buys assets like Government and corporate bonds with its new cash. The companies selling those assets - usually commercial banks or other financial businesses such as insurance companies - will then have new money in their accounts, which in turn should feed into the wider economy. 

Central banks create money to buy government, and sometimes corporate, bonds, for three main reasons:

• To reduce the cost of borrowing - buying government bonds increases their price and lowers their yield, which in turn puts downward pressure on interest rates across the spectrum;
• To inflate asset prices - with bonds paying out lower interest rates, investors look to buy other asset classes, such as equities, real estate thereby pushing prices up;
• To increase lending - by paying money to banks to buy bonds, the banks then have more money to lend to businesses and individuals.

In theory if QE works, credit growth should pick up and businesses should find it easier to get credit.

How is this different from actions of the 1920s Germany and Mugabe’s Zimbabwe?

Weimar Republic (German Reich) resorted to printing money to finance government debt and war reparation damages. The value of the Papiermark declined from 4.2 per U.S. dollar at the outbreak of World War I to 1 million per dollar by August 1923 and a further slid to 238 million to dollar by November 1923. Following this, new terms were negotiated, a new currency was introduced, at a rate of 1 trillion Papiermark for one Rentenmark, bringing back the US Dollar to 4.2 to a Rentenmark!

More recent actions of printing money were undertaken in Mugabe’s Zimbabwe. In 1980, Zim dollar was worth US$ 1.54. In March 2007, the Z$ 500,000-note was issued, signalling the official arrival of hyperinflation (more than 50% inflation per month). In January, 2009, Zimbabwe issued the one-hundred-trillion Zim dollar note, the largest denomination banknote ever!! It marked the end of the currency. In February 2009, the Reserve Bank of Zimbabwe introduced the fourth Zim dollar, which chopped off 12 zeros. Finally in 2009 the currency was abandoned, a humiliating end.

In contrast the US and the UK are buying asset backed securities and government bonds.  To the extent banks are required to hold government bonds as regulatory liquidity requirements, Central Banks buying of bonds indirectly feeds the government deficit financing, very similar to printing money!

Has it ever worked ?

No. Let's look at Japan’s lost decade(s) - After keeping rates near zero for an extended period, the Bank of Japan finally launched QE in March 2001 and dropped in March 2006. Over the five years, the Bank of Japan increased its outright purchases of longer-dated Japanese government securities driving the call-money rates to zero. The policy helped to stabilise the weak banks but failed to spur growth.

At first, it appeared the program had succeeded in stabilizing the economy and halting the slide in prices. But deflation returned with a vengeance, putting the Bank of Japan back on the spot. Critics say the Japanese central bank wasn't aggressive enough in launching and expanding its bond-buying program—then dropped it too soon. Others say Japan simply waited too long to resort to the policy.

BOJ officials have said quantitative easing wasn't the right tool to fight Japan's deflation, which was rooted in structural problems such as a rigid employment system that failed to eliminate redundant jobs to stay competitive.

Some economists support QE as the right medicine, then why doesn’t it work?

The arguments for QE are based on money multiplier effect. As the available reserves increases, banks ability to lend increases, creating the money multiplier effect leading to economic recovery.  But for this to work economic conditions needs to be different!

Factors that are NOT aiding monetary transmission or lending growth:

1. Banks are over leveraged and capital deficient; additional cheap source of liquidity is helping it to refinance expensive funding and improve profitability; but very little flow through to the real economy;
2. Interest rates have remained low for 4 years and yet demand has been muted, further QE is not going to spur demand;
3. Over leveraged consumer, weak labour market combined with declining home prices have failed to create any new housing demand;
4. Small business are not looking to borrow due to the uncertain economic outlook;
5. Large corporations will borrow more at even lower rates — even though they’re already sitting on mountains of cash.

But such large corporation borrowing won’t create new jobs and may even lead to job losses as they invest their cheaper cash to achieve further economies through mergers and acquisitions. QE1 reduced corporate-borrowing rates by nearly a percentage point; while QE2 succeeded in bringing down corporate rates by only 13 basis points. The law of diminishing returns come into play.

Banks have increased their reserves with the Central Bank rather than use the proceeds of QE for further lending. The average level of excess reserves for banks was roughly $19 billion from 1984 to 2008.  

Since 2008 excess reserves held at banks has swelled to more than $1.5 trillion currently!! As explained earlier, this is due to the combination of lack of demand for credit and overstretched balance sheet of banks.

While the pending inventory has dropped to pre-crisis levels of 6 months, this conceals the housing market weakness as the effects of foreclosure moratorium and pending foreclosures on home owners (estimated at 700,000) is not reflected in this. The average time take to foreclose has also increased from 4 months in to over 12 months. 

Once banks recommence their foreclosure process, the supply overhang will continue. This combined with lack of credit growth will push the housing market recovery further out. 

Quantitative easing didn’t help the Japanese economy, instead it only big Japanese companies and the current experience will be no different.

Do QE programmes have any effect on employment…

The chart shows net gains in employment since beginning of 2009 as compared to the number of individuals that have moved into the "Not In Labor Force" category where they are no longer counted. While there was an increase of 3.4 million jobs since the financial crisis, that is far lower for a sustainable economic recovery.  At the same time, more that 8.4 million have either "given up" or "retired" during that period. The decline in unemployment rate to 8.3% is partly as a result of a fall in workforce participation.

There is NO evidence that bond buying programs have any effect on fostering employment. However, at the current rate of individuals leaving the work force, Bernanke is likely to achieve low unemployment rate in the next few of years!  Of course, economic prosperity will have deteriorated much further as the rise of the "welfare state" persists.

The charts below show the number of individuals, since 2009, who are now claiming disability and food stamps and the increase in welfare costs.

If core inflation is benign, what is the harm in pursuing QE?

The Federal Reserve claims QE is not a problem because "core inflation" has been relatively contained. But core inflation excludes food and energy prices, which are two of the biggest components of consumer budgets and have been rising. On top of that, the average US household income has declined by over 9% since the onset of recession. As a result, food and energy consume more of wages and salaries it leaves less available for consumption within other areas of the economy. The chart below shows the consumer conundrum where declining wages meet up with rising costs of food and energy. With recent severe drought in the US food prices will only rise further. Of course, the USD benefits from its status as a reserve currency that offsets potentially severe outcomes.

 

The important point is that for businesses to hire require an increase in aggregate end demand. Rising inflationary pressures in food and energy prices only act as depressants to discretionary consumption thereby reducing the need for employers to expand capacity.  It is unlikely that the Fed's purchases of mortgage back securities will spur businesses to expand.  The inflation expectation has also risen above 2 per cent and there is little justification for additional QE at this point.

Conclusion

While QE will push liquidity into the equity markets thereby inducing higher asset prices - it will do little to help the economy, employment or housing.  Money will chase anything that is perceived as a “hard asset.” Industrial metals have already risen by 16.6 per cent since early August. The S&P is near all time highs, but if viewed in terms of gold it is 61 per cent below its 2007 high. Fed is engaged in debasing the dollar and this leading to competitive devaluation from other Central Banks (Japan has reacted). 

Monetary policy has a very limited reach economically and cannot be a substitute for fiscal policy measures that are required to promote economic growth.  

With the consumer sentiment weak, unemployment high, foreclosures and delinquencies still burdensome, and businesses constrained by lack of demand - there is little desire or need and even if there was, the banks are too constrained to lend.  This is unlikely to change anytime soon even as businesses are forced to pullback as demand is further reduced by rising inflationary pressures.

The lack of employment, lower incomes, excess debt and poor credit history will keep a large chunk of the population from qualifying to avail a mortgage for quite some time.  If the lowest mortgage rates in history could not lead a housing market recovery, there is little likelihood that a few more basis points will do the trick.

With QE Infinity, Bernanke is determined to pump up the US economy, full throttle. Be prepared for the next asset bubble burst, only this time it’s going to be a lot bigger and a lot more painful! 

TAMING THE BANKS – AN ELUSIVE GOAL?

Five years since the financial crisis broke and a trillions dollars later, you would be forgiven for thinking that enough has been done to restore the financial system and the banks to pristine health. Nothing could be further from that!

Subsequent to the various tax funded bail outs of various financial institutions in almost all the major western economies, one would have thought that the banks would have learnt their lessons. If recent revelations on libor fixing, swap mis-selling, weak money laundering processes or humungous trading losses are anything to go by, obviously not!

Bob Diamond, ex-CEO of Barclays famously said to the Treasury Select Committee in Jan 2011 that the time for remorse was over.  He will be ruing that statement now.

Banks have been handed significant financial penalty in recent weeks but very little of personal accountability is being assigned by the regulator other than moral suasion or by the media outcry.  ING Bank was fined c $600m, Barclays was fined c$500m and it is rumoured that HSBC may be fined a whopping $1bn.  Other banks including BoFA, Citi, Deutsche, JP Morgan etc are under investigation and are most likely to fined as well for their failures over the coming weeks and sadly may not lead to much more than that.  

What this shows is the systematic manner in which corporate greed has eroded the moral fabric of these institutions. The regularity with which we hear of repeated failings in banks, it is obvious that the banks have become ‘too big to manage’.

And if you now thought enough was enough, what are your real choices? Precious little! Competition has been eroded by mega mergers and what we now have is oligopoly. 

So where are we now? The short answer is ‘between a rock and a hard place’! 

How did we land up here?

The ‘light touch’ regulation and the new set of accounting standards for measurement of financial instruments (introduced in 2005) provided a potent playfield to create weapons of mass destruction to fuel the corporate greed.  This combined with the pressure to deliver quarter on quarter earnings growth and the pressure to beat analysts estimates further reinforced the perverse behaviour.

The ability to recognise revenue upfront on long-term products through product structuring was a strong incentive for bankers. Skewed incentive structure resulted in structuring financial products to enable up-front recognition of income facilitated by new accounting standard (IAS39)!

As bankers’ variable compensation is linked to annual performance, early recognition of income leads to a culture of creating more complex structured products. This has lead to mis-selling claims as customers were not offered vanilla products or were lured into structured products by overegging the benefits.

A classic example is the current mis-selling claims of swaps to SME's - bundling of interest rate swap with term loans. A simple term loan product was structured as a floating rate loan with an interest rate swap overlay to facilitate instant revenue recognition by loading the margins on the interest rate swap.  Banks have systematically taken advantage of this accounting asymmetry.  In many instances swaps were offered as a free product on a floating rate loan as a hedge to these unsuspecting and often uninformed customers.  This is not to say that swaps per se are inappropriate as they are a good risk management tool but should be sold where appropriate rather than to unsuspecting and unsophisticated customers. 


Even the CDO market was created on the bank of sub-prime and other mortgage loans with the aim of creating marketable securities to accelerate revenue recognition with devastating effect as the greed took hold and underwriting standards were non-existent. 

Let’s take a look on what has been done by the regulators and how effective it has been thus far and what else is coming…

Recapitalisation of banks

Soon after the financial crisis several financial institutions were recapitalised by Treasury (in most markets) and saved the financial sector from falling abyss.  Banks promptly got back to their old ways, started helping themselves by reestablishing their variable compensation.  Conservation of capital or boosting lending for economic recovery was a secondary objective!

Monetary policy actions have run out of steam…

The monetary policy of the central banks has resulted in a near zero interest environment and significant inflation of the balance sheet of the major central banks.  Neither of these actions has resulted in any perceptible impact on economic growth but it is widely believed that these actions have certainly helped in preventing a deeper recession.

The low interest rate regime has helped with greater disposable income for borrowers but that has not resulted in increased consumer spending.  So far both banks and the customers have been actively deleveraging.  And this could go on for a few years!  At the same time the low interest rates are hurting the savers and the pensioners.  There is a significant wealth shift from savers to borrowers and our pensions are not going to be worth that much.

An avalanche of new regulations…

In order to regulate the banks in a more effective manner, the regulators around the world have been busy developing a raft of regulations that is coming thick and fast! The Basel 3 or CRD IV directive covering new capital and liquidity requirements for banks will mean that banks will need several billions dollars more in capital to meet and more than a trillion dollars of liquidity to meet the new norms. There are several other regulatory initiatives, which take cumulatively would push any hopes of an economic recovery into oblivion. Some of these are:

·                     Volker’s Rule or the Dodd-Frank Act

·                     Vickers Report for UK banks to ring fence retail banks

·                     Crisis management directive – Resolution Plans or Living Wills

·                     Centralised Clearing House for swaps

·                     Significant increase in regulatory reporting requirements

·                     Retail distribution review

And there are some regulations that have much stronger impact than the others.  It’s important for the regulators to prioritise the order in which some of these regulations to take effect to achieve the twin objective of putting the fire out and redesigning the house for the future.

The current penchant for a raft of regulations aimed to minimise risk taking may cumulatively just achieve that, minimal risk taking!  As the Chinese saying goes, be careful what you wish for!

Regulators need to be cautious, lest the medicine may become the ‘poison chalice’.

While it is essential to make the banking system safer to avoid future tax payer funded bail-outs, this can be achieved differently.  Increasing capital requirements now is akin to designing a new fire resistant house while the current one is on fire!  Instead of focusing on putting out the fire first and then rebuilding the house, the regulators are leapfrogging to create a safer banking environment.

  

Basel 3 is driving banks to conserve capital

The Basel 3 capital requirements raises the core capital requirements to north of 10% (including various buffers) from the current 4% equity and hybrid capital and 8% in total.  In practice the impact is far greater when taken together with the regulatory deductions from capital and increase in risk measurements for trading risk and certain types of risks in the portfolio. The cumulative effect of the above is an increase in capital requirements by about 3 to 5 times from existing levels depending on the institutions asset risk profile.

Banks are in the business of taking risk and do this through both credit extension and maturity transformation. By significantly raising the capital requirements, the credit extension is effectively blunted and by stipulating stringent liquidity norms, the maturity transformation is also severely impaired.

This increased requirement is stifling banks from supporting trade and finance. Banks are actively deleveraging in order to meet the new capital requirements.  Even as  the cost of capital and liquidity have risen resulting in squeezed margins,  the business volumes have significantly shrunk resulting in depressed profitability and limited core equity generation.

Why would anyone provide more capital to an industry stuck in a quagmire of regulations, declining earnings, poor returns on equity, uncertain economic climate and an uncertain future?

….It’s the Capital, Stupid

The Central banks’ are too consumed by monetary aggregates and inflation figures.  They are busy administering increased liquidity measures through their Asset purchases, Long term repo’s (LTRO’s and Operation Twists) and Quantitative Easing hoping that more liquidity will lead to more lending.  Whilst all this is helping liquidity and driving interest rates, it is not providing any impetus to lending.  As lending would result in increased capital requirements at a time when capital is scarce, banks are rightly focused on deleveraging.

So, it is important for regulators to appreciate this and sequence the regulatory changes with the foremost objective of boosting lending to support the economy and even while addressing the safety issues.

It is time the central bankers started focusing on addressing capital requirements of banks.  No amount of increased liquidity is going to encourage the capital starved banks into lending!

…more capital is not a panacea

More capital will only mean that a bank can lose more money before going broke.  Under deployed capital is an equally a bad outcome with cost of credit increasing to ensure adequate returns on capital. 

A set of simple regulations with more effective supervision that aims to instill a strong risk culture that curbs excessive risk taking, significant disincentives for senior management failure will be far more desirable. 

What can be done?

While Quantitative easing has kept the interest rates low, it could have delivered a far greater impact if the Central Banks created a ‘Special Assets Vehicle’ to buy risk assets off the bank.

Special Assets Vehicle

A vehicle funded by the Central Bank can start buying illiquid assets (not necessarily bad assets) from banks at an ‘arms length’ price.  These assets unwind over time as the underlying loans amortise. 

This would alleviate both liquidity and capital in banks, thereby creating capacity for new lending. Ultimately, if banks have to get strong, economy has to fire again and if the economy has to fire again, banks have to start lending!  The situation now is neither is happening and we are in the danger of getting into a downward spiral loop!

….some immediate priorities

Instead of spending endless hours to debate and construct a comprehensive regulatory regime that is leading to more uncertainty stifling new capital for banks, it would be far more beneficial if the immediate focus was on the following:

·             set up a special assets vehicle and buy illiquid assets off banks using quantitative easing (can set strict credit criteria for loans to be bought);

·       enforce a risk culture and ensure Boards of Banks are represented adequately by risk professionals who can set and monitor risk appetite;

·               hold senior management accountable for failure;

·             levy stiffer penalties including criminal prosecution in case of fraud and systematic abuse like money laundering or mis-selling;

·            set prudent guidelines on executive compensation that does not encourage excessive risk taking and has a sufficiently large deferred component that is linked to long term performance;

·                have claw back provisions for failure including docking of pensions;

·               leave the quantum capital at a level of 8% and focus on quality of capital i.e. equity;

·       enforce robust resolution plans including setting sufficient bail-in’able debt to cushion losses;

·             use macro prudential filters to curb excessive risk than stipulating higher capital minimums for all banks… a one size fit all approach is counterproductive.

Having prudent compensation guidelines and strict rules to curb gaming of tax, accounting and regulations alone would have more salutary effect than oodles of regulation! 

And once the dust settles, that would be time to revisit and design a more robust financial framework. The aim should be to have a financial sector that ring fences activities that are raison d’être of banks i.e. of providing payment services, savings and lending products to clients and customers.  And a framework where customers have a choice!  A call for back to simplicity!

The law makers should then take steps to dismantle the ‘too big to manage’ and ‘too big to fail’ institutions that may eventually address the big goal of ‘taming the banks’!

As Gertrude Jekyll, a British horticulturist once said, “There is no spot of ground, however arid, bare or ugly, that cannot be tamed into such a state as may give an impression of beauty and delight.”

She certainly wasn’t thinking of banks!

Leadership Series - Part 3

The Five levels of Leadership

John C Maxwell wrote on the Five levels of leadership explaining the source of a leaders following.  From a base level of power lead followership to the more evolved level of inspired followership, leaders operate at different levels. 

I shall briefly cover the five levels of leadership and also discuss how to become a Level 6 leader.

Level 1 – Position (Rights)

At the base level of leadership, the key is the position; at this level people follow because they have to follow, because the leader is the ‘boss’. The Level one of leadership derives followership because of the authority that is given to the leader and the position, without which the person can’t lead.  This level of leadership is essentially hierarchical and often prevalent in the bureaucracy, defense forces and political parties.

Level 2 – Permission (Relationship)

The leader operating at this level focuses on building relationship with the people. In order to enhance their leadership they strive to develop a relationship and this often results in people wanting to follow. Leader likes the people and the people begin to like the leader and are ready to move the next mile. So in this level leader’s ability to connect with people is very important. 

Level 3 – Production (Results)

Leaders who drive results develop following because they ooze confidence and positivity. In this level the people follow because of the leader’s outstanding contribution to the organisation.  They start to talk about the leader in term of the organization’s results. In Level 3 the leader starts to taste the feeling of success and a winning atmosphere and is seen as a person who can make things happen.  Leader’s in commercial organisations enjoy this form of followership when the results of the entity are in a continuous uptrend.

Level 4 – People Development (Reproduction)

At this level, people follow because of what the leader has done for them, they love to follow the leader because of the interest the leader takes in developing them and the leader is feeling happy because the people are doing better, and become loyal to the leader and gives the leader the credit.  This form of leadership is prevalent in academia.

Level 5 – Pinnacle (Respect)

At this level, people follow you because who you are and what you represent, it's the personhood level.   The level-five leader, the Builder, strives not to reach a goal but to build an institution. Builders are legendary leaders such as IBM's Tom Watson Jr., Apple’s Steve Jobs, GM's Alfred P. Sloan, and Harpo's Oprah Winfrey. These people serve their institutions by managing for the long term and not allowing themselves to be seduced by the twin mirages of short-term profit or stock market valuations. They have a grand vision for the future of their organizations, and they infect others with their energy, enthusiasm, and integrity. These are the leaders we write books about, study, try to understand, and lionize.

The leader at level 6 – Transcendental

Making a difference

Builders are few and far between, but there is an even rarer type of leader who transcends the Builder: the Transcendent. Level-six leaders transcend their political party, their ethnic or racial group, and even their institutions. They focus on how to benefit all of society and are "global citizens,".

Leaders at this level are motivated by the need to make a difference to the world. They’re interested in creating mutually beneficial partnerships and strategic alliances with other individuals or groups who share the same goals. They will work with customers and suppliers and produce win-win situations.

They are active in the local community, building relationships that create goodwill. They know how important it is to look after the environment, going beyond mere compliance to operate in an ethical and environmentally-friendly manner. They also recognise and demonstrate inclusiveness in all their work.

When dealing with people, they display empathy, and actively find ways to help their staff find personal fulfilment in their work. They create a nurturing working environment where people can excel, mentoring and coaching staff, to build a pool of talent for the organisation. Their values are so embedded in their personalities that they make decisions intuitively.  Level 6 leaders are at the top of their game. They are true servant leaders.

There is no better example of what it really takes to be a Transcendent than the first black president of South Africa, Nelson Mandela. He was able to soar above hatred for his white jailers, the political tug of the African National Congress, the pull of his racial and tribal group, and the rejection by the Afrikaners to build a South Africa for all South Africans. Now in his 90s, he is perhaps the world's greatest living leader.  Nelson Mandela’s leadership is so beautifully captured in the movie ‘Invictus’ where Morgan Freeman brings it out so powerfully.

The Dalai Lama, another Transcendent, mentioned that the first thing he does in the morning after he finishes his prayers is to ask himself, "How can I help to make the world better today?"

Imagine if our senior political and business leaders started their day by asking that question and acting on the answer.  The world would be a much better place!