BALANCE SHEET EXERCISE

AM | @MackinlayEuruni


QUESTION. READ FIRST AND ‘LOCATE’ PROBLEMS IN THE BALANCE SHEET: DOES IT AFFECT ASSETS? DOES IT AFFECT LIABILTIES? DOES IT AFFECT BOTH?. AS YOU PROVIDE ANSWERS, WE PLOT THE POINTS INTO THE BALANCE SHEET.

(1) “Many banks are struggling to fund themselves as Europe’s debt crisis deepens” (David Oakley: “CDS highlights funding worries”, Financial Times, October 5 2011).

(2) “Austrian banking supervisors have instructed the country’s banks to limit future lending in their eastern European subsidiaries … The government is concerned about losses in eastern Europe –where they are the biggest lenders- and their exposure to Italy … Erste Bank, Raiffesen Bank and Bank Austria have a CEE exposure that exceeds Austria’s GDP”. (Eric Frey: “Austrian banks ordered to limit central and east Europe exposure”, Financial Times, November 22 2011).

(3) “Many European banks have been shut out of traditional funding markets in recent months, forcing them to rely on central banks for liquidity or to become more creative in obtaining new financing amid market turmoil. Accordingly, some of the strongest UK banks are providing strained European lenders shut out of global funding markets with large amounts of financing. The deals average €200-€500m in size, with maturity dates of two to 10 years. However, amounts of up to €1bn have also been heard. ‘Haircuts’, or collateral taken to protect the lender from adverse movements, were very high, at 15 to 25 per cent or more”. (“Tracy Alloway: “Europe’s banks strike funding deals”, Financial Times, November 24 2011).

(4) “Some banks in countries such as Spain and Italy are finding it harder to secure euro funding from conventional sources amid concerns about a possible Greek sovereign debt default, and in the face of deep skepticism from foreign banks. One measure of the pressure on Spanish banks in particular was their net borrowing from the European Central Bank, which increased sharply to average €6992bn in August, from €52.05 in August, according to figures from the Bank of Spain” (Victor Mallet: “Small banks remain in need of funding”, Financial Times, October 5 2011).

(5) “The onslaught on European banks is unremitting. In the latest setback for banks in Europe, Moody’s Investors Service has put the subordinated debt of nearly 90 per cent of them under review for a possible downgrade. No surprises here: European sovereigns have limited appetite or ability to support them, let alone bondholders. But the warning highlights the risk of a European credit crunch as banks shrink assets and as they struggle to fund those assets”. FROM THE CHART: Italy’s Unicredit pays a 700 basis point spread in the interbank market; Santander is at 480 bps, while Barclays stands at 201 bps. (Lex: “Euro bunch of losers”, Financial Times, December 1 2011).

(6) “Mario Draghi, ECB president, told the European Parliament last week: We have observed serious credit crunch tightening which, combined with a weakening in the business cycle, does not bode at all well for months to come. Small and medium-sized companies are being the hardest hit. The most important thing for the ECB is to repair the credit channel” (Ralph Atkins: “ECB sets sights on shoring up banks”, Financial Times, December 5 2011).
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FINANCIAL CRISIS, FLIGHT-TO-QUALITY AND THE DOLLAR PROBLEM

AM | @MackinlayEuruni

. The Role of the Dollar as the key international reserve currency. Understanding the banking crisis: a (brief) look at the US dollar as the key international reserve currency. 1945-1973: Germany & Japan; 1978-2007: China. The stock of productive capital destroyed; authoritarian political culture. The solution: LOW COST OF LABOUR through a fixed (and undervalued) local currency against the dollar.

 . China’s economic development model. In order to avoid an exchange rate adjustment, China recycles its foreign-exchange reserves into the US credit market. [QUESTION: IMPACT ON THE US CREDIT MARKET??][CHART] [Annex to the Federal Reserve’s Weekly Balance Sheet]. Michael P. Dooley, David Folkerts-Landau & Peter Garber: “An Essay on the Revived Bretton Woods System”, NBER Working Paper 9971 (2003).

. Psychology & Markets: Attitudes toward risk. US credit markets flooded with cash! Jacques Rueff. Le péché monétaire de l’Occident. Paris: Plon, 1971:

The process works this way. When the U.S. has an unfavorable balance with another country (let us take as an example France), it settles up in dollars. The Frenchmen who receive these dollars sell them to the central bank, the Banque de France, taking their own national money, francs, in exchange. The Banque de France, in effect, creates these francs against the dollars. But then it turns around and invests the dollars back into the U.S. Thus the very same dollars expand the credit system of France, while still underpinning the credit system in the U.S. The country with a key currency is thus in the deceptively euphoric position of never having to pay off its international debts.

The money it pays to foreign creditors comes right back home, like a boomerang … The functioning of the international monetary system is thus reduced to a childish game in which, after each round, the winners return their marbles to the losers … The discovery of that secret [namely, that no adjustment takes place] has a profound impact on the psychology of nations (la psychologie des peuples) … This is the marvelous secret of the deficit without tears, which somehow gives some people the (false) impression that they can give without taking, lend without borrowing, and purchase without paying. This situation is the result of a collective error of historic proportions.
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FLIGHT-TO-SAFETY: SOME FOOD FOR THOUGHT

AM | @MackinlayEuruni

The F-t-S episode triggered by the collapse of Lehman Brother and by the European debt crisis has reached such proportions that more and more scholars, regulators and journalists are turning to the question from a variety of points of view. Here's a brief review of some of the most recent material.

. John Coates. The Hour Between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust. Penguin, 2012 [info] [VIDEO]. See review by Clive Cookson: "The biology of banking", Financial Times, May 19-20, 2012.

. Paul Ormerod. Positive Linking. How Networks Can Revolutionise the World. Faber & Faber, 2012 [info]. See review by Claire Jones: "When copying others is the rational choice", Financial Times, July 9, 2012.

. Akerlof, George A. & Schiller, Robert A. Animal Spirits. How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism (Princeton University Press, 2009) [see]

. Turner Review. A regulatory response to the global banking crisis (London: Financial Services Authority, 2009). See p. 41: “Individual behaviour is not entirely rational. There are moreover insights from behavioural economics, cognitive psychology and neuroscience, which reveal that people often do not make decisions in the rational front of brain way assumed in neoclassical economics, but make decisions which are rooted in the instinctive part of the brain, and which at the collective level are bound to produce herd effects and thus irrational momentum swings”.

. J. M. Coates & J. Herbert: “Endogenous steroids and financial risk taking on a London trading floor”, Proceedings of the National Academy of Sciences, April 2008 [Judge Business School, University of Cambridge, Cambridge CB2 1AG, United Kingdom ; Cambridge Center for Brain Repair, University of Cambridge, Cambridge CB2 0PY, United Kingdom]. Edited by Bruce S. McEwen, The Rockefeller University, New York, NY, and approved November 6, 2007 (received for review May 1, 2007). Abstract: Little is known about the role of the endocrine system in financial risk taking. Here, we report the findings of a study in which we sampled, under real working conditions, endogenous steroids from a group of male traders in the City of London. We found that a trader's morning testosterone level predicts his day's profitability. We also found that a trader's cortisol rises with both the variance of his trading results and the volatility of the market. Our results suggest that higher testosterone may contribute to economic return, whereas cortisol is increased by risk. Our results point to a further possibility: testosterone and cortisol are known to have cognitive and behavioral effects, so if the acutely elevated steroids we observed were to persist or increase as volatility rises, they may shift risk preferences and even affect a trader's ability to engage in rational choice.

. Roger Boyes: "Age of Testosterone comes to end in Iceland", TimesOnline (February 7, 2009). Iceland, ravaged throughout history by volcanic eruptions and natural catastrophes, is struggling with a man-made disaster so overwhelming that the women are taking over. It is, they say here, the end of the Age of Testosterone. Next week a newly minted left-leaning Government led by Johanna Sigurdardottir will start to tackle the tough agenda of cleaning out the old-school-chum networks that have led Iceland to the verge of bankruptcy. Half of her Cabinet will be women; female advisers carrying briefcases move in and out of the Prime Minister's whitewashed office, a former jailhouse in the middle of Reykjavik. Two women, Birna Einarsdottir and Elin Sigfusdottir, now run the struggling and disgraced New Landsbanki and New Glitnir banks. We have to create a new sense of solidarity,” says the Social Democrat Prime Minister. The departing Government — retreating would be more precise — put business first, people second, say the premier's counsellors. Now is the time for a shift in values. Listening to Ms Sigurdardottir talk in her dry, schoolmistress manner, it becomes clear that the fall of the Icelandic Government was not just the first political casualty of the global downturn, but also a signal that men in suits have led the world astray. “We are going to base our economic policies on prudence and responsibility, but we also stress social values, women's rights, equality and justice,” she says. “You can see what is happening,” says Katrin Olafsdottir, Associate Professor of Economics and a member of the board of New Glitnir, which is trying to devise a new mission for the crippled bank. “The men went out there and took these incredibly irrational risks — and getting loads of money for doing it, feeling really good about it - and then the women have to come in to clean it up.”
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UNDERSTANDING CREDIT MARKETS: FLIGHT-TO-SAFETY!

AM | @MackinlayEuruni

When Lehman Brothers declared bankruptcy on September 15 2008, one money-market fund that had lent as much as $785 million to Lehman declared that it was unable to pay the full amount of its liabilities. It was the first time that such an event took place! Investors promptly took $40 billion out of that fund. NOW EVERY PARTICIPANT IN THE CREDIT MARKET STARTS TO FEAR ABOUT THE SOLVENCY OF EVERYBODY ELSE!!! WHO HAS LENT TO LEHMAN? WHO HAS INSURED THOSE WHO HAVE LENT? ETC. ETC. ETC.

This feeling of general distrust sets in motion a flight-to-quality episode in credit markets. Let us see how that works. Imagine one Ms. De Souza, a 37-year old hospital manager in Sao Paulo, Brazil. A mother of two, she wants to send her children to a US college. She needs to very cautious about her $400.000 nest egg! She watches the Lehman news on TV; she reads the newspapers. She starts to worry. “What if my investments in loans to companies both in Brazil and the US decline in value as banks refuse to lend to private companies? What if my investments in loans to emerging market states decline in value as global economic trade and growth falls, forcing some states to default on their debt?” She makes up her mind and calls her broker in Sao Paulo, with three very precise instructions:

1. Stop all lending to entrepreneurs, wherever they are located

2. Stop all lending to sovereign issuers from emerging markets countries

3. Invest all the available resources into loans to the US Federal government, or to the German government.

The behavior of our hypothetical Ms. De Souza is replicated worldwide. Many investors react exactly like her: in Russia (INVESTING IN GERMAN BUNDS), in Thailand, in the Netherlands, etc. Now remember the paper from Horace Brock (Session 1): INTEREST RATES CHANGE WHENEVER NEW INFORMATION ALTERS THE BEHAVIOR OF EITHER/OR THOSE WHO SUPPLY LOANABLE RESOURCES AND THOSE WHO DEMAND CREDIT. The Lehman Brothers bankruptcy IS INDEED NEW INFORMATION! Interest rates are bound to change. But how? Let us look at two different kinds of credit markets: (a) sovereign borrowers; (b) corporate borrowers. 

(a) Sovereign borrowers (national governments). They can be further divided into two categories. Some countries that feature an institutional framework that protects the performance of contracts (rule of law, stable property rights, judicial independence). That list would include: US, UK, Canada, Germany, The Netherlands, Japan, most Nordic countries, Switzerland, etc. These tend to be perceived as risk-free borrowers.

(b) Corporations (companies). Unlike sovereign issuers, private companies are unable to impose taxes; their solvency is at risk whenever the economy goes into a prolonged recession.

Note that the definition of “risk-free” is not set in stone. The USA were very risky issuers of debt between 1776 and 1783! Nowadays, some emerging-market countries have made phenomenal progress in terms of property rights protection and credit market sophistication (Brazil, Singapore and South Korea come to mind here). BUT GENERALLY SPEAKING, FLIGHT-TO-QUALITY EPISODES TEND TO END UP WITH LOANABLE RESOURCES BEING REDIRECTED TO SOVEREIGN BONDS OF COUNTRIES WITH INDEPENDENT CENTRAL BANKS, JUDICIAL INDEPENDENCE, RULEOF LAW, ETC.

[DIAGRAMS. WE PLOT CHANGES IN THREE CREDIT MARKETS]

(a) AT EACH LEVEL OF THE INTEREST RATE, SUPPLIERS OF LOANABLE RESOURCES SUPPLY LESS IN THE ENTREPRENEURS CREDIT MARKET: THE INTEREST RATE GOES UP.

(b) AT EACH LEVEL OF THE INTEREST RATE, SUPPLIERS OF LOANABLE RESOURCES SUPPLY LESS IN THE CREDIT MARKET FOR RISKY SOVEREIGN BORROWERS: THE INTEREST RATE GOES UP.

(c) AT EACH LEVEL OF THE INTEREST RATE, SUPPLIERS OF LOANABLE RESOURCES SUPPLY MORE IN THE CREDIT MARKET FOR RISK-FREE SOVEREIGN BORROWERS: THE INTEREST RATE GOES DOWN.

A FLIGHT-TO-QUALITY EPISODE OCCURS WHENENVER EVENTS (a), (b) and (c) take place.
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Credit spreads

Credit spreads are important financial and economic indicators. Credit spreads are simply the difference between two interest rates, one from a risk-free credit market and the other from a risky credit market.

(a) Credit spread between entrepreneurs’ and risk-free credit markets. Example. In the USA, the so-called “junk bonds” are credit contracts issued by entrepreneurs (see here). The risk-free credit market is the Treasury debt market – that is, debt issued by the US Federal government. If the interest rate for entrepreneurs is 6.70% and the interest rate for US Treasury debt is 1.86% (see), then the credit spread is 6.70% minus 1.86% = 4.84% [Note: these rates change every day, every hour, every minute!] 

(b) Credit spread between sovereign emerging market debtors and risk-free credit markets. Example. The average interest rate paid by risky sovereign issuers in emerging markets is currently 5.30% (see). The risk-free credit market is the Treasury debt market – that is, debt issued by the US Federal government. If the interest rate for risky sovereign emerging markets issuers is 5.30% and the interest rate for US Treasury debt is 1.86% (see), then the credit spread is 5.30% minus 1.86% = 3.44% [Note: these rates change every day, every hour, every minute!]

DURING A FLIGHT-TO-QUALITY EPISODE, CREDIT SPREADS TEND TO WIDEN, AS INTEREST RATES IN RISKY CREDIT MARKETS RISE, WHILE INTEREST RATES IN RISK-FREE CREDIT MARKETS DECREASES.

[CHARTS: JUNK BOND SPREADS]

NEGATIVE INTEREST RATES? ON DECEMBER 19, 2008, THE US 3-MONTH TREASURY BILL GOES NEGATIVE. WHAT DOES THAT MEAN?
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The Horace Brock Paper

Horace Brock: "Determinants of interest rates", in Boris Antl (ed.). Management of Interest Rate Risk (London: Euromoney Publications, 1988].

An ‘extended’ law of supply and demand 

How do we analyze the determinants of interest rate movements in today’s deregulated, globalized environment? What paradigm is most appropriate? We shall argue that the complexities of today’s environment require that we analyze interest movements in what can be called an ‘extended’ law of supply and demand in the credit market. Although this approach is both theoretically correct and intuitively appealing, it is surprisingly unfamiliar to market participants as well as to many who construct forecasting models.

Surprisingly, one reason this is true is that most people do not understand what the law of supply and demand means in a credit (as opposed to a money) market context. In this regard, shifts in credit supply and demand are often mistakenly identified with changes in economic flow-of-funds. In other instances, supply and demand considerations are incorrectly seen as incompatible with more important ‘psychological’ factors. This chapter will clarify the true meaning of supply and demand in today’s deregulated credit market. In doing so, it will demonstrate how the extended law of supply and demand is able uniquely to explain numerous dramatic events in credit markets.

The extended law of credit supply and demand Exhibit 1 [not reproduced here] shows the working of today’s credit market. On the left are those who ‘lend’. Note that the central bank fits in here in a natural way via its open market activities that provide bank reserves to the banking system. As the diagram indicates, it is the banks that provide credit — not the central bank.

How do interest rates change within this framework? They change when the behavior of borrowers and lenders/investors changes. But what do we mean by a ‘change of behavior’? Understanding this concept is the key to everything. The ‘supply schedule’ here can be best thought of as the nation’s aggregate ‘willingness to lend’ schedule (foreign lending is included). This schedule depicts the total amount of funds that will be made available at any given nominal interest rate. Naturally, the higher the interest rate, the more credit will be made available, other things being equal. Hence the schedule has a positive slope. A parallel analysis holds for the demand schedule, although in this case the quantity demanded decreases as the price rises. Equilibrium occurs at the point of intersection of the two schedules.

Changes in interest rates
As the state of the world changes, the aggregate willingness to lend at any given interest rate (say € 500bn annually at a 5% interest rate) will change. It will either increase or decrease. For example, if inflation escalates, people might only be willing to lend € 400bn at the same 5% nominal rate. But as this decrease will be true for any and every level of interest rates, the entire schedule clearly shifts backward. It is this ‘functional shift’ (of the schedule) that causes interest rates to change.

Why do we emphasize this point? Because it is often misunderstood. For example, suppose you hear that ‘mortgage credit demand has increased’. Does this constitute a ‘change’ that will lead to an increase in interest rates? Not necessarily. If the increased demand is itself simply a response to a lower interest rates, then this increase represents a shift ‘along’ the given demand curve. It is only when demand is greater or lesser at a given interest rate that the entire schedule shifts, and this that interest rates can and do change.

Document 3: Sweden & the bond market

“Corporate Debt to Surge in Sweden as Bank Credit Dries Up”, Bloomberg News

By Adam Ewing and Meera Bhatia

Sweden’s corporate bond market is poised for a surge this year as companies abandon an “extreme”reliance on bank loans amid stricter capital rules, said Mats Carlsson, who heads the investment bank Pareto Ohman AB.

“The banks will be more conservative with their lending, while at the same time there will still be the same demand from companies,” Carlsson, who became chief executive officer at Pareto Ohman in July, said in an interview in Stockholm. “Supply will diminish and demand will grow.”

Sweden’s government wants the country’s lenders to target more rigorous capital standards than those set by the Basel Committee on Banking Supervision and has set a deadline that’s six years earlier than Basel’s 2019 goal. As the cost of bank credit rises, firms are seeking alternatives. With Swedish companies now relying on banks for 80 percent of their debt financing, versus about 30 percent in the U.S., the scope for a surge in corporate issuance is considerable, Carlsson said.

So far this year, Swedish corporates and municipalities have issued 34.8 billion kronor ($4.9 billion), bringing sales to 11 percent of the amount sold in 2011, according to data compiled by Bloomberg. Among the main issuers were Securitas AB, a security and alarm company, which this month sold 400 million kronor in three year notes at 3.45 percent interest. TeliaSonera AB sold 1.1 billion kronor in debt on Jan. 13. The figures only reflect krona-denominated sales.

“We expect more and more companies to come to the market for financing and to try to find other financing sources,”Magnus Nilsson, a Stockholm-based fund manager at Catella Fondforvaltning AB, which manages $1 billion in fixed income assets, said in an interview.

According to Daniel Sachs, the chief executive officer at corporate bond investor Proventus, this year will see a greater demand from Swedish corporates to sell their bonds than there will be a supply of credit.

Document 2: Speech by Mario Draghi

Speech by Mario Draghi, December 15, 2011

To explain our recent monetary policy measures, let me recall the particular role of banks in the euro area economy. The flow of credit to firms and households in the euro area works largely through banks. During recent years, about three quarters of firms’ external financing have come from that source.

This means that any impairment in the bank lending channel will have stronger consequences in the euro area than in other economies where firms’ external financing comes largely from corporate bond markets.

Banks in the euro area have recently come under pressure both as regards their capital bases and their funding conditions.

The plan to strengthen their capital bases is an attempt to reinforce their standing in financial markets, but this is not an easy process. There are essentially three options for banks to pursue to raise their capital ratios as demanded by the European Banking Authority: they can raise their capital levels, sell assets or reduce their provision of credit to the real economy.

The first option is much better than the second, and the second option is much better than the third. But raising capital levels is expensive in a depressed market and faces resistance from shareholders. Selling assets is less preferable and curtailing credit to the real economy is even worse. Therefore, public authorities ought to cushion the impact on the real economy and banks should consider restraining dividends and ad hoc compensation to strengthen buffers.

Banks are also facing problems in raising longer-term funding in financial markets. The resulting shortening of their funding leads in turn to maturity mismatches on balance sheets of the kind that caused the financial crisis.

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Document 1: Globalization of Banking

The IMF on the Globalization of Banking

http://www.imf.org/External/Pubs/FT/GFSR/2007/01/pdf/text.pdf

Although no one indicator fully captures institutional globalization in all its aspects and forms, one telling illustration is the volume of cross-border M&A in the financial sector. M&A activity in the financial system has risen sharply since 2000, with crossborder M&A increasing from less than 1 percent to nearly 40 percent of the total value of financial sector M&A activity from 1997 to 2006.

Institutions have internationalized for a wide range of reasons, including expectations that knowledge and efficiencies in undertaking business and underwriting risk in one market can be transferred into others; that economies of scale and scope can be achieved when operating multi-country operations; and that a crossborder group can better allocate a large and stable capital base profitably across business lines to those where profitability is expected to be greatest, while also diversifying risk.

Cross-border expansion into emerging market (EM) countries has often been particularly appealing. Emerging markets have been seen as offering the prospect of faster business and profit growth, especially given the relative underdevelopment of their financial markets and institutions. For many emerging European countries, the prospects of closer economic integration with the European Union—including through EU accession and eventual membership in the euro area—have been a significant driving force in this regard. Of all types of financial institutions, Banks are most active in pursuing an international presence. One measure of the rapid internationalization of banking in recent years is the rising number of foreign claims (loans made and deposits placed externally) of Bank for International Settlements (BIS) reporting banks. The increase in foreign ownership was particularly rapid in Eastern Europe, where the share of banking assets under foreign control increased from 25 percent in 1995 to 58 percent in 2005, and in Latin America, where that share rose from 18 to 38 percent of total bank assets.

The past decade has also seen a transformation of the role of foreign banks in EMs. First, while the large international banks have continued their expansion in selected markets, a number of mid-sized banks have also become increasingly active across borders since the mid-1990s, particularly in emerging Europe. This has partly reflected limited expansion opportunities, heightened competition in home markets, and prospects of strong profitability in host markets.

Second, there has been a significant shift toward local activities by foreign banks in EMs. Traditionally, foreign banks primarily focused on providing financial services to their inter-national corporate clients in host countries, but there is now often a growing emphasis on housing-related and other personal lending. One reflection of this development is that direct cross-border lending by the head offices of international banks has been progressively overshadowed by local lending by their foreign affiliates.

[EXAMPLE: SWEDBANK EXPANDS INTO BALTIC NATIONS]

http://www.swedbank.com/

http://www.swedbank.com/about-swedbank/group-presence/index.htm