Banks continue to display perfectly rational economic behaviour. They were presented a free lunch by a combination of cheap funding while the governments implicitly guaranteed their risk taking. Equally, they have an economic incentive to continue to exercise the same behaviour and pursue many of the same profitable strategies as before the crisis as long as possible. Why shouldn't they? If these banks were deemed too important to the system in the beginning of last year they can probably assume to be deemed too important to the system today! We are concerned with the hasty return of many parts of the credit markets, specifically the credit derivatives market which points to renewed risk to the system. We also believe that it would be a mistake to think that bad debt is now only a thing of the past. Many banks still carry many of the same instruments that nearly brought them to their knees.
While we admit we did not imagine that the stock market would rise as far and as fast as it has since early March, we continue to see the banking sector as a speculative trade. We believe banks will face higher capital requirements, at least for certain activities, resulting in lower profitability and valuation.
We are however concerned about the absence of structural answers to the current crisis and the lack of competition in the banking sector. The result is that companies are now paying substantially higher fees on capital raising activities compared to before the crisis. Both issues need to be addressed in order to have an efficient and less disaster prone financial system. It would however be unrealistic to believe that this change should come from the banks. This remains a job for legislators and regulators.
In a broader view the governments and central banks around the world are now presented with a unique opportunity to deal with the transactional based and speculative nature that has dominated the financial system for the last decade. We hope they don't waste this opportunity, but we are not optimistic. Populist measures like the ones we have seen on bankers bonus payments and current discussion of various transactions taxes will not do the job.
One of the big questions for the stock market this year will be the effect of the exit strategies from the stimulus packages. We believe that central banks will stay accommodative until the real economy sees a firm recovery. Central banks and governments seem more afraid of a stalling economy than the risk of overdoing it in terms of stimulus with the latent risk of inflation, and probably rightly so. With the substantial increase in public debt, developed economies now, like many emerging economies, need growth more than ever albeit for different reasons. The emerging economies need growth for social reasons, the developed economies for the mountain of public debt left in the wake of the financial crisis.
The high level of public debt poses a threat to the future level of economic growth due to the risk of higher interest rates and limits of the ability to counter any future crisis. The cost of insuring the risk of default has already risen on UK debt not to speak of Greece. Bringing down the current deficits and debt levels must take priority. |
