A Useful White Paper?
Have ministers got the prescription right to protect us from future banking and economic crises?
After a difficult gestation, the Government’s blueprint for regulating the City finally emerged blinking into the cold light of day. Observers anticipated few surprises in the White Paper, much of which is based on the relatively uncontroversial proposal put forward by Lord Turner, chairman of the FSA, in March.
As expected, the Chancellor made clear that he did not favour splitting up big and complex global banks, dubbing such proposals “simplistic”. Instead, they will be forced to hold more capital to absorb losses and to have greater liquid assets to guard against a run on deposits. The riskier a bank’s operations are deemed to be, the more capital they will have to hold. There will also be a new “backstop” power to prevent them borrowing too much.
The initial reaction from the City was broadly positive. As well it might be. Investment banks, including Barclays Capital, are already inventing schemes to reduce the capital cost of risky assets on balance sheets to a practice BarCap calls smart securitisation. Some will see this as a sign that financial boffins have already found a way to run rings around rules on capital designed to make banks safer.
Certainly signs of life in the securitisations market should serve as a warning to regulators: the plan to impose higher capital thresholds will only succeed if the riskiness of the derivative products can be accurately monitored. What does the White Paper say on that? Not much. Little detail was given on how macro-prudential oversight is to work, or who will be in charge. As such, the Chancellor’s proposals are a wholly inadequate response to the banking crisis.
The bottom line is that Alistair Darling has plumped for fudge. Perhaps the biggest dollop is the new Council for Financial Stability, which is actually just a rechristened version of the old tripartite system, comprising the Treasury, the FSA and the Bank of England. The old trio failed miserably, largely because they couldn’t communicate effectively and things fell through the cracks.
In future, both the bank and the FSA will have slightly broader powers and the Council - chaired by the Chancellor - will be more transparent. But these are mere tweaks. The Chancellor has also deferred the important questions of exactly how counter-cyclical measures, such as jacking up capital ratios, will be applied.
Getting the details right is clearly important, but so is getting things done. There is some good stuff in this White Paper, but unless momentum is maintained, the Government could end up wasting a good crisis.
Britain’s “Credibility Gap”
Both the IMF and Standard & Poor warn that Britain’s public finances need drastic surgery. Are our politicians up to it?
On the face of it, it is clear why Standard & Poor’s has cut Britain’s debt outlook from “stable” to “negative” for the first time in decades and threatened to strip us of its cherished AAA rating for the first time ever. After all, new stats show that government borrowing surged fivefold in the year to April, while tax receipts slumped 10%.
S&P warned that the UK’s ratio of debt to GDP could be about to double to 100% and stay there – and they might be right. On the other hand, these are the same people who brought you triple-A rated collateralised debt obligations, rock-solid Icelandic banks – and failed to predict any of the financial crises of the past 20 years. Ratings agencies always accentuate the book and exaggerate the bust, and this latest offering is typical of their output: a risible piece of guesswork.
That said, it’s not too hard to spot the gigantic hole in the UK’s public finances, and it doesn’t help that the Bank of England’s quantitative easing strategy has meant that it’s busy buying back the Government’s own debt from lenders – underpinning and distorting the price of gilts. Ernest Saunders went to prison for doing something similar.
S&P aren’t saying anything that hasn’t been well documented by any number of other worthy bodies – including the IMF. The S&P downgrade matters, because if we lose our AAA rating, our problems will be much worse. Foreign investors buy two-fifths of our government debt, and many of them are only allowed to hold paper with a pristine rating. That’s scary.
Given the current political disarray, it was no surprise that the Treasury couldn’t come up with a convincing response to S&P. They need to – and fast. When it comes to getting people to lend money, Britain has historically relied on two factors: its strong and stable governance, combined with a history of paying our debts back. There is no fundamental reason why that can’t continue. Even the chasmal fiscal deficit of 12.4% projected for 2009-10 is affordable as a one-off, but only if investors are told how the Government is going to pay them back eventually.
Instead, Britain is suffering from a credibility gap. With the expenses scandal and uncertainty over the state of the election causing political paralysis, and neither party remotely clear about their future tax and spending plans, the UK looks financially exposed and politically weak, and that’s perfect ground for ratings agencies to wreak their usual havoc.
Angry Shareholders
The outrage over bonuses has spread way beyond banks, as Shell has discovered. Are the protests too little too late?
There is a distinct whiff of cordite in the air. Investors at this year’s AGMs have been expressing rage at the wholesale destruction of value. Eggs were thrown at the directors of Allied Irish Bank; protestors singing the Marseillaise stormed the stage at Belgian bank Fortis; and there have been confrontations over pay at BP, Provident Financial and Amec.
This has been the biggest backlash yet. In one of the most significant investor rebellions in years, 59% of Royal Dutch Shell shareholders voted to reject the company’s executive pay plan – evidence of the mounting anger over remuneration and bonuses.
Shell had it coming: the behaviour of the non-executive directors on the company’s remuneration committee was outrageous. According to their own rules, bonuses would be due if Shell came third or better in a league of five oil majors ranked by total shareholder return. When the company finished fourth, directors brazenly declared that the race was so close that fourth was as good as third. Shell moved the goalposts. But there are plenty of other cases where the goalposts were simply set in the wrong place, with shareholders’ approval, making it ridiculously easy for executives to claim huge payouts for mediocre performances.
That fact, one suspects, partly explains the sudden outbreak of rebellion. Investors are finally realising that the wool has been pulled over their eyes for years. Stock markets are back where they were a decade ago, dividends are being slashed, but boardroom pay has gone to the moon.
In boardrooms, in clubs – and at certain flower shows one might mention – you will hear much huffing and puffing from some directors about having their hands tied. Others will feel they can shrug off shareholder votes, which are non-binding, even when they’re made on the scale we saw at Shell. But Shell’s remuneration committee, led by Sir Peter Job, has taken shareholders for granted for the last time.
Other directors take note: next time, the protest could get personal. If that is what it takes to remind self-interested executives who really owns their firms, so be it. The crunch has highlighted a crisis of ownership.
Supine institutional shareholders, such as pension funds, were the handmaidens of recklessness, greed, corruption and destruction- and they allowed it to happen with our money. Regulation is only part of the answer: we need to move from a culture of entitlement to a culture of responsible ownership. Executives, like politicians, must be forced to realise that they work for us.
Are Hopes Of Recovery Over-Done?
In our thirst for good news, we may have been getting ahead of ourselves. But a cheery outlook is, in itself, worth celebrating.
They say you know the tide has turned when the last great pessimist throws in the towel. So there was some significance in George Soros’s recent pronouncement that apocalypse has been avoided. “The economic freefall has been stopped, the collapse of the financial system averted,” said the billionaire investor whose graphic warnings of imminent doom shocked the world last year.
And all around, it seems, there is optimism that the worst of the slump may be behind us. Commodity prices are rising, indicating that global manufacturing demand may be picking up; investors seem willing to stump up cash for banks and companies; even the OECD now indicates that a sharp bounce in April activity suggests that the best-case scenario – a V-shaped recession – is no longer out of the questions.
But, there’s a big difference between an economy getting worse more slowly and one that is on the path to recovery. Even if modest signs of improvement develop into rising output by the autumn, there is still a strong risk of relapse into a double-dip recession. The bank of England recognises as much: its move to step up quantitative easing with an extra £50bn shows it believes the banking system remains fragile. And unemployment, up by almost 250,000 in Q1 (the biggest quarterly rise since 1981), still looks worrying.
We can’t assume the international outlook is altogether rosy either. It would take a sustained rise in Chinese exports to suggest that demand in the rest of the worlds has turned, yet they fell by 3.5% between March and April. And US property prices are still falling, while losses at Wall Street banks continue to mount. As Gordon Brown never tires of telling us, this crisis began across the pond. And that’s where it will end.
Green shoots have been proliferating in the hothouse of the financial markets, but step outside and the climate is very differen. Bank governor Mervyn King’s withering summary of conditions suggests an economy that, rather than shooting, looks shot. Recovery won’t begin until 2010, King said, and even then there are pretty solid reasons for questioning if that will be sustained.
The coming years will certainly be rough, yet the nation today is markedly different from the shabby, defeated country we were in the 1970s. Britain, in fact, seems determinedly cheerful. Why? Perhaps because, although things are bad, no other country seems to be doing markedly better; or perhaps because – having dug ourselves out of a hole once before – we feel we can do it again.
Spring Fever
Some eminent punters are betting that the second bull market of the 21st century has begun. Are they nuts in May?
Swine flu, a major bankruptcy, rumours of big holes in US bank balance sheets… last week looked like “yet another shocker” to add to all the others that have roiled the financial system.
Not so long ago, any one of these events would have wiped billions off stock markets; together they would have caused catastrophe. But something has changes. Traders seem bent on shrugging off the bad news and continuing a winning streak that has lasted almost two months. As Richard Dunbar of Scottish Widows observed on the BBC Radio 4 Today programme, “the market has moved from 100% fear to 100% greed” in six weeks flat.
This feels like a pivotal moment in 2009’s titanic battle between bulls and bears, and the bulls would appear to be in the ascendancy. Equity markets across the developed world have jumped by a third; emerging stocks are on fire; and risk indicators are retreating. Three-month Libor (the inter-bank lending rate) dropped below 1% this week, reflecting banks’ willingness to trust each other again.
Meanwhile the big guns are out in force, reiterating their conviction that the good times are rolling again. Hedge fund manager Crispin Odey, who made a fortune shorting bank shares on their way down, has reportedly made another mint after buying them at the bottom, and he’s convinced the rally has only just begun.
Investors, like policy-makers, are betting that optimism will prove self-fulfilling. Clouds become mere appendages to big silver linings. As for unequivocally bad news – a huge increase, or confirmation that UK house prices are still falling – it is simply ignored. Investors seem to be on a mood-enhancing drug. And, in a sense, they are. Governments and central banks have been issuing vast quantities of a stimulant (cheap money) that gets markets high. But the drug is still in trials, and may yet have adverse side-effects. Try soaring inflation, for starters.
There’s now a risk of a massive trap for unwary investors. Having preserved their money after the first big crash, they are now being set up to lose it in the next one. The economy is still in deep trouble and markets cannot ignore that fact forever. The most that can be said at this point is that financial Armageddon is no longer looming. If that’s true, it may well be worth 20% on share prices, but is can’t create a sustained bull market. For that to happen, more good news is required. Recoveries in the real economy tend to require something more substantial than a handful of semi-cheery surveys.
How Broke Is Britain?
A shocking Budget revealed the fiscal nightmare facing Britain. How willing are lenders to continue financing the debt?
It is considered a golden rule in politics that Budgets that look good on the day, start to look poor by the weekend and vice versa. Last week’s Budget broke that rule. Even the dreadful borrowing figures announced by the Chancellor of the Exchequer last week – pushing the national debt well beyond £1trn – were not dreadful enough to describe the reality, as became clear within days, when a set of shocking GDP figures recorded a contraction far worse than expected. Over half a trillion pounds of borrowing is scheduled over the next few years.
It could easily be more. On the Government’s own forecasts, the public finances will come nowhere near balance until 2018. Some experts reckon we’re looking well into the 2030s or the 2050s. “In the long run”, Keynes famously said, “we are all dead”. But this is getting ridiculous.
The Chancellor has admitted the Government needs to borrow £220bn in the gilts market this year, just to keep finances afloat. After that, he claims, things will start to get easier. Really? Darling’s expectation that the economy will shrink by “only”3.5% this year already looks out of date. But this wildly hopeful assumption that this decline will somehow reverse into a growth rate of 3.5% in two years’ time seems preposterous.
Using the IMF’s more neutral economic forecasts, Monument Securities reckons Britain will have to tap gilt buyers for some £230-235bn this year and about the same in 2010/11. At the moment, the Government is having little trouble finding lenders: the increased supply of gilts is being soaked up by the Bank of England’s £75bn quantitative easing programme and by foreign buyers. But if investors begin to doubt the Government’s ability to close the deficit, the market’s willingness to refinance sovereign debt could come to a sudden halt. Epithets of “banana republic” and “sick man of Europe” may yet return to haunt the British.
Britain does have one advantage. It entered the recession with relatively low levels of public indebtedness compared to other countries. This means that, even with a dramatic surge in liabilities, it will end up with only a middling level of debt compared with G7 countries overall. Yet we shouldn’t take refuge in that. On some measures, Britain’s public finances are now the worst of any rich country: next year, we will probably have a bigger deficit, as a percentage of GDP, than the like of Italy.
Retaining market confidence calls for plausibility and willingness to forego overly optimistic forecasts. The only way out is to confront the problem head on. This dishonest Budget has done Britain no favours at all.
Darling’s Recession Budget
The stakes were high when the Chancellor stood up on Wednesday. Did he offer any meaningful way out of Britain’s black hole?
You’ve got to hand it to Alistair Darling. Only this most emollient of politicians could manage to make this Budget seem boring. Yet the content of the speech was, in many ways, explosive. He told the country that British prosperity was, in important respects, as fraudulent as collateralised debt obligation; that the boasts of ‘no more Tory boom and bust’ are a joke; that the economic forecasts he gave only last November were nonsense, and the public finances are deteriorating at a rate never seen before in peacetime. And all with a deadpan face.
Darling announced a rash of measure to steer Britain towards recovery, but the Chancellor’s efforts to offer a little to everyone failed to find approval in most quarters. Indeed, he faced a chorus of disappointment.
Apart from the sheer mess of the economy, the big problem facing Darling was that hopes were perversely high. This was one of the most anticipated Budgets in decades, with commentators on both the left and right urging dramatic action. Be bold Chancellor, you could be our next Lloyd George,” said Polly Toynbee in The Guardian. “Give voters a rock-solid reminder of what Labour is for”. The Times was equally convinced that that Chancellor should follow the advice of President Obama’s chief to staff, Rahm Emanuel, and not let “a serious crisis to go to waste”.
With the weight of the public finances endangering the nation’s prospects for recovery, the Budget presented a perfect opportunity for ministers to change course away from ever-rising public expenditure and to profoundly change the shape of the government. In the event, the Chancellor did announce a cut in public service spending growth: it will fall from 1.1%, to 0.7% in 2001-12. He also announced £15bn in “efficiency savings”. But this is a little more than tinkering around the edges, £15bn over five years represents only a fraction of Britain’s annual interest payments on its public debt. Far more profound changes are needed in a public sector that has grown out of all proportions to Britain’s ability to pay.
Darling’s Budget task was daunting enough to evoke pity. He had to reassure investors that Britain isn’t going bust, but to do so without taking too much money from the beleaguered taxpayer, or out of and economy in deep recession. His response was a flight into fantasy. There was no bust Britain, he seemed to say, only a temporarily tripped-up Britain, which would soon be swanning along again. He offered no meaningful explanation of how the deficit would be shrunk. He acted like a fantasist – presenting the terrible news and pretending it didn’t matter. Britain’s black hole required an adult response. We didn’t get it.