Party Pooping...

The IMF this week said that they think that the world's banks are still yet to acknowledge over half of the losses that they projected in April this year. Their projected figure was $2,800bn back then, and in their latest financial stability report that figure remains their expectation. So far during the financial crisis the world's banks have acknowledged $1,300bn of writedowns, leaving another $1,500bn of losses to be accounted for - if the IMF are to be believed. At the same time, one of the main topics of regulatory discussion is how insufficient bank capital was under the old regime, and how it needs to be greater in future.

Basically regulators want banks to be better capitalised. If for example banks were forced to return to the average tangible common equity to assets ratios they had in the 1990s, then US and European banks would need to raise upwards of $1,000bn. So, adding that number to the IMF number of unaccounted-for losses, is a simple calculation adding to a fairly mind-blowing figure of $2,500bn.

That's $2,500bn worth of equity capital. Even if the real number is much less than that, what is patently clear is that the world is going to have to de-lever significantly. If we held things constant and assumed that banks lend something along the lines of 12 times equity (a conservative estimate given that Lehman Brothers were around 50 times leveraged in September 2008), then that is $30 trillion worth of credit that very theoretically would have to be removed from the system before the world's banking system is back to being "well capitalised".

When you consider that number (again this is highly conceptual) in some context then the current revival of global asset prices seems a bit crass. The biggest five banks in the world have total assets of around $15 trillion, the top ten around $26 trillion and the top 50 banks in the world have a total of $62 trillion of assets. So, essentially to regain the IMF and regulators' concept of sufficiently "capitalised" we are looking at the top 50 banks in the world halving the size of their balance sheets, or more likely all of the world's banks reducing the size of their balance sheets by somewhere between 25-40%.

To reiterate - this is all very much a rough pointer to the numbers; the IMF may be way off the mark (unlikely) and regulators may not enforce capital rules to such a strong extent (more likely). Nonetheless, there is no doubt at all that banks are going to have to raise very large sums of new equity capital, whether it be to counteract write-downs or to deal with a stiffer regulatory requirement.

At the moment there are several things helping to postpone this inevitability. Firstly the real level of interest rates around the world is next to nil, so there is an abundance of liquidity available to virtually all banks to rollover their balance sheets for the short term in debt capital markets. This is helping to sustain, or increase asset prices and is as a consequence preventing the need to acknowledge further mark-to-market write downs in the short term - even the most extravagant assets of the credit boom (things like CDO equity and subprime ABS) have seen their prices rise significantly over the past couple of quarters.

Secondly, the fact that interest rates are so low has enticed retail deposit investors to ditch their savings accounts paying 0.5% and to look for higher returns in other asset markets, from stock markets to property to convertible bonds - all of these are rising as buying interest grows. Thirdly, and this is related to the first two points, banks have seen stellar earnings from their capital markets operations in the past few quarters as debt and equity underwriting, trading and mortgage refinancing activity has created big earning opportunities. This paradise has meant that banks can claim to be "recapitalising" themselves through earnings.

All of these points, I believe, are blinding the markets from the bigger picture reality that nobody is incentivised to acknowledge. Banks may see margins erode as they incur higher debt interest costs to extend their funding, and competition for savings bids up the cost of attracting deposits. Furthermore, higher deposit insurance premiums, costs from tighter regulation and the need to hold more and higher quality capital will reduce returns on equity.

The current trend is for banks and governments to suggest that they can pay off their liabilities, or increase their equity bases through earnings or growth. In both cases the scale of the growth requirement just to get back to a relatively even keel is beyond what both government bond prices and bank equity prices justify. Friday saw stock markets respond badly to the US non-farm payroll figure, and the knock-on effect on the US jobless rate which has hit 9.8%. Another statistic that should cause concern (ironically) is that the US savings rate is increasing all the time and is now at a significant high of over 8%. The growth that is required around the world to sustain our economic system needs to have a US consumer in the hot seat - they need to be spending like there is no tomorrow and buying up cheap imports from China and their cheap exporting brethren. If the US consumer is not at the party, then it's a bit like a pub with no beer.

I don't want to be a party pooper, but there seems to be an startled ostrich approach from the world's financial markets to the inevitable issues that the world's banks and governments will have to deal with. Stick your head in the sand, interest rates are low, and liabilities are on the back burner. At a fundamental level the system, by any measure, remains way over-leveraged, and ironically is actually getting more leveraged in many areas. While that makes people feel good in the short-run, I can't see how it's sustainable for the long-term.

I think it's fair to say that I'm not a buyer of the current rally!