Fault Lines - Strangely Calm

That Retired Guy (TRG) spent a few weeks away from the blog, but he's back now.  In the time that he was gone, a strange calm settled into the markets.  It is strange because the overall picture has probably become more troubling even if the terms for Spain seemed more acceptable.  The Spanish bank bailout exposed a new dynamic in the European political landscape.  France can no longer be expected to march to Germany's orders.  Now, Francios Hollande has become a sort of kingmaker, and he seems keen to make anyone but Angela Merkel king.  In the last round he sided with Mariano Rajoy, and Mario Monti  but in future rounds, it's harder to predict.

So the last few weeks have created yet more uncertainty for the future.  Certainly, the problems have not become any less urgent, but the solutions are even more remote.  So where are the fault lines for the next few weeks?  The may reside in surprising places:


Watch The Budgets and Forecasts
It is now mid summer, mid year, and the next round of GDP and budget forecasts will be on the way soon for most of Europe.  The expectations are low, and TRG expects that there will be no positive surprises.  The reason this is a fault line, is that serious issues can (and probably will) be exposed even without negative surprises.  In Greece for example, it will probably start to become clear that even more bailout money would be required to end the crisis.  France, Spain and Italy each stand a serious risk of looking weak in the numbers, and any one of them can easily set off another catastrophe.  Although less likely, even Germany could have bad numbers.  Basically, over the next few weeks, there will likely be problems unless every country in Europe surprises to the up side, and that is certainly very unlikely.

LIBOR Fraud
This is not exclusively a European problem , but the fault line here is so broad for the banking industry that Europe can not possibly be excluded from the trouble.  It may take more then a few weeks for this pot to really boil over, however the heat has been on 'high' for a while now, and it just gets more and more dangerous.  As Bloomberg notes, the real problems will come when the banks start to fight each other.  Any bank involved in fudging LIBOR (or any other benchmark rate) will face a horrible one sided liability problem.  The problem is that they will be sued by every injured party, but they will have no way of claiming from parties who benefited from the fraud.   The potential liability is huge, hard to calculate, and likely to start showing up in the next quarters results.  European banks desperately need profits to repair their balance sheets, so a big LIBOR problem could easily snowball.

Fixing Banking

The banking industry is broken.  That Retired Guy (TRG) is hard pressed to find anyone who will defend the industry, but just in case there are some readers who don't think that the banking industry is broken, read this, and this.  The question now should be 'how do we fix it?', but unfortunately, there has not been much discussion in this area.  TRG actually thinks that just 3 simple, easy to enact laws would completely rectify nearly all of the issues.

1.  Separate Commercial Banking From Investment Banking
It is time to re-enact the bits of the Glass-Steagall Act that separated commercial and investment banking.  It is very simple, commercial banking should include only the following activity:

• Taking deposits and servicing depositors
• Investing in conservative loans mostly held to maturity
• Providing other basic consumer financial services such as credit cards

Investment banking activities can broadly be defined as 'all the other stuff' including underwriting, brokering, trading, investment management and so on.  The fact is that the reasons they were separated by the Glass-Steagall Act in the 1930's are still valid today, and as Barry Ritholtz makes very clear in his book Bailout Nation, it is the regulatory changes that are most responsible for the latest crisis.  The activities of Investment Banking are often by there very nature, high risk, and generally high reward.  Doing these activities lends itself to the type of culture that is incompatible with the activities of commercial banks.  Simply put, if you have a culture of risk taking, you will be a bad custodian of depositors' money.

2.  Mandate That All Commercial Banks Must Be Mutual In Structure
Structure matters.  In a mutual structure, the bank is owned by it's depositors.  This aligns the interests of the organisation with the people who most need the organisation's care and protection.  Mutual banking works, and it exists today in a multitude of credit union organisations.  Generally, they are service oriented, and very conservative in their investments.  There have been problems with credit unions (usually frauds, but that happens in commercial banks too), however, credit unions have NEVER come anywhere near the problems that corporate commercial banks have created.

3.  Mandate That Investment Banks (Hedge Funds Included) Must Be Partnerships In Structure
Partnerships require the managers to own the company completely.  When senior managers become partners, they are required to purchase their partnership share, and therefore, they have a lot (usually nearly all) of their net worth tied to the success of the company.  The investment banks were generally all partnerships before the early nineties, and it worked to keep them small (it's harder to raise capital from a small group of partners then broader corporate shareholders) and risk adverse (partners worried more about risk because the structure provides the ultimate claw back).