Friday, 28 November 2008

The State of European Banking

by Vault

There has been so much drama in the European banking sector between 2007 and 2008 that it has, at times, made great television. In less than a year the world has seen the spectacular fall of banking giants, queues of angry customers outside a British bank for the first time since the 19th century, a massive rogue trader scandal in France, tens of thousands of job losses and stories of malicious rumours planted to stir trouble at international banks. Oh, and a global subprime crisis.

In the spring of 2007, Europe’s banking sector was comfortably (and excitedly) busy with a series of mergers and acquisitions, and several large banks were set on eating each other whole. Italy’s UniCredit paid more than 29 billion dollars in May last year for its smaller rival Capitalia, creating Europe’s second-largest bank after HSBC. A fierce bidding war for Dutch bank ABN Amro also held the continent’s attention, with Barclays pitting itself against a pan-European consortium comprised of the Royal Bank of Scotland, the Benelux’s Fortis and Spanish banking giant Santander.

Yet once the US mortgage market hit the buffers in late spring 2007 and its impact began to spread around the world, lending of all sorts began to dry up, and many of the mighty looked set to fall.

This has caused significant shifts in European banking priorities. Previously in the mature markets of North America and Europe, lending had risen to historic highs, thanks to booming property prices and a general loosening of regulations. Whereas lenders would typically be allowed to borrow perhaps three times their income in a normal market, by 2006 they were borrowing on far higher multiples and at proportions above the value of their properties, with banks presuming that future rises in value would secure these loans.

Known in the US as “Ninja” loans (“No income, no job”), the practice of issuing loans like this had not been seen in Western markets since the late 1980s, just before the last major house price crash. Since late 2007, conditions have worsened across almost all kinds of banking in Europe. The deterioration has taken place in several stages, each accompanied by a dramatic event. Some of the most notable events in this process demonstrate the fragility of customer confidence in retail banking and the dangers of over-borrowing (Northern Rock), the lack of proper oversight (Société Générale) and the dangerous contagion of market rumours (Bear Stearns and HBOS).

On the Northern Rocks

One of the UK’s largest mortgage lenders, Northern Rock’s business model was to lend money to customers that it had borrowed from other financial institutions at a lower interest rate. Once the credit crunch took hold in summer 2007, it could no longer borrow at these advantageous rates and began to run out of money. This news spread across the UK and its many thousands of account holders queued to retrieve their money in case it went bankrupt. Eventually the UK government took the bank over by nationalising it and bringing security to depositors, but leaving the UK taxpayer with a very large potential liability.
The practice of lending to on-lend, as exemplified by Northern Rock, is now under close scrutiny, with other European governments watching developments with interest. If their own major financial institutions were to get into trouble, would they do something similar — especially if the UK appears to have achieved good results?
Regardless, the situation has still been an embarrassment for the UK’s financial regulators — who have admitted that they failed to act in time — and for the British government, which had prided itself on solid financial management.

Société Kerviel

When 31-year-old French trader Jérôme Kerviel was found to have lost Société Générale almost five billion euros, it was reported by the media as the biggest fraud in financial history, wiping out profits from France’s second-largest bank for 2007 and raising fears that the bank would be acquired by a rival sometime in the coming months or years. Some felt that the heavy stock market losses that happened in the same week as the news of the fraud broke were linked to it. Certainly it did nothing to bolster confidence in banks.
The scandal was seized upon by some commentators as evidence that the banking profession had sunk to new lows. “The banking industry used to have a reputation for honesty, trust and prudence,” said Roger Steare, professor of organisational studies at the Cass Business School in London. “This latest scandal, on top of the massive losses in credit markets and the ongoing incidence of mis-selling to retail customers, indicates that there is a systematic deficit in ethical values within the banking industry.”
The Société Générale case, however, was more about complexity and lack of oversight rather than about an ethical gap. Financial products have become so labyrinthine and pass through so many people’s hands that it can be a Herculean task for individual banks to exactly know the state of their liabilities. These gaps in oversight were further evinced when major banks began to go public on writedowns that appeared to have come out of nowhere, even for bank employees who were paid to be in the know. In many cases, these writedowns went up and up in the course of their publication, as closer scrutiny was made of the exact value lost.
Europe is undergoing a period of turbulence, as in the US, where the older generation of banking managers who grew up in a relatively slow-paced environment, with a few, relatively straight-forward products, is giving way to a generation of managers with highly specialised IT skills, dealing with very complex financial instruments, with different risk and reward parameters, operating outside the traditional geographical and financial boundaries. Learning how to avoid Jérôme Kerviel-style scenarios will be crucial for the bankers of tomorrow.

No picnic for this Bear

In the first couple of weeks after the subprime situation in the US hit the international headlines, the financial pages were reporting that Bear Stearns bank in the US had been forced to close two of its large mortgage lending operations because of bad debt. It was not alone, but it was taking a bigger and faster hit than many of the other banks.
Around nine months later, the problems had not gone away and Bear Stearns was effectively bankrupt. It was acquired by J.P. Morgan for a fraction of its value just a year earlier, putting the financial community on notice that even the big boys were not immune to disaster.
A couple of weeks later, Halifax Bank of Scotland (HBOS) in the UK found itself at the centre of an unexpected storm when rumours began to circulate that it was in trouble with bad debt and might have to be sold or go out of business. Its share price plunged. HBOS managers and directors kicked up a big fuss about how outrageous it was that unfounded rumours should be flying around. In a few days, the stock market price returned to normal and it emerged that several of the top directors had quickly bought hundreds of thousands of pounds worth of shares, while they were low, “to show support for the bank,” as they put it. How fortunate for them that the share price quickly rose again...
In better times, such unfounded rumours would not have been given any credence. Today, it is only too possible to imagine a large bank crashing, thanks to Northern Rock and Bear Stearns doing the previously unthinkable. The mood of anxiety in the banking profession had turned to desperation by spring 2008, as the scale of losses across the industry, both in money and jobs, became clear. By mid-March, industry experts were warning of 15 percent job losses in US and European investment banking firms. Research agency Experian estimated that as many as 200,000 jobs would disappear across the global financial services sector during 2008, with 65,000 having gone between August 2007 and the beginning of 2008. In total, 12 million people are employed in financial services in the US and Europe.
Restructuring work is writ large among the new opportunities for graduates in European banking. Many companies in various business sectors such as real estate, retail and indeed financial services are well-run and profitable enterprises with solid customer bases. However, they have over-borrowed and are facing cashflow difficulties as interest rates rise and lending becomes tighter. Banks have a major role to play in helping companies turn themselves around and regain stability. At the same time, opportunities in the emerging markets of China, India, Russia and throughout Central and Eastern Europe, are providing new scope for many European banks. For example, in March 2008 Barclays paid 745 million dollars for Russia’s Expobank, showing its appetite to do business in a country where lending is rising at 45 percent annually. Deutsche Bank formally launched itself in China in January 2008, as many fellow European banks have done in recent years.
Salaries available in the banking sector will still be among the highest in Europe, but the mood of buoyant optimism that has permeated the sector for the past five or more years has certainly diminished. What many will find themselves doing this year is working to prevent losses and restructure companies. Many banks have been left with bad debt, from unwisely granted mortgages or from businesses that have failed. European banks are now shoring up their defences and trying not to allow more debt to accumulate.
Graduates who understand how the banking landscape is changing and show
awareness of the new priorities will find there is still a great range of opportunities in the industry.

Vault is an employment advice Organisation providing information for students.
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Sunday, 16 November 2008

On the History of Economic Thought

by Dr Andy Denis

Not only is History of Economic Thought (HET) useful and intellectually stimulating, it’s also packed full of incident, drama and personality. We might learn not only about the Wealth of Nations, but also about the time a young Adam Smith was kidnapped – and then rescued at gun-point by his uncle. We might find out whether the Phillips machine was actually any good at modelling the economy or just a quick way to cover the floor with coloured water. And we might explore why there’s a dead economist in a glass box (Jeremy Bentham’s Auto-Icon) in the corridor at University College London. A good HET course will turn up some surprises for the student!

HET courses vary widely. A typical survey course will attempt to chart the development of the discipline – from Adam Smith to the present. Some courses focus on trying to show how the past has formed the present – how ideas such as demand curves and different market structures first emerged and how they evolved to their present form. In others the emphasis is on the emergence and submergence of ideas in the controversies of the past. Just because an idea has been forgotten does not necessarily mean that it can be assumed to be without merit, and the fact that it has changed shape need not necessarily imply progress. Other HET modules might illustrate the history of the discipline by reference to a case study – how, for example, economists have articulated the case for the particular economic role of the state that they advocate.

HET is often confused with Economic History, but they are distinct areas. Economic history is the history of the economy (an examination of the depression of the 1930s, for example), rather than the history of the study of the economy (for example, the emergence and reception of Keynes’s General Theory). There is clearly a link: what is happening in the economy should affect the development of ideas in economics. Some HET courses will teach the development of the discipline be referring to changes in the economic world at different times. Others may take a more austerely intellectual approach, with the development of the discipline explained by reference to the inner logic of the ideas themselves.

Finally, an understanding of the history of the discipline is extremely helpful for evaluating the claims of the various minority schools of thought in the discipline today, including Marxians, Austrians, Feminists, Post Keynesians, Institutionalists, and Critical Realists, and some HET courses will give some attention to the emergence of these trends, what divides them, and what they share with the neoclassical mainstream.

Dr Andy Denis is the Senior Lecturer in Political Economy at The City University, London.

Instances of Inflation

by Tim Robinson

"All that is solid melts into air" - Karl Marx

"And do my people value this as gold, Do court and army think these payments hold?" - Faust, Goethe.

In March 1987 in a ski resort restaurant in Slovenia the Yugoslav Prime Minister Branko Mikulić was refused service by striking waiters protesting the ceiling placed on wages by him. The wage ceiling was one of Mikulić's efforts to reduce the runaway levels of Yugoslavian inflation. In the late 80s and early 90s the Republic of Yugoslavia underwent the highest recorded levels of inflation culminating the in the 500 Billion Dinar note shown. The Republic reformed the currency in 1990 resetting 1 new dinar to be worth 10,000 old dinar, in 1992 (1 new for 10 old), 1993 (1 new for 1 million old) and twice in 1994 (1 new for 1 billion old then a month later 1 novi dinar for 10.5 million dinar)

The line of Mephistopheles from the play above "such paper-wealth, replacing pearls or gold is practical: you know just what you hold" falls short of reality. The value of money should by definition be stored over time, with currency this is not always the case, to various extremes.

The Case of Rome

In the 3rd Century Roman Empire the debasement of the coinage (as successive emperors began to adulterate the currency to meet military and administrative costs) led to such widespread distrust in the currency value that the government ceased to accept it as payment for taxes. The fleeting nature of the tenure of some emperors made banks hesitant to accept the coinage minted by usurpers. (For example the coins of the sons of Fulvius Macrianus , Macrianus Minor and Quietus who reigned in 260-1, who rose to the throne after the death of Valerian; in certain cases banks showed an "unwillingness to accept the divine coin of the emperors"[1]. Which given the length of their reign proved prescient.) Perhaps the most well known reaction to this inflation was Diocletian's edict on maximum prices (not an uncommon reaction, more recently the Zimbabwe government fixed the prices of certain commodities), fixing an upper ceiling on the prices and wages (for example a higher quality scribe could command up to 25 denarii for 100 words, but no more) as well as replacing the debased currency with a new coinage.
By means of policing these price fixes across the Empire artisan guilds would have to file schedules stating they were not exceeding the maximum prices set. (Arguable not a very vigorous method of policing)
The Diocletian reforms came on the heel of a series of debasements which had seen the silver content of the denarius fall 99% since the time of Marcus Aurelius (A period of about a century).

The Case of Modern Europe

In the 20s Austria, Hungary, Germany, Poland and Russia all suffered from fairly sustained periods of hyperinflation. Partially because of effort to fund the costs of the bureaucracy, partially because in the aftermath of war large amounts of territory were lost, and partially because of funding other wars. Austria and Hungary had to contend with the loss of its territory and printing money necessitated by the cost of payroll (The loss of territory effect also occurred for the Confederacy, as the Union forces took their territory people sent their remaining money back to the much smaller Confederate States.) The Treaty of Versailles made Germany responsible for large reparation payments to Allied powers in the aftermath of World War 1. From November 1918 until July 1919 (Prior to the signing of the Treaty) German price levels rose 42.7% on domestic prices. The Treaty was signed in January of 1921 agreeing that Germany pay around $394 billion in 2005 prices. From May 1921 to July 1922 prices rose by 634.6% on internal prices. Then from July 1922 to June 1923 internal prices rose by around 18,000%. By July 31st 1923 prices were 161,000 times higher than they had been about a decade earlier. By September 4th prices were around 182 times higher than the July 31st figure. By November 20th prices were around 576,397,515,527,950 times higher than the July 31st figure. Overall between 1913 to November 15th 1923 prices were internally 92,800,000,000,000,000,000 times higher.

In Germany some firms ceased accepting the national currency, and began delaying tax payments to reduce the extent of their liability, such was the extent of the inflation that even a short term delay had significant impact.

On the first of November 1923 infamously a single glass of beer cost 4 billion marks.

The Case of Zimbabwe

In December 2007 the Zimbabwe Standard ran the headline 'Gono labelled ‘No. 1 saboteur’. The Governor of the Reserve Bank of Zimbabwe has fallen since the declaration in early 2005 that he was 'man of the year', with the lofty statement that "one man can make a difference to the course of history".
Inflation reached 624% in early 2004, then fell back to low triple digits before surging to 1,730% in March 2007. In June 2007 the government released figures of 7,638%. The predictions for the annual inflation range from 3,000% (according to the IMF) to 8,000%. The Reserve Board of Zimbabwe in a written statement blamed rampant inflation in part on the slow distribution of larger notes causing inefficiency in exchange (lowering productivity). In early May 2006 the government printed around 60 trillion Zimbabwe dollars (In February it printed 21 trillion to borrow foreign money). In February 2007 certain price rises on commodities were declared illegal. In June 2007 the estimate of inflation (Month on Month) was 11,000%. The IMF estimates over 100,000% for January 2008. New notes have been issued superseding ones intended to last until the 30th June 2008. The ZRB is not unforthcoming with effort, this year it revalued the currency taking 10 zeroes from the notes (the largest of which was the 100 billion million Z$, released shortly before the revaluation.) Necessitated by the impracticality of the size of the monetary denominations the measure is likely to be only of short term aid. The official estimate of inflation year-on-year from the ZRB is 11268758.90%; prices doubling roughly every 22 days.

(Since this article was written the July 2008 figures have shown inflation levels year on year of 231150888.87%; prices double every 17 days.)