Banks recapitalization – market value matters

The recent financial markets' volatility forced Greece, Belgium, France, Italy and Spain to extend bans on short-selling. The updated news regarding the measures taken by EU competent authorities to prohibit market abuse were published on the European Securities and Market Authority’s website on August 25, 2011. The other warning to shield financial institutions was reported by Christine Lagarde. The Managing Director of the IMF encouraged speeding European banks’ recapitalization at the Federal Reserve Bank of Kansas City’s annual conference in Jackson Hole on August 27, 2011. So, are the fears of the financial system’s collapse reliable and are protective actions reasonable?

One of the main ratios to capture the value of a public company is the price-earnings ratio (P/E), which is equal to the market capitalization divided by the net income. If a company generates steady cash flows and its share price falls it may seem that undervalued stocks are an attractive investment opportunity. However, danger may lie in its leverage. A company defaults once the market value of its liabilities exceeds its assets. Such being the case retained earnings may be used to increase capital, or the firm can issue new shares if it has access to the capital markets. Thus, the market value of debt-equity ratio is very important as it reflects a company’s solvency.

An inaccurate measure of a bank’s solvency may arise according to the leverage ratio which is introduced by the Basel Committee on Banking Supervision in the Basel III: A global regulatory framework for more resilient banks and banking systems. A measure of the minimum Tier 1 leverage ratio of 3% is based on banks' accounting balance sheets these do not reflect the performance of the market.

Market value matters for public companies. Banks recapitalization should not be ignored.

Interventions in financial markets’ shocks

The US congressional leaders’ agreement on an increased debt ceiling until 2013 and a reduction of $2.4 trillion spending over 10 years has retrieved the US bond market; however, the concerns about the ongoing US fiscal and economic challenges and the S&P’s downgraded US long-term credit rating from the AAA to AA+, as well as set a negative outlook for the US economy, has driven down the major stocks indexes and commodities’ prices sharply. The panic in the global financial markets has boosted the gold price above $1,700 per ounce and surged the Swiss franc to 1.350 against the US dollar, these being the prices of the assets considered as secure investment to preserve investors’ capital until the fundamentals of the investments are reassessed.

The last week was notable for governments’ and central banks' interventions. The US attempted to tackle the possible default on sovereign debts, announced the debt reduction plan and raised the debt ceiling. Italy initiated constitutional changes to strengthen the budget discipline and the ECB purchased Spain’s and Italy’s bonds to calm the rally of the sovereign bonds’ yields. The Swiss National Bank rushed to decrease the three-month LIBOR to 0,00-0,25% and announced the expansion of banks' deposits to CHF80 billion as well as their intentions to repurchase outstanding the SNB bills in order that the appreciated currency wasn’t threatening the Switzerland economy. The Bank of Japan sold up to Y4,000 billion due to the similar currency appreciation threats to domestic economy. The US Federal Reserve promised to keep unchanged low interest rates until 2013 to stop panic stocks sales. It seems that only the price of gold, - the alternative currency, may not be easily manipulated by government interventions. Consequently, private and institutional investors might be willing to increase their gold reserves to hedge assets from the depreciation.

Considering the alternative investments, the Pregin’s, a research and consultancy firm which focuses on alternative asset classes noted that hedge funds become more “mainstream” rather than “alternative” within institutional portfolios. According to the Pregin’s Hedge Fund Spotlight published in August 2011, the percentage structure of institutional investors in hedge funds are the following: 21% Funds of Hedge Funds, 15% Foundations, 15% Endowment Plans, 13% Public Pension Funds, 12% Private Pension Funds, 6% Asset Managers, 5% Family Offices, 4% Insurance Companies, 2% Banks, 1% Investment Companies, 1% Sovereign Wealth Funds and 5% Others. Analysis of banks investing in hedge funds reveals that 60% of European banks, 13% of North American banks, 10% of Asian banks and 17% from the rest of the world are investing in hedge funds. The most active five banks investing in hedge funds are the Royal Bank of Canada with $751.9 billion of AUM, Pictet & Cie with $302.3 billion of AUM, F. Van Lanschot Bankiers with $29 billion of AUM, Investec with $4 billion of AUM and Credit Mutuel de Maine-Anjou, Basse-Normandie with $0.2 billion of AUM.

So, do we need it that governments and central banks were focused on short term financial markets’ shocks when financial alternatives may be used to transfer risks in the financial markets?

The US solutions on debt ceiling and further recovery policy

Markets are closed at weekends but not political debates. Consequently, the need for constant vigilant remains essential. The political negotiations regarding additional borrowing in the US went quite smoothly last week and it seemed that the deal on a new $2.4 trillion borrowing was reached. However, according to the president Obama's remarks released on the last Friday’s evening, Speaker Boehner was going away from the final deal, therefore, setting up uncertainties regarding the further recovery policy of the US economy.

A short-term extension of the US debt ceiling which should be settled till the 2nd of August in order the US was able to avoid a default on its debt was considered alongside with the deficit reduction options. According to the political negotiations the $650 billion cuts from Medical, Medicaid and Social Security programmes could be achieved immediately and budget deficit might be reduced by $4 trillion over the next 10 years. Although the solutions to cut ineffective spending were worked collectively the disagreement between the Republicans and the Democrats aroused regarding the Democrats’ suggested additional revenues. It was proposed to raise $1.2 trillion budget incomes by eliminating loopholes, some deductions and initiating a tax reform that could have lowered tax rates generally while broadening the base.

The US default on its debt may ruin the whole financial system in a moment. Thus, the US has no choice but to increase its short-term debt ceiling. The financial markets judge politicians on their short-term solutions. However, should the current state of economy become worse to empower significant decisions whose change trends of long-term recovery.

The role of the economic policy

The imbalance of the global economy and the threat of the possible double dip recession force to reconsider the role of economic policies. Like never before, functions of states to identify key guidelines of development of domestic economy should be reassessed in order the private and public interests were balanced along with restitution of domestic justice and efficiency.

The main driver of economy is demand. Thus, let’s review where the demand comes from. The criterion which may characterise the propensity to consume and determines the growth of economy is profit. In addition, it is assumed that the greatest efficiency is achieved in the market economy. However, the circumstances of perfect competition create superior conditions for domination of monopolies those dictate prices of goods and services. Consequently, the trends of global economy are also under their influence.

Thus, I consider how important the states’ economic policies are nowadays. Moreover, how long it could take for the governments of states to retrieve their authority and intellectual creativity, rethink the concepts of the states’ economic policies so that the global economy distortions were reduced and social justice recovered?

Volatility may be provoked

The Governing Council of the ECB decided to increase the key interest rates by 25 basis points to 1.5% on the 7th of July due to the high inflation in euro area. The annual HICP inflation was 2.7% in June 2011 that is inconsistent with the primary objective of the ECB’s monetary policy to maintain inflation rates below, but close to, 2% over the medium term. According to the introductory statement to the press conference such anchoring is a prerequisite condition to the economic growth in euro area. However, the ECB’s attempts to strengthen euro by increased key interest rates may evoke even higher volatility. The results of the EU wide stress test will be announced on Friday, 15 July. Moreover, participants of the financial markets are sensitive to news those increase burden of the “peripheral” countries to manage their debts.


According to the EU wide stress test scenario based on the ongoing EU sovereign debt crisis, the domestic demand of the euro area will decline affecting consumption and investment. It is assumed that the long-term interest rates will go up by 75 basis points, stock prices will fall by 15%, house prices will decline, tensions regarding the European money market will renew and contribute to an increase in short-term interest inter-bank rates by125 basis points. Considering the scenario which involves global negative effect of the US policy and a USD depreciation vis-à-vis all currencies, the private consumption and investment will be getting worse; however, it is assumed that both oil and non-oil commodities will be unaffected and the monetary policy will be unchanged. Considering the circumstances mentioned above it is anticipated that the overall effect of the EU-specific and external environment shocks will reduce the GDP growth by around 2% in both 2011 and 2012 and HICP will be lower by 0.5 and 1.1 percentage points for the euro area.

Although the ECB expects that the increased interest rates will reduce inflation and contribute to enhance economic growth, higher energy and commodity prices those are the main reason of the increased HICP little can be changed by such decision. Moreover, when the increased interest rates are used to reduce monetary liquidity and at the same time the opposite actions such as emergency liquidity to assist banking system in the event of crisis are considered it leads to higher volatility in the financial markets. Thus, I wish the ECB was able to identify though was not following the anticipated negative scenarios of the EU wide stress test.

Could the fixed balance sheets restore financial stability?

The OECD’s Economic Outlook published on the 25th of May and the BIS’s 81st Annual Report brought out on the 26th of June characterize the global recovery as self-sustained. It is projected that the US economy will grow by 2.6% in 2011 and 3.1% in 2012, the GDP in Euro area will rise by 2% in each of upcoming two years and the Japan’s GDP increase by 0.9 % and by 2.2% in 2011 and 2012 accordingly. Consequently, the safeguards of financial stability recommend withdrawing fiscal and monetary stimulus due to the rising inflation. However, these suggestions bear a strong resemblance to the decisions how to fix balance sheets instead of restoring foundations of financial stability.

From my point of view, the described economy recovery of the advanced countries in the OECD’s and the BIS’s reports is lack of structural analyses. Once the pressure of the inflation is taking under considerations I would rather like to know whose industrial sectors are overheated and why their development requires suppression. Moreover, has anybody estimated how the imposed extra costs associated with the suggested growth of interest rates would affect other fragile industries?

Additionally, increased capital (10.5% - total capital requirements that involves minimum capital plus conservation buffer), leverage and liquidity standards for banks according to the Basel III requirements and other endeavours such as accepted “ringfence” concept – the British initiative that intends to protect essential banks’ operations (deposit taking and payment systems) in big diverse banks; regulators agreement on extra capital charges of 1% to 2.5% of risk-adjusted assets on the 30 global systematically important institutions as well as suggestions of the BIS and the BCBS to apply supplementary countercyclical capital buffers are attempts to absorb losses in bad times and keep clean balance sheets of financial institutions after the banks’ bail outs started in 2008. However, those achievements do not mean that losses of the Financial Crisis are vanished. In most cases, they are just transferred to the governments’ balance sheets and the particular focus is required to recover the fragile economies of advanced regions.

However, according to the BIS's Annual Report “very low interest rates in major advanced economies delay the necessary balance sheet adjustments of households and financial institutions”. Thus, it may imply that encouragement to increase interest rates is aimed to restore price stability rather that the soundness of the whole financial system.

Trends of voluntary aid

A meeting of Eurozone finance ministers in Luxemburg today, on 20 June, ended without approval to lend €12bn  ($17bn) to Greece until the country’s parliament passes new spending cuts and economic reforms worth of €28bn. The matter is time sensitive as Greece needs the €12bn by July to avoid defaulting on its debt. The Eurozone finance ministers require further austerity measures; however, Greece may also relay on some EU countries’ voluntary aid.

French President Nicolas Sarkozy and German Chancellor Angela Merkel announced on last Friday that they will support Greece by purchasing new Greek bonds when existing bonds mature and encouraged others to follow their suggestion on voluntary basis. Such decision may not be acceptable in regard to taxpayers of Germany and France but when the possible decline of euro is directly related to the worth of governed assets, a voluntary aid is fully understandable.

However, looking to the long term perspective sound investment programmes, but not just austerity measures, should be the main focus for the Eurozone finance ministers as long as European Investment Bank, European Investment Funds and European Bank for Reconstruction and Development were established for the purpose to make a long-term finance available.

Similarly, analysing the outlook of the US economy state, id.est accomplished QE2 programme, increasing debt obligations and additional borrowing needs; the raise of yields of US long term treasury bonds and depreciation of US dollar should be expected in short term perspective. Consequently, countries those use US dollar as reserve currency and possess trade surpluses most likely will suggest their voluntary aid and buy US long term treasury bonds so that the worth of their governed assets were preserved.

Thus, for those who follow short term trends, summer time should be an important period to observe. Most likely the capital flows will be based on a voluntary aid.