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Sunday, 17 December 2017

Basel faulty

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Although the starting gun for the global financial crisis was fired in August 2007, in most people’s minds 2008 was when it all went wrong. 

As we come closer to 2018, the reflections on the past 10 years and all the extraordinary events that have taken place during that period will become more and more common. One of the key changes is to be found in Basel III, which aims to take Basel II a bit further and encourage not just the implementation of the rules governing capital and reserves but also a more uniform interpretation of the risks embedded in certain assets. This is particularly important within the eurozone where the push to further level the playing field needs to be driven forward. 

Although great on paper, there is a systemic risk, which will be enhanced by tighter capital requirements. The huge growth in the corporate bond market in general and the high-yield sector in particular has brought about a lightening of banks’ balance sheets which are, for capital adequacy purposes carrying visibly less risk. But that risk has not gone away; it has been unloaded, if that is the correct term, in the form of bonds on institutional investors and thus by proxy on their clients. 

The taxpayer, whether Joe, Hans, Giovanni or Jean-Jacques SixPack, is no longer on the hook to bail out the banks if their loan book goes belly up because the banks no longer own the risk. The taxpayers own it themselves with no intermediary balance sheet and no government-sponsored deposit guarantee scheme to protect them. Furthermore, tighter reserve requirements and a higher cost of capital will drive banks to further reduce the amount of the precious resource committed to market making. In the event of a sharp sell-down of assets in a crisis of confidence traders will quickly be able to hide behind their statutory inability to provide bids. 

Tougher capital rules have not made credit risk go away but they will end up making the transfer of risks across the financial system more difficult and, by definition, more expensive. In the post-2007 world the scarcity and the cost of capital have become the banks’ running shoes. Tightening the rules will do nothing other than force further disintermediation of lending while giving the banks a greater head start in the run for the door when the balloon finally goes up. And up it will go unless our central banks pursue a dedicated exercise of minimal interest rate policy. 

I was one of the very few who maintained from the beginning to the end of 2017 that the Fed would tighten three times during the course of the year. If they oblige next week as all of the smoke signals have indicated I will have been right. The consensus is that they will tighten again three times in 2018. Three 25bp moves would still only take Fed Funds to 2.00% although, assuming no sudden burst on the inflation front, that should take most of the yield curve back into positive real return territory. That said, two 25bp moves might achieve the same effect without posing quite the same mark-to-market risk to bond market, let alone the default risk to overleveraged borrowers. It’s not a soft landing of the economy that the Fed and its peers will be grappling with next year but a soft landing of risk asset markets. The first step towards this has to be an increase in market liquidity, not in capital reserves.

 

Bit silly 

On the subject of risks, bitcoin shot through US$14,000 last night. The much-awaited CME futures contract is in peril of being put on ice as the ability to maintain correct and sufficient margin in such a volatile market is as good as beyond the capacity of the broker community. Those who have read James Clavell’s Noble House will be aware of the difference in trading discipline between westerners and Chinese investors, always keen on a big-time gamble. With the latter now firmly in the driving seat my recommendation is to steer clear of involvement in that particular cryptocurrency. The problem is not in the currency, it’s in the people who are blindly driving the prices higher and it will surely sooner or later impoverish a lot of people. 

I yesterday attended a lunch with a senior banker aimed at explaining the workings of BlockEx and its ongoing ICO. What struck my BlockEx colleague and I was the way in which we had to keep drawing the conversation away from bitcoin and back to blockchain and distributive ledger technology. Blockchain and bitcoin are causally linked but there is still a huge mountain of technology in the DLT space that has nothing to do with speculating on virtual currencies and which is in the process of revolutionising the world we live in. The internet of things, which allows you to reheat your dinner while you’re on the way home from the office, is chickenfeed in comparison to the paradigm shift that blockchain technology is in the process of effecting. It is at the core of peer-to-peer business models, which today look as alien as did the idea 15 years ago of buying one’s groceries from one’s desk. I’m sure that back then the press was full of assertions that it will never catch on.

 

Deal or no deal 

Finally on Brexit. The DUP has had its 15 minutes of fame and surely knows that if it holds out too long it will bring down the government and with it its brief spell in the limelight. Turkeys don’t vote for Christmas. A compromise will be reached because the cost to not doing so is too high for all involved. I am confident that a solution will be reached, that a trade deal will be concluded and that an orderly Brexit will be achieved. On that basis I repeat that I think it might be time for non-UK investors to begin thinking about both the currency and British assets which I hope they were underweight of through 2017 as I suggested at the beginning of the year. 

Apart from that, volumes are declining while the calorie intake is increasing…

 

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