Federal Reserve Rate Hike and its Implications on the Global Economy

Jonathan Eng

After the release of the Federal Open Market Committee (FOMC) minutes on the 22nd November, there has been a mixture of reactions to the signalling of an increase in the Federal Rate. The minutes reflect a more positive atmosphere in the US economy; with a strengthening labour market and a gradual increase in household spending and business investment. A streak of hurricanes drove up gasoline prices in September, fuelling short-term inflation. However, little has been done to impact medium- to long-term growth, with expected longer-term inflation targets remaining unaffected.

The FOMC expect that such economic activity will prevail, which warrants a gradual increase in the federal fund rate—henceforth, Rate—but will remain at levels lower than what is expected to prevail in the long-run. This sentiment has had several repercussions in the dollar, gold, Treasury Bonds and Foreign Exchange markets.

Theoretically, any rise in the Rate would result in the appreciation of the dollar as there becomes fewer dollars in the market due to a higher Rate. However, the dollar currently remains at one its weakest levels since mid-October and has fallen 0.9%. This is mainly due to the fact that markets have already priced in the potential hike in December into existing prices. However, beyond December 2017, the minutes appear vague and uncertain; compounding this with a flattening of US yield curves which only points to short-term Rate hikes and the result is a defensive dollar to protect domestic interests.

This uncertainty in the medium-to-long run in monetary policy has also been reflected in the price of gold and Treasury bonds. Gold went up 1% and traded at 0.8% higher and yield on 10-year Treasuries dipped slightly after the release of the FOMC minutes. Gold is generally perceived as a ‘safe-haven commodity’ whilst US treasury bonds are secure investments with sure-returns; essentially a ‘safe-haven investment’. The fact that gold and Treasury prices have risen reflect cautious investor confidence in the market. This attitude in investor confidence will result in 1 of 2 outcomes; either the price of gold continues to rise while treasury yields fall, or an influx of FDI will go towards China.

Attitudes across the Pacific contrast the defensive reaction in the West. The Yen and Australian dollar went up 0.3% against the dollar while the Dollar Index, which tracks the dollar against a basket of global peers, was down 0.2% in Asia. The index had moved down as much as 0.8% on the day, ahead of the release of the minutes. A weaker dollar remains favourable for China, which pegs the yuan against the dollar. Given China’s current appetite for exports and reputation for cheap labour, a lower dollar will relieve pressures on Chinese exports to the West for the time being.

Despite uncertainty in the medium-to-long term, what is clear in the short run is that the US economy is showing signs of being on track to recovery, with historic quantitative easing being rolled back and Rate hikes being back on the discussion table. What is less certain is how rates will change in the long run, as US inflation is expected to fail to meet its 2% target. How markets will price the dollar and yields accordingly is also undecided. For the time being however, China would almost certainly welcome a weaker dollar, as it continues to leverage cheap exports and extensive FDI to fuel its economic growth.

Ethical Investing: watching the triple bottom line has started to make real economic sense

Isabella Ferros

Be it Corporate Social Responsibly, Corporate Accountability, or Creating Shared Value, a plethora of terms have emerged and somewhat inconsequentially circulated the ranks of financial institutions over the last half century. Only recently have investment patterns actually begun to mirror these sentiments. Recent analysis shows that funds which have integrated environmental, social, and governance (ESG) standards in their strategy are now outperforming those who don’t by a significant margin. The rationale behind such investing is multifarious. These funds seek to claim a stake in future opportunities that will arise within the realm of clean technologies, such as renewable energy and electric vehicles. Furthermore, such investing will insulate portfolios against the downturn of the smokestack industries that comprised the “old economy.” This is an important consideration at a time when the green revolution continues to gain credence.

These new investing behaviours are evidenced globally. The world’s largest pension investment fund, the GPIF (which belongs to the Japanese Government), announced in July that it has selected three ESG indices to track. Norihiro Takahashi, president of the GPIF, has expressed that the organisation will entrust 1 trillion Yen ($9 billion US dollars) of Japanese equity investments against these benchmarks; an allocation which is likely to rise even higher in future. In a similar vein, one of Europe’s biggest insurers Swiss Re has also revealed plans to shift the entirety of its $130 billion-dollar portfolio away from traditional benchmarks and invest in a multitude of ESG aligned stocks instead. This shift, emboldened by the solid performance of current ESG indices, signifies the that the market has reached a pivotal point where ethical investing is no longer just “doing good” — it also makes economic sense.

There are clear social and environmental benefits accredited to ESG, such as that companies who show little regard towards workers’ welfare, act exploitatively towards their communities and fuel conflicts by funding corrupt parties, will be expunged. However, the deciding factor in a fund adopting a new strategy will always lie ultimately in protecting portfolios against downside risks. Spokespeople for global macro investment at BlackRock have articulated that ESG’s move to mainstream is “about not losing a tonne of money. [Funds who] invested in the US coal sector in June 2014 lost 85 per cent by the end of 2015.” On the flip side, inflows of capital into ESG index tracking funds on BlackRock’s iShares platform have brought in a total of $5.7 billion over the last eight years. Similarly, the four indices devised by one of the largest index providers, the FTSE Russell, which groups companies that are involved in green applications, have garnered superior returns in comparison to the FTSE Global All Cap Index.

However, despite the appearance that ESG investments are going from strength to strength, it’s not all plain sailing. The ambiguity surrounding classification of ESG factors has created a rift amongst industry players. Management at Swiss Re have expressed frustration around ESG benchmarking, citing that the lack of clear market standards and guidelines on accepted technologies and practices is dragging on the general acceptance of ESG. Sceptics also cite that the acceleration of “green” companies has been artificially enhanced by generous governmental subsidies divvied out en masse so governments meet the pledges they made under the UN Paris climate accord. Without these, iconoclasts state that the outperformance of ESG indices would be much slimmer, and that the capital flows propping up renewable energy, electric vehicles and all other green technologies would be insufficient.

Regardless, the Global Sustainable Investment Alliance has estimated that ESG integration reached $10.4 trillion dollars in 2016, which is an increase of 38% since 2014. With infrastructures such as policy, governance strategy and implementation reporting which will underpin future ESG investments being developed at speed by large fund managers, this trajectory doesn’t seem set to change any time soon. It can be considered that in order to make ESG investing truly mainstream, the private and public sector will have to work together to achieve stronger harmonisation regarding ESG guidelines. With infrastructure and acceptance of ESG proliferating, investors are now finding that if they do good for the people and planet, it tends to do good for their pockets, too.

Global Real Estate Concerns – The House Always Wins?

Benjamin Foster

Global real estate markets are facing increased concerns as the fundamentals of previously booming markets begin to scare regulators and institutional investors. The main target of this disquiet is China, with Beijing and Shanghai both well known for ballooning house prices and witnessing double-digit gains last year. Whilst this has prompted a degree of regulatory tightening in the main cities, Bloomberg’s recent investigation into the economic data of ten key Chinese cities highlights a large degree of fluctuation in the fundamentals behind property bubbles. These fundamentals (including population growth, income gains and the ratio between house prices and pay) and their fluctuation across the Chinese market are raising interesting concerns for those navigating the region’s real estate market.

A deep examination of the ten cities, selected out of the 70 that the government closely monitors, reveals a mixed picture. Shanghai and Beijing — facing lower population growth, moderate increases in wages and elevated home prices — appear increasingly vulnerable, especially when one factors in plans to cap their population and curb urban sprawl, traffic congestion and air pollution. Smaller cities also should be regarded as somewhat risky investments, with Haikou offering weak wage gains and lower population growth, raising concerns over the increased investment in the region. In contrast, Guangzhou and Shenzhen in the south may face less pressure, with far more favourable rates of population and income growth, as well as far more opportunities for development across the board.

A similarly troubled market is also clearly present across the Pacific, with the Australian housing market finally winding down. With almost half a decade of surging prices, the market value of the nation’s homes has exploded over $5 trillion, four times the country’s gross domestic product. Not even the U.S. and U.K. markets achieved such heady peaks a decade ago. Like the U.S. and the U.K. however, Australia’s obsession with home ownership is firmly entrenched in the nation’s economic focus. Record-low interest rates, tax breaks and increasing breadth, and depth of mortgage lending have pumped incredible amounts of debt into Australian homes.

The increasing treatment of housing as a financial commodity has seen a spike of borrowers tying themselves into a maze of mortgage-related products. Whilst this has been incredibly profitable in the short term for banks operating in the region, Daniel Blake, economist at Morgan Stanley, highlights that banks may find it harder to value their collateral if — or more likely when — the market falls dramatically as investors look to consolidate their portfolios of multiple homes. Indeed, the signs from some institutional investors are not particularly positive, with UBS economists declaring that “Australia’s world-record housing boom is officially over… The cooling may be happening a bit more quickly than even we expected.”

The world’s biggest sovereign wealth fund, however, says it has no intention of pulling back from real estate. Whilst Norway’s $1 trillion fund does note that gaps are opening between the noted valued of real estate and their value on the physical market, a potential sign that a correction could be looming, the fund is steadily growing its real estate empire (valued at $32 billion).

“It’s clearly a red flag in pricing if anything is too far off in any direction,” Karsten Kallevig, chief executive officer of Norges Bank Real Estate Management, said in an interview at his Oslo office on Wednesday. Yet perhaps the fund’s holistic approach to the sector, in its eyes, helps to mitigate these risks. Investing in a wide range of key global cities with prime office space, rather than domestic real estate being the backbone of their portfolio, the fund also holds an increasing amount of retail and logistics properties. With Amazon as one of its biggest tenants, the real estate unit is a close observer of the shift to online shopping.

“Retail is going through an evolution for sure, and it is something we are very focused on,” said Romain Veber, the London-based head of European markets. The fund is placing its bets on “high street retail,” which will “survive in the long term,” he said.

Stepping Up Scrutiny of Initial Coin Offerings

Isabella Ferros

Initial Coin Offerings (ICOs), a method of digitally raising funds from the public using cryptocurrencies, have become an increasing quandary amongst regulators in recent months.

Functionally, an ICO can be considered as a ‘coin sale’, whereby issuers accept cryptocurrencies such as Bitcoin or Ether in return for a proprietary ‘coin’ or ‘token’, which generally represents either a share in a firm or project or a prepayment voucher for future services.  The ICO’s issuer can keep the ether or bitcoin, and use the funds to develop its project.

Although they were as good as unknown a year ago, this method of raising funds has now become more celebrated that the initial public offering (IPO), which is the conventional way of floating a company. According to data provider Coinschedule, more than 3 billion US dollars has been raised in over 200 ICO’s over the last 12 months, compared to around $70 million in the previous annum. The velocity with which ICOs are increasing has in turn fuelled the rapid ascent in the value of all cryptocurrencies, from about $17 billion at the start of the year to a record high of close to $180 billion at the beginning of September.

As articulated by former New York securities regulator Benjamin Lawsky, “Regulators have never seen a new financial product explode with the speed and velocity,” and this unchartered growth is beginning to merit concern from those in charge of financial regulation.

For many, it seems that the crux of the quandary lies in determining what exactly ICOs and their tokens represent, and thus where they should fit into the regulatory framework. Champions of ICOs declare that, although they are initially used to raise funds, they also have a function in the projects they finance, and hence should be treated as utility tokens. It is proving difficult for regulators to be convinced of this, however. According to Lex Sokolin of Autonomous Research, being pieces of code, they can take on the form of any financial product. “They collapse all asset classes into one.” This is causing legal friction, particularly in America, where different asset classes are regulated by different agencies. Other jurisdictions are not proving easy to navigate, either.

At the end of September, Swiss financial regulator FINMA remarked upon the stark increase in initial coin offerings conducted in Switzerland, stating that it is “looking into a number of cases” that have been flagged for concern due to possible breaches of Swiss law.  Up to now, many crypto firms have based themselves in Zug, which has appropriately coined the name “Crypto-Valley,” where they have been less likely to be branded by authorities as a security (therefore saving on taxes).  However, in a similar vein to FINMA, the Crypto Valley Association has recently issued a statement in support of ICO regulation and said it was working with its members to develop an ICO code of conduct. This will likely spell out greater regulatory intervention for prominent blockchain projects operating out of the area.

The move to increase the oversight of projects puts Switzerland in line with other international authorities who have already cast a sharper eye over the new crowdfunding method. Whilst the Chinese and Korean authorities have outlawed ICOs under the premise that they are an extension of gambling culture, Wall Street’s main regulator has ruled that ICOs should be subject to the same safeguards as traditional securities. This is a sentiment shared by many regulators in other Western countries who have now voiced that they also consider at least some of the tokens distributed in an ICO to come under the classification of a security, thus needing to be regulated as such.

To avoid the heaviest regulation, issuers have been scrambling to keep the lawyers busy, but in early October JPMorgan Chief Executive Jamie Dimon declared that bitcoin, the original and largest cryptocurrency, is “a fraud” that will eventually “blow up” when regulators crack down. The coming months will be pivotal, but for the moment, the future of ICOs is mired in ambiguity.

Innovative Payments in FI: Block by (Sort of) Blockchain

Benjamin Foster

Financial innovation company R3 CEV and its 22 member banks have developed a new, blockchain-based platform to enable cost effective and near instantaneous cross-border payments, based upon Corda, a distributed ledger technology. At present, international transactions can take several days to be fully finalised, leading not only to delays, but the greater potential for fraud. With R3’s innovation Corda, however, banks and other financial institutions are approaching the capacity to execute payments almost instantly – building upon Goldman Sachs’ work on its Utility Settlement Coin from earlier this year (a system that envisions settling securities trades using a built-in cryptocurrency).

“International payments systems have struggled to keep pace with the explosion of global trade and the globalisation of the world’s markets,” said David E. Rutter, CEO of R3. “This marks a significant milestone for distributed ledger technology as we work alongside our bank members to harness its unique attributes to build the world’s first true international payments system.” The newly developed platform will sustain digitized versions of fiat currencies on a decentralized ledger and will look to also incorporate central bank-developed digital currencies in the future.

R3’s platform is not, however, a blockchain, with the company shifting away from its original research goal of developing an international payments blockchain, due to a number of key issues with the technology. The speed at which transactions can be processed, issues with the scalability of the technology (as Bitcoin’s ‘forking debate’ of the past year has demonstrated), and security concerns of irrevocably committing sensitive financial information to a public ledger have all forced R3 to shift towards the development of a Distributed Ledger Technology (DLT).

In addition to addressing many of the inherent obstacles for incorporating a blockchain system into international finance, R3’s DLT has also achieved API stability for the first time, allowing developers to build apps from within the ledger (CorDApps) that can be enabled without changing the core API or forcing the client to move its data outside of the secure platform. For instance, RegTech Accuity’s financial fraud screening capability has already been incorporated into Corda, with Accuity stating the feature is ready to use, but will likely only become accessible in 2018 when its licensing terms are finalized.

The integration is targeted at Corda’s financial institution users, including ING, BBVA, and HSBC, among others, and will allow Corda users to scan transactions using an “oracle node” (a key component of Corda that establishes a secure link between a DLT-based smart contract and external data sources), and cross-reference the transaction with regulations such as 4MLD and the US Patriot Act. Whilst Accuity’s integration into Corda is a key step in addressing major concerns of financial institutions regarding blockchain-based platforms – that is, ensuring processes are legally and regulatory compliant – Accuity has stated that it plans to strike similar deals with R3 competitors Hyperledger and Ethereum, suggesting that embedded compliance tools will soon become the standard among such providers and wiping away some of R3’s current, market-leading shine.

R3 is betting, however, that by leading the way in providing connectivity to existing networks, it will speed up the adoption of its open source applications and encourage banks to form coalitions with other network members to experiment with the technology. With R3 now working with over 100 banks, financial institutions, regulators, trade associations, professional services companies, including Barclays, Commerzbank, HSBC, Natixis, and U.S. Bank, the company’s vision for the future of its DLT will undeniably have a key impact on the development of blockchain-based FinTech.

This sector of the market is becoming increasingly key to innovation within both financial and technology giants, with Google and Goldman Sachs two of the most active corporate investors in blockchain companies according to latest reports. The number of corporate investors in blockchain companies hit a record high of 91 this year, just behind the 95 venture capital firms in the space, according to a report by data firm CB Insights published last Tuesday, with $327 million in equity investments made already this year and just trailing the $390 million for the whole of 2016.

Basel, (aisle) III

Jonathan Eng

With the start of 2018 mere weeks away, Basel III is set to be fully implemented across the EU and America. The roll-out has been gradual since its conception in 2010 to allow banks to restructure their balance sheets and capital structure. Basel III is a follow-up, voluntary, set of regulations from Basel II, which is aimed at improving bank liquidity, funding stability and capital structure, to better prepare banks for the next financial crisis. But are banks complying?

Basel III’s focus is mainly three areas: Capital, Liquidity and Leverage.  It specifies new capital target ratios and redefines what would constitute each tier of capital and ensures that firms have a strong enough financial base to weather another financial crisis. Basel III is analogous to a bitter medicine – nobody likes to take it but it’s good for you.

Capital

The new capital target ratio requires firms to hold 7% Common Equity Tier 1 (CET1) capital- which means that if they were to lend out $100, they had to be holding $7 capital (broken down into 4.5% CET1 and 2.5% capital conservation buffer). At a broader level, requirement for Tier 1 capital was set at 8.5%, including CET1 of 7%. Basel III also sets new standards for ST funding and sketches out requirements for LT funding.  An additional problem was with the rather complex redefinition of what would constitute Tier 1 or Tier 2 capital. Whilst it might seem quite complex, the principle behind it is quite straightforward; have enough in reserves to maintain bank credibility that enough cash can be returned to customers, preventing panic.

Liquidity

The ‘Liquidity Coverage Ratio’ is a requirement that banks hold enough liquid assets, or assets that they may liquidate at short notice, to cover net cash outflows over a period of 30 days. The intention behind it is much the same as requiring having to hold more top-tier capital. On top of this ratio, Basel III also put forth the ‘Net Stable Funding Ratio’ (NSFR), a policy that requires the available amount of stable funding a firm had, to be more than the amount the firm was required, over a one-year period of extended stress.

Compliance?

A lot of this was largely predicated on the redefinitions of capital. The Committee for European Bank Supervisors (EBS) estimated that the capital shortfall for top-tier banks would be between €53bn for the CET1 minimum requirement and €263bn for CET1 target level of 7%. Tier 2 Banks need €9bn for their minimum CET1 percentage and €28bn to achieve the target level of 7%. T1 capital ratios for Tier 1 Banks would, on average, decline from 10.3% to 5.6% whilst total capital ratios would decrease from 14.0% to 8.1%. Tier 2 Banks’ T1 capital ratios would decrease from 10.3% to 7.6% and total capital ratios would decline from 13.1% to 10.3%.

From this we can see that Basel III is already making a difference. And given the impact on high-tier firms, probably for the best. McKinsey estimate that pre-tax ROE will decrease between 3.7 – 4.3% from pre-crisis levels of 15%. There is no doubt that firms’ bottom lines would be affected in the midst of restructuring and reducing balance sheets, and since it’s voluntary, would anyone be interested in adopting such measures?

In one word, yes. There are signs that banks are adopting these new measures. As of the latest data from the EBS, the average LCR is already 134.2% and 170.1% respectively for Tier 1 and Tier 2 banks. 99.2% of banks show an LCR above 100%. This success can be attributed to the structural adjustments undertaken by firms and re-framing of the LCR framework. Furthermore, 87.5% of banks surveyed have met minimum NSFR requirement of 100%.

While the effectiveness of such safeguards will not be discernible until the next financial crisis, there is little doubt that adopting these new measures will better prepare firms for financial distress and also cushion the next big crisis – even though one can’t predict the next crisis. With so much uncertainty in today’s market, perhaps it is for the best that banks prepare for the next financial fall-out.

Will Trump’s election widen the ECB’s shrinking action space?

Tamas Laszlo Babos

Donald Trump’s election instantly impacted global markets. Although the vote’s exact effect on Europe’s trade, security, and political landscape remains unclear, it seems to be positive from the European Central Bank’s perspective. The European economy could enjoy a boost due to the reaction of markets, which would indeed widen the action space of the central bank.

One of the positive shocks came from foreign exchange. The euro has weakened 3 per cent against the dollar since the vote on the 8th of November. The currency, now being on its lowest level this year, clearly assists the ECB in stimulating economic growth and inflation through boosting exports.

On the other hand, the bond market is also affected. European yields have risen sharply since the vote, which is mainly explained by to factors: Higher inflation expectations reflect anticipated tax cuts, while higher government spending expectations suggest a possible shift from the politics of austerity. Overall, people are revising their expectations of fiscal policy as opposed to global interest rates.

Although such activity in the bond market negatively affects the ECB’s current quantitative easing program, it also helps policymakers achieve their targets. Earlier this year, the bank, in order to suppress borrowing costs, announced its policy to buy €80bn worth of securities a month.

Recently, the ECB was close to find itself in a tough situation: the safest bonds started to yield negative rates, thus putting the bank at risk by exhausting German bonds to buy. Such situation would have either led to a change in the central bank’s policy, or to a limitation in its ability to act.

So how do bond prices reflect inflation expectations? Rising prices have a tremendous effect on bonds due to fixed coupon payments – rising yields imply falling prices. Therefore, the increasing yield of long-dated euro bonds postulates that investors are seriously taking the risk of inflation into consideration.

Echoing Frederik Ducrozet’s notion published in the Financial Times, the ECB gained roughly six months of asset purchases due to the sell-off in Eurozone bond markets. The senior economist at Pictet also speculates about a possible new round of bond purchases which would strengthen the economy.

Optimism should however not blind policymakers. Yields remain depressed and inflation is not yet recovering in the Eurozone, reiterates Vítor Constânci. The ECB vice-president also points out that protectionism would likely have negative effects on the economy. Reverberating off Ducrozet’s perception, nothing justifies rising yields in Europe. Prematurely rising interest rates will hopefully be avoided.

State-controlled RBS and its failure in Bank of England’s stress tests

Alexander Baldwin

 

In the Bank of England’s latest round of UK annual stress tests, RBS, Barclays, and Standard Chartered Bank all failed to meet the minimum standards in the stress scenarios, with the former emerging as the worst performer.

 

BoE modelled their tests in the toughest scenarios ever set by the central bank. A shrinking of the Chinese and Hong Kong economy and a global economy contraction of 1.9 per cent were the centre of the test scenarios. A further test was conducted on a drop in UK housing prices over five years.

 

Although both Barclays and Standard Chartered did fail to meet some minimum requirements, the BoE decided they have enough capital raising plans for the given scenarios of the stress tests.

 

The Bank of England added in its report that  “The stress test demonstrates that RBS remains susceptible to financial and economic stress”.

 

BoE’s report identified RBS must now find a further £2bn in capital at address the Bank’s shortcomings, most likely through cutting costs and selling some of its assets.  In response to this the stress tests results “RBS has already updated its capital plan to incorporate further capital strengthening actions and this revised plan has been accepted by the PRA Board” the central bank said.

 

Lloyds, Nationwide, Santander UK and Nationwide all successfully passed the central bank’s tests. BoE Governor Mark Carney gave praise to banks for their balance sheets and was happy enough with the banks being able to provide enough credit in tough financial times and withstand the economic stress.

 

Despite RBS’ shares recovering after a 2% drop on early morning trading after the stress test announcement, the bank has faced growing concerns and criticisms regarding its turn around strategy. Many shareholders are hoping to receive dividends in the near future, whilst the government wants to start selling its 72% stake in RBS. With estimated US department of justice fines surmounting to $12bn, questions are arising around its strategy and current chief executive Ross McEwan going forward.

 

 

Tighter Regulatory Measures or Financial Panic?

Ąžuolas Ališauskas

 

For those naïve enough to believe that European banks have resolved their problems, the Bank of England’s most recent stress tests serve as a perfect reminder not to rush to conclusions. Although only RBS failed the test and vulnerabilities were highlighted at Barclays and Standard Chartered, the aggregate Return on Equity (RoE) of the seven tested banks is about 2.5 percent. In comparison, before the financial crisis some banks were enjoying a RoE of above 30 percent. The main issue is that banks have to make enough profit across the business cycle and thereby accumulate sufficient capital to withstand the shocks when they hit. Such shocks might occur following the referendum in Italy.

 

Although banks across Europe would prefer to focus on long term prospects and hope that the economic environment will improve, they are nervously awaiting the results of Italy’s constitutional referendum this Sunday. But do not fall into the trap of presuming that bankers harbour any concern regarding changes in Italy’s constitutional landscape. Of more importance to them is the Italian Prime Minister Matteo Renzi who has promised to resign should the constitutional reforms be rejected. Bankers are worried that without Mr Renzi, who championed the market solution to solve the problems of Italy’s €4tn banking system, market turbulence will ensue, thus deterring private investors from recapitalising the troubled banks.

 

8 Italian banks are in various stages of distress, most importantly Banca Monte dei Paschi di Siena, the third largest Italian bank by assets and the oldest surviving bank in the world has seen its share price plummet from the heights of €1000 in 2012 to €20 at present. The main problem the distressed Italian banks are facing is non-performing loans (NPLs) which are loans whose borrowers have not made required payments for at least 90 days. For Banca Monte dei Paschi di Siena NPLs are close to 22 percent of total loans. A possible resolution of the problem hinges on the outcome of Italian Constitutional Referendum on 4 December.

 

Though most recent polls suggest that the reforms will be rejected (albeit by a margin of 6 percent), Trump’s victory and Brexit have demonstrated the inherent fallibility of polls. If the polls happen to be right, however, bankers will have a number of things to worry about. If Mr Renzi keeps his promise, a new government will have to be formed. In the best-case scenario, the much-needed solutions to solve the problems of Italy’s banking system will be merely delayed, thus only causing minor turbulence in financial markets. But the worst-case scenario may result in the formation of an anti-EU coalition, provoking Italy to leave the Eurozone and thereby weakening an already fragmented union even further, with panic ensuing in financial markets as a result. Though this may seem an unrealistic prediction at present, Trump’s victory was similarly presumed impossible and if the events of 2016 have taught us anything, we ought not to evade the possibility of seemingly implausible outcomes.

 

On the other hand, if the people of Italy decide to accept constitutional reforms, banks will have little to cheer about even if the 8 distressed Italian banks’ problems are resolved. Financial regulators have no intentions of slowing down to continue their job in an attempt to strengthen the European banking sector. Despite bankers’ complaints about endlessly evolving regulations, The Basel Committee on Banking Supervision has recently been working on introducing a new peace of regulation. The key element of this regulation package is how banks can use their internal models to determine the riskiness of their loans. Also, the element where policymakers from Europe and the US strongly disagree have so far prevented the Basel Committee from signing off on the reform measures. Furthermore, the European Commission has recently tightened regulatory measures. The most recent one, on which, however no agreement has been achieved yet, is a rule forcing large banks to issue more securities that can be easily written off in the event of a failure of the bank. This is yet another attempt to solve the “too big too fail” problem.
The 2008 Financial Crisis changed the banking industry. Having been blamed for causing a recession whose consequences still resonate to date, large banks had to adapt to an environment of endlessly tightening regulatory rules. This has weakened bank’s profits, but made the financial system more resistant to shocks. The Constitutional Referendum in Italy on 4 December will test the strength of the banking industry in Europe. Although it is hard to predict the worst possible outcome of the shifting power dynamics of Italy, there is no doubt about regulators’ eagerness to reform the banking industry being detrimental to banks’ ability to generate profits.

 

For those naïve enough to believe that European banks have resolved their problems, the Bank of England’s most recent stress tests serve as a perfect reminder not to rush to conclusions. Although only RBS failed the test and vulnerabilities were highlighted at Barclays and Standard Chartered, the aggregate Return on Equity (RoE) of the seven tested banks is about 2.5 percent. In comparison, before the financial crisis some banks were enjoying a RoE of above 30 percent. The main issue is that banks have to make enough profit across the business cycle and thereby accumulate sufficient capital to withstand the shocks when they hit. Such shocks might occur following the referendum in Italy.

 

Although banks across Europe would prefer to focus on long term prospects and hope that the economic environment will improve, they are nervously awaiting the results of Italy’s constitutional referendum this Sunday. But do not fall into the trap of presuming that bankers harbour any concern regarding changes in Italy’s constitutional landscape. Of more importance to them is the Italian Prime Minister Matteo Renzi who has promised to resign should the constitutional reforms be rejected. Bankers are worried that without Mr Renzi, who championed the market solution to solve the problems of Italy’s €4tn banking system, market turbulence will ensue, thus deterring private investors from recapitalising the troubled banks.

 

8 Italian banks are in various stages of distress, most importantly Banca Monte dei Paschi di Siena, the third largest Italian bank by assets and the oldest surviving bank in the world has seen its share price plummet from the heights of €1000 in 2012 to €20 at present. The main problem the distressed Italian banks are facing is non-performing loans (NPLs) which are loans whose borrowers have not made required payments for at least 90 days. For Banca Monte dei Paschi di Siena NPLs are close to 22 percent of total loans. A possible resolution of the problem hinges on the outcome of Italian Constitutional Referendum on 4 December.

 

Though most recent polls suggest that the reforms will be rejected (albeit by a margin of 6 percent), Trump’s victory and Brexit have demonstrated the inherent fallibility of polls. If the polls happen to be right, however, bankers will have a number of things to worry about. If Mr Renzi keeps his promise, a new government will have to be formed. In the best-case scenario, the much-needed solutions to solve the problems of Italy’s banking system will be merely delayed, thus only causing minor turbulence in financial markets. But the worst-case scenario may result in the formation of an anti-EU coalition, provoking Italy to leave the Eurozone and thereby weakening an already fragmented union even further, with panic ensuing in financial markets as a result. Though this may seem an unrealistic prediction at present, Trump’s victory was similarly presumed impossible and if the events of 2016 have taught us anything, we ought not to evade the possibility of seemingly implausible outcomes.

 

On the other hand, if the people of Italy decide to accept constitutional reforms, banks will have little to cheer about even if the 8 distressed Italian banks’ problems are resolved. Financial regulators have no intentions of slowing down to continue their job in an attempt to strengthen the European banking sector. Despite bankers’ complaints about endlessly evolving regulations, The Basel Committee on Banking Supervision has recently been working on introducing a new peace of regulation. The key element of this regulation package is how banks can use their internal models to determine the riskiness of their loans. Also, the element where policymakers from Europe and the US strongly disagree have so far prevented the Basel Committee from signing off on the reform measures. Furthermore, the European Commission has recently tightened regulatory measures. The most recent one, on which, however no agreement has been achieved yet, is a rule forcing large banks to issue more securities that can be easily written off in the event of a failure of the bank. This is yet another attempt to solve the “too big too fail” problem.
The 2008 Financial Crisis changed the banking industry. Having been blamed for causing a recession whose consequences still resonate to date, large banks had to adapt to an environment of endlessly tightening regulatory rules. This has weakened bank’s profits, but made the financial system more resistant to shocks. The Constitutional Referendum in Italy on 4 December will test the strength of the banking industry in Europe. Although it is hard to predict the worst possible outcome of the shifting power dynamics of Italy, there is no doubt about regulators’ eagerness to reform the banking industry being detrimental to banks’ ability to generate profits.

 

 

Overview of the financial markets: Brexit vs. Trump’s victory

Ąžuolas Ališauskas

It is hard to tell whether Britain’s vote to leave the European Union was more surprising than Donald J. Trump’s victory in the US presidential election. However, it is clear that they were both highly unexpected, and triggered massive activity in the financial markets. Both Brexit and Trump’s victory are seen as the resurgence of nationalist sentiment in the West and a protest vote against the elite. Are these similarities implying a similar reaction of financial markets – currencies, commodities, bonds and equities?

Equities

When markets opened after surprising election results on June 24th and November 9th completely different trends appeared. Panic unfolded after the Brexit vote with the FTSE 100 losing almost 9%, however recovering and closing down 3.2%. The panic was even clearer in the FTSE 250, an index that is far more dependent on the UK for revenues, which finished down 7.2%. The S&P and Dow Jones, on the other hand, on November 9th after a short-lived panic, as a result of expected fiscal stimulus, recovered and closed up 1.11 and 1.4% respectively. It is also worth noting that the banking sector was hardest hit by Brexit, whereas it was helped by Trump’s victory due to expected deregulation of the financial industry.
Currencies

Currency market’s response to Brexit vote was very clear. Due to uncertainty about Britain’s future relationship with the EU and a widespread belief that the economy will slow down after leaving the bloc, investors sold out the pound. Its value shrank from 1.49036 a dollar to 1.36834 in just one day. On the other hand, although representing rising levels of uncertainty, Trump’s victory had a mixed effect on the dollar. After a rocky start, the dollar, helped by Trump’s calming victory speech, recovered and returned to strength, closing up against a number of currencies, including the Euro. Moreover, the value of the pound hit 31-year record low of below 1.09 a dollar in the second half of October, whereas the dollar index has risen 2.6% since Trump’s victory.

Gold

The development of the price of gold indicates that Brexit has generated more uncertainty than Trump’s victory. As gold is usually used as an insurance against political upheavals, it is expected to rally when uncertainty rises. In the build-up to the Brexit vote, the precious metal has gained 26% as Brexit prompted investors to seek out less risky assets. On the day after the referendum gold gained further 5%. Yet again the story is different for the controversial Republican candidate’s victory. Despite strengthening whenever polls predicted Trump’s victory in the run-up to the election, gold failed to rally after Trump’s win. Although prices temporarily jumped 5%, they eased back and closed 0.1% lower.

Government Bonds

Government bonds represent another area where the two most important votes of 2016 yielded completely different outcomes. With the levels of uncertainty rocketing after the United Kingdom decided to leave the European Union, investors piled up into government bonds. Both the German 10-year Bund and the 10-year UK Gilt yields hit record lows. After Trump’s victory, however, the opposite happened – investors dumped bonds, expecting higher inflation and expansionary fiscal policy, piling into equities.

Investors who expected Trump’s victory to have the same effect on the markets as Brexit were punished. High level of activity in the markets seems to be the only significant characteristic shared by the two analysed events. Being equally unexpected, these events had radically different impacts on the financial markets – Brexit’s outcome surprised few, if anyone at all, whereas Trump’s victory’s effect was a massive surprise to analysts globally.