Wednesday, January 21, 2009

El-Erian on Banking

From the Financial Times:

We have to bring the banking sector back to life
By Mohamed El-Erian

There was a time when US banks were like the high-priced properties on a Monopoly board: expensive to buy yet very profitable, especially once you added houses and hotels. This is no longer the case. Banks increasingly resemble the utilities on the board: cheap to buy, with low revenue potential and limited ability to leverage.

The transformation of the banking system into a utility model has become inevitable in light of the risks that banks’ damaged balance sheets pose for the broader economy. The process is being driven by both market- and government-related factors and the implications are huge. In the weeks ahead, look for bold government initiatives, even greater fiscal spending and a further subordination of equity holders. The longer-term impact is even more consequential and threatens to erode the dynamism and growth potential of the US economy.

Banks play an important role in any economy – so much so that, by efficiently channelling funds to productive uses, they can meaningfully improve prospects for employment and wealth creation. Yet, if they run into difficulties, they become sources of turmoil and painful contraction in economic activity.

Emerging economies are familiar – in some cases too familiar – with this binary phenomenon; so are some of the small and medium-sized industrial countries. Until recently, however, large industrial countries had not experienced the downside since the 1930s. Now they are doing so.

For the reasons set out in my Financial Times article of September 25, we are in the midst of a historic consolidation of the banking system. This follows a period of over-expansion in balance sheets and overreach in business plans.

Banks were particularly ill prepared for the abrupt change in global liquidity conditions that took place last year, and they are ill prepared for the global economic contraction that is still building momentum. With fresh capital essentially sidelined by uncertainties and losses, weaker banks have become highly distressed sellers. In a very public manner, they are forced to dispose of assets and business lines into illiquid and unreceptive markets.

The results inevitably fall short of what is needed. Moreover, as the Bank of America-Merrill Lynch case vividly illustrates, the alternative of institutional consolidations offers no panacea. It simply results in the weaker partner contaminating the stronger one.

It should therefore come as no surprise that, returning to the Monopoly analogy, banks’ balance sheet rehabilitation efforts have not moved meaningfully beyond “Go”, and this notwithstanding the fact they have received billions of dollars of capital injections from the government. Instead, the banking system remains a huge liability for the overall economy.

Over the next few weeks, the US government will be forced to do more. Further capital injections are likely to be supplemented by ambitious attempts to remove in one swoop the overhang of toxic assets. This can be done by aggregating them into a new government-supported institution that benefits from abundant and permanent capital. The institution would liquidate the toxic assets in a gradual and orderly fashion. This sensible approach is costly to the taxpayer and it can be sustained only if accompanied by meaningful steps to ensure that banks do not return to their bad habits – thereby accelerating the government-inspired march towards a “de-risked” and slimmed-down financial system. Governments will be more than strict regulators; they will be meddling partial owners.

Under the utility model, banks will perform narrow functions within well-defined and constrained leverage. They will be less risky, but also less innovative and less able to lend imaginatively. This will inevitably reduce the speed limit for medium-term economic growth in the US and beyond. It is too late to stop the transformation of banks into utilities. But it is not too late to start working on a subsequent reinvigoration in the context of a more effective regulatory structure. Let us hope the Obama administration includes this in the long list of “must-dos” it has just inherited. Otherwise, both my and my daughter’s generation will face the higher tax bills in the context of a muted ability to generate revenues.

The writer is chief executive of Pimco and author of When Markets Collide: Investment Strategies for the Age of Global Economic Change, winner of the 2008 FT/Goldman Sachs business book of the year award

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This work by Nicholas E. Radice is licensed under a Creative Commons Attribution-No Derivative Works 3.0 United States License.