ôThe wholesale money markets are no longer going to fund financial sector balance sheets to the degree they did in the past on the basis of so little information. This together with new regulations and risk aversion will mean a much slower pace of credit growth,ö he said in a luncheon speech at the CLSA InvestorsÆ Forum on Friday. ôOf course, securitised debt and all that will continue to exist, but it is going to exist in a way where banks remain responsible borrowers and set aside reserves against it û the investment banking business model is now dead and the market has pronounced it to be so.ö
Roche also notes that the damage done to the capital base of the financial intermediaries will force them to focus on deleveraging for several years to come, which will have a further negative impact on global credit growth û the past few years of credit growing at five times the pace of GDP will be replaced by an environment where it is expanding more in line with nominal GDP growth.
And while the easy-to-come-by credit removed the need to save, particularly in the countries where credit was the most democratised, the next 10 years will see the opposite, i.e. thrift will have to replace leverage.
Capital will be scarcer, but it will be priced more appropriately for risk and it will be better invested. He also expects profits to come down as a percentage of GDP, while wage share will rise, partly due to inflation and partly because unfavourable income differentials will be clawed back û as seen by the attempts by Congress to attach remuneration limits to the governmentÆs $700 billion bailout programme.
ôAbsolute returns wonÆt be so brilliant, but at least they will be driven by return on investment rather than leverage. M&A and LBO deals will still exist and can still make money, but they will have to make money by bringing something to the companies they buy that the old management couldnÆt provide, rather than from simply gearing up the balance sheet,ö Roche says.
In his view, the total losses resulting from the bursting of the credit bubble will amount to about $1.3 trillion, of which $800 billion will stem from the US and the remainder primarily from Europe. So far, banks have announced $510 billion worth of losses or write-downs, while non-deposit-taking financial institutions (primarily broker-dealers) have owed up to $250 billion of losses. However, Roche argues that there is no reason to assume that the assets held by the NDFIs are any better in quality or any less urgent to deal with than at the banks. In fact, they are exactly the same and the only reason that NDFIs have admitted to or written off less so far is that these institutions have significantly less capital that can take the hit, he says.
RocheÆs estimates suggest that the NDFIs will account for about 54% of the final $1.3 trillion tally, which suggests that this is where most of the pain will be felt.
So far, $400 billion of new capital has been raised to replace the capital that has been lost, but Roche argues that it takes credit growth of at least 7% per year to sustain economic growth of 2%-3%, which implies a capital need of at least $1.047 billion this year û or an additional $647 billion.
ôThis is the degree by which the net wipe-out of capital in the financial system will constrain credit growth. It is not enough to replace the capital. What you need to do is to replace the capital fast enough in order for credit to continue to grow, because a credit squeeze is not composed of credit standing still, a credit squeeze is when credit will not grow by enough to fund the growth in the economy. And that is the risk we are facing,ö he says.
Roche has earned himself a significant degree of credibility on the issue, having warned about the risks of the excessive liquidity in the system two years ago. His theories, which have since been presented in a book titled New Monetarism (of which he is the co-author) centre around a redefinition of liquidity to include securitised debt and derivatives. This broader liquidity measure produces a very telling inverted pyramid where the ôbottomö is made up of equity capital corresponding to 1% of total liquidity and the equivalent of 7% of global GDP, followed by bank loans with 6% of the liquidity and 80% of GDP. Then it gets scary.
The next layer is made up of securitised debt corresponding to 12% of liquidity and 145% of global GDP, while the top derivatives layer accounts for 81% of the liquidity and the equivalent 976% of global GDP.
The main culprits for creating this environment, according to Roche, can be found at the US Federal Reserve and he notes that both former chairman Alan Greenspan and current Chairman Ben Bernanke were very slow to catch on to the problems that were being created by years of loose monetary policy. The policy produced lower economic and financial market volatility but it encouraged excessive leverage as a way to make decent returns and the derivatives markets allowed the banks both to lock in a low cost of capital and to transfer the risks to non-deposit taking institutions that were willing to bear them û although not necessarily the most able to handle them should the market turn.
As financial markets continued to head higher over successive years, the incentives and rewards also became heavily stacked in favour of risk-taking. And it was the same across the industry û the traders and originators working towards their bonuses, the rating agencies getting paid for rating the new instruments, and the regulators who were engulfed in a race to liberalise.
ôThe system could not stop,ö says Roche, adding that it led to an environment where banks were no longer making money from the margin between loans and deposits, but by doing deals and by borrowing short-term to fund long-term assets that were either kept on their own books or moved into structured investment vehicles (SIVs) that repackaged them into various exotic structured products which could be sold through the wholesale money markets.
This new model was embraced most strongly in the US and the UK, while European banks continued to back up their lending practises with large capital reserves. Japanese banks have also been largely sheltered from the fallout of the credit bubble, but according to Roche they were neither smarter nor more cautious than the US banks. Rather they were helped by Japan's massive savings ratio and the fact that they remained pre-occupied by deleveraging until only a few years ago.
ôWhat saved the Japanese banks was that they started too late and didnÆt catch up to the US banks (in terms of borrowing),ö he says.