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by internationalbanker

By Phillip Mann – phillip.mann@internationalbanker.com 

Recent months have produced a significant degree of change in the banking and financial-services sectors. The plunging price of oil coupled with ever-present political tensions and turmoil across the globe have provided the backdrop to conditions of continuing uncertainty both within the banking and financial sectors and for economic groups, individuals and institutions of all sizes across the world. In Europe, the economy has been suffering for a while now—unable to regain momentum in economic growth. Within the last few weeks, the European Central Bank (ECB) has announced a plan of quantitative easing (QE) to help boost the economy by providing liquidity, aid and support to banking and financial sectors through asset purchases. Quantitative easing is a monetary policy used by central banks to stimulate national economies when rudimentary monetary-policy measures have become ineffective. A central bank typically executes a quantitative-easing plan by buying specific amounts of financial assets from commercial banks and other private financial-services institutions, which acts to raise the prices of those financial assets and to lower their yields, while at the same time increasing the monetary base. This differs from the more typical policy of buying or selling short-term government bonds in order to keep interbank interest rates at a specified target value. Expansionary monetary policy to stimulate the economy typically involves the central bank buying short-term government bonds in order to lower short-term market interest rates. However, when short-term interest rates reach or approach zero—as is most particularly the case in Europe, alongside many other nations—this method can no longer work. In such conditions central banks and monetary authorities may then use quantitative easing to further boost the economy by buying assets of longer maturity than short-term government bonds, thereby lowering longer-term interest rates further out on the yield curve. 

The ECB has unleashed a programme of quantitative easing, somewhat of a surprise to market and banking participants, which has provided boosts to the stock markets since the announcement. The European Central Bank launched its long-awaited strategy to stimulate the European economy and fight deflation with a €60-billion-per-month bond-buying programme that is in fact much larger than economists, bankers and investors had originally expected. ECB’s president, Mario Draghi, commented that the bank would purchase upwards of €1 trillion in financial assets by September of next year (2016), including private-sector and government bonds. Quantitative easing can help ensure that inflation does not fall below a target. Risks include the policy being more effective than intended in acting against deflation (leading to higher inflation in the longer term, due to increased money supply) or not being effective enough if banks do not lend out the additional reserves. The action of the ECB is not without precedent. The programme of quantitative easing that has now been wound down in the US was a success in stimulating the economy. The US economy is now enjoying improved employment and wage levels as well as boosted investment and consumer spending and what at this time appears to be manageable inflation conditions and levels. And according to research from the International Monetary Fund and various economic research groups, quantitative easing undertaken since the global financial crisis of 2007–2008 has mitigated some of the adverse effects of that crisis.

The ECB has also stated that it will maintain the option to extend the quantitative-easing programme. The particular goal of this strategy is for the ECB to increase the Eurozone inflation level to its pre-specified target of just under two percent. The ECB QE programme will involve the ECB buying €60-billion-worth of assets a month as well as purchasing sovereign debt, asset-backed securities and covered bonds. However, the QE programme will not involve the buying of corporate bonds in this case. The programme will be launched in March of this year and is initially estimated to last up until the end of September 2016 and potentially will continue until inflation is close to its two-percent target level. The programme has been restricted so that the ECB will buy at a maximum a third of a country’s debt issuance, and the strategy has been designed to involve risk sharing on 20 percent of the assets. In addition, as part of the QE programme, the ECB has enhanced the terms of its longer-term refinancing options. This will allow banks to obtain affordable loans and help lower the interest rates at which they are offered—this is designed to hopefully increase the take-up of the refinancing options, which have to date been lacklustre at best.

However, the move from the ECB to launch such a large-scale quantitative-easing programme has come up against strong and vocal opposition in Germany, both pre and post announcement. German economic experts alongside bankers, political and business leaders are concerned the QE programme will reduce the incentives for European countries to restructure and reform their economies through tough economic action and decision-making, as they are being provided with an easier option of economic support. Meanwhile, stock-market participants and investors across the globe appear to have welcomed the QE plan, with bond prices spiking across the board and European share prices rising, while the euro fell substantially at the same time. In the extreme case, one of Germany’s leading euro-sceptics has already been preparing to take the ECB to the country’s constitutional court over the bond-buying programme; Peter Gauweiler, a conservative MP who has launched numerous legal actions against the common currency, has announced that he has instructed a law expert to prepare a case. 

A further concern in Europe is Greece. Mr Draghi has made it clear in his comments that there will be “no special rules” for Greece. However, with the election winner of the far-left Syriza party overseeing from Athens a coalition government formed with the far-right Independent Greeks, the Eurozone has been forced into a new phase of uncertainty. Anti-austerity Syriza head and now Greek Prime Minister Alexis Tsipras has since his election been purportedly planning to write off a significant amount of Greece’s debts with regards to its bailouts, which took place in 2010 and 2012. This idea has understandably sent shock waves through the Eurozone, as national leaders and policy makers are now faced with the possibility of Greece exiting the Eurozone altogether if agreement of terms cannot be made on the sizeable debts involved, which are due to mature several months into this year. Germany again is particularly against the suggestions, as is Finland and the Netherlands, as the move would result in significant losses to their balance sheets as well as to those of European nations across the region that have contributed to the bailouts. However, for Greece to be eligible for the announced QE programme, it would have to honour the original commitments and terms of its international bailout provisions—which is certainly something it will want to consider as part of its seeking to boost its national economic conditions. 

The ECB’s decision brings it closer into the line of strategy of the US Federal Reserve and the UK’s Bank of England, which started buying government debt soon after the 2007-2008 global financial crisis more than five years ago. Mr Draghi further commented during a press conference at the ECB’s headquarters in Frankfurt that “expectations work only if there is a certain credibility”; he also added that “today we are showing that credibility is deserved”. After coercion from German leaders and advisers, the ECB agreed that each nation’s central bank would hold the majority of the responsibility for the risks and losses stemming from any reshaping or default of its commensurate national debt. This is a departure from the Eurozone’s historical record that has been applied in previous sovereign-bond-buying schemes. However, there will in fact be risk-sharing on 20 percent of the assets involved in the QE programme, which will be, in the main, debt issued by European institutions purchased by national central banks. Although the QE-plan announcement came as a surprise to market and economic participants, there were some prior hints of such a plan from the ECB. The Eurozone fell into deflation in December of last year (2014)—this is the first period of deflation in the Eurozone in more than five years. Government leaders and policy setters have been at loggerheads with the ECB over the core details of the QE plan—evident in particular by the objections of Germany, the Eurozone’s strongest national economy by far. German leaders have not been quiet about their objections. For example, speaking at the World Economic Forum in Davos, Switzerland, this year, Germany’s chancellor, Angela Merkel, vocalised her objections and directly criticised the ECB, whilst also voicing concern that QE could lessen the urgency felt by Eurozone governments to reform and overhaul their economies. She remarked at the conference that “I think it is important we are … not tempted to buy time and avoid doing structural reforms”. German banks have been even more direct, noting that they believe that the QE plan will have only marginal effects in exchange for significantly increased risks of asset-price bubbles, inaccurate risk assessments and misguided investments. 

The ECB’s announcement of the QE plan has come after several months of intense speculation over whether Mr Draghi would succeed in overcoming derisions and divisions over the bond-buying plan amongst policy makers on the central bank’s governing council. Although there were a number of objections, eventually the decision to launch QE was supported by “a large majority [of the ECB’s governing council], so large we didn’t need to take a vote,” Mr Draghi has commented. Following the announcement, the euro fell to its lowest level in greater than 11 years, falling almost two percent against the dollar to $1.1405. Meanwhile, stock-market prices increased, with the FTSEurofirst 300 Index gaining 1.6 percent to its highest point in more than six years. In addition, bond prices rose—for example, the yield on France’s benchmark 10-year bond fell to a new low of 0.6 percent, while the Spanish benchmark 10-year bond dropped 13 basis points, and Germany’s benchmark 10-year bond fell from 0.58 percent to 0.44 percent. At a number of press conferences since the QE plan was announced, Mr Draghi has repeatedly faced concerns from a number of countries that only limited sharing of risk would lead to greater fragmentation of monetary policy in the Eurozone or may even lead to doubts being raised about the cohesiveness across the region. Mr Draghi has further remarked that the ECB and national central banks will never buy more than one-third of a country’s debt issuances and that the maturities of sovereign bonds purchased through the programme will range in maturities of between two and 30 years. 

Mr Draghi has been facing a delicate and difficult balancing act between satisfying the demands of the Eurozone with a QE package that will help convince markets that he and the ECB are committed about returning inflation to just below two percent and at the same time allaying the concerns of critics of QE. Although a compromise and middle ground appear to have resulted from the discourse, the question marks still remain significant enough at this early stage to hold some uncertainty for investors. Investor perception is what drives investor confidence, which in turn drives capital and liquidity into the financial system and feeds economic development and growth. If the European leaders are not able to signal to the markets that they are capable of achieving a sensible and practical plan then Europe will most likely continue with, if not worsen, its lacklustre levels of economic performance as experienced over the past few years. Bearing in mind the comments from objectors and opposers of QE, Mr Draghi has commented that the council was “unanimous in stating that the asset-purchase programme is a monetary policy tool” that “establishes the principle”.

Meanwhile, the UK is continuing to have a diminishing role and involvement in EU financial and banking sectors, as has been the trend over the past few years. UK leaders and lawmakers have expressed backing and support for EU financial reforms, but at the same time have been commenting that the diminishing influence of the UK in the EU is disappointing and disproportionate to their contribution within the region. According to a recent UK parliamentary report, the UK is losing influence over EU financial-sector reforms. In addition, the majority of the EU’s range of post- crisis financial-services and banking reforms were “necessary and proportionate” and would have been put in place via national law if the EU had not legislated them, according to the UK parliamentary report. The “Post-crisis EU financial regulatory framework” report published on February 2, 2015, by the House of Lords’ EU committee has indicated general and broad support for the majority of the EU’s financial-services and banking reforms but also noted the UK’s “diminishing” role in structuring and shaping the financial-sector legislation. After the global financial crisis of 2007–2008 that took place more than five years ago, the EU implemented a number of strategies involving financial rules and regulations so as to provide increased stability to the financial marketplace and economic environment and reduce the risks, volatility and vulnerabilities that contributed to the financial crisis to begin with. The range of proposals included more than 40 differing legislative changes, and this was in addition to an overhaul of the bloc’s banking union framework—which has now been concluded through the course of 2014. 

Despite the common impression that the UK is repeatedly ignored or overruled on financial- and banking-sector reform of regulation, David Cameron, as the conservative-led UK government leader, has only been outvoted on one file in the last legislative term (the most recent version of the directive on bank capital requirements—which the UK opposed because of an inclusion to further restrict bonus pay). In addition, the UK, over that period of time, opposed proposed plans for a financial-transactions tax that would apply across the EU region, which was then taken up by 11 members of the bloc. However, in both of these cases, the UK proceeded to file legal cases and actions against the European Commission. This type of behaviour and contribution has shown the UK to have had a strong influence within the EU over past years. However, the recent committee report has warned that “the UK’s influence over the EU financial services agenda is diminishing”. The UK parliamentary report noted that the especially flawed legislative proposals were the result of political pressure to take action and/or to make the financial-services and banking sectors pay for the 2007-2008 global financial crisis, and in particular cited that the capital-requirements bill and laws governing investment-fund managers as part of this new legislation were designed to address this distribution of blame. The drafted financial-transactions tax proposal was also designed with this aim, according to the report. However, the report also commented that “the bulk of the new regulatory framework was necessary and proportionate, and would have been implemented by the UK even if action had not been taken at the EU level”. The key conclusion was that the UK is losing influence in Brussels when it comes to financial and banking policy and that this imbalance should be restored in order to enhance efficiency, productivity and output for both the UK and European regions. By participating actively and contributing significantly to the debate on these types of financial-sector legislative matters, the UK will maintain influence and have more of its economic interests protected—which will help sustainable and stable development into the future. The UK is exposed to the EU and its economic and financial-sector conditions, whatever its influence on policy, given that the world economy operates on a globalised platform today and that the UK is a direct geographic neighbour to the region. It is, therefore, in the UK’s interest to help shape and structure policy with a vocal presence, as the results will affect the UK banking and financial-services sectors either directly or indirectly eventually.   

London remains a dominant and prominent financial hub of skills, expertise, talent and output for the financial-services and banking sectors on a global scale, yet London risks being side-lined from EU agenda and policy setting. London is furthermore the EU’s largest financial-sector hub. Jonathan Hill was given the financial-services portfolio when made the UK’s new commissioner, and as part of his work in this role it is expected that he will implement a strategy to harmonise the EU’s capital markets in an effort to lower European businesses’ reliance on bank lending. The plan will be designed to instead divert companies towards capital markets to raise funds for business growth and development through a more free-market mechanism, whereby investors may judge the true merits of the business and signal their conclusions with their money and capital investments. Mr Hill wants to step away from a model in which European firms rely on banks for 80 percent of business-finance needs and follow the US example, whereby businesses and companies receive five times the amount of funding from capital markets as compared to their EU counterparts. In addition, Mr Hill has said that a commission ideas paper would be launched in coming months, before he goes on to put together a more comprehensive action plan later in the year, around autumn, which will include possible legislative measures to move in that direction in the autumn. In addition, the UK parliamentary report has noted that the EU’s three supervisory agencies for markets, insurance and banking should be given more power, commenting that despite having been responsible for much good work, they are held back by a number of fundamental weaknesses, which include a lack of independence, authority, resources and influence over the legislative process. 

Meanwhile, in the US, the falling oil price is a key concern for many of the larger US banks—particularly those serving the commodities and energy industries to a large degree. Oil prices are falling, and banks that have been servicing at their cores the commodities and energy sectors are exposed. Energy and certain commodities markets have provided some buoyancy in an otherwise drowning marketplace for the US banking sector over the past few years. However, the recent tumble in oil prices risks damaging the progress made in this area since the fallout of the global financial crisis. US banks have been lending to the energy sector—keeping busy underwriting bonds, providing merger advice and financing home building for workers and employees of the oil sector—whilst other areas of business have dried up. However, this positive trend is headed for a reversal as crude oil falls in price and crucially falls below levels that would be sufficient for a number of energy companies to continue business and normal operations through proper servicing of their huge debts. Across the industry strains are already being felt, and economic advisers and industry experts are forecasting defaults in the horizon. A slowdown is coming for the energy sector and related banking and financial-services businesses. Reduced required loans and increased numbers of defaults as well as an increasing number of closures are fuelling the trend that has resulted from falling crude. Providing banking and financial services to energy businesses has been a significant contributor to profits for northern US banks over the past few years, and the contraction in the oil sector is likely to hurt revenues and bottom lines for these banking institutions. Texan banks, during the 1980s, experienced a significant fall in the energy business, and this led to large losses for banks and lenders— in some cases, banks were forced to close or had to be rescued from collapse. The current situation may not be as dire as conditions stand, but given the delicate balance bankers and banking executives face, and having to contend with the current potential vulnerabilities and shock factors over the horizon, they should remain prepared and cautious. On the other hand, lower oil prices help banks in a smaller measure in a different way. This is especially the case for those banks with large consumer businesses. Through helping consumers to carry out their spending and financial services through lower energy costs, banks may see some increased output in this department of business. This may help retail lending as consumers face lower bills and may be more likely to take up lending through mortgages and credit cards, for example. However, if oil prices remain around $50 a barrel persistently, economists and industry analysts expect a sharp deceleration in output and production over 2015, cutting into energy banking fees in a larger degree than gains made in consumer areas. According to research produced by data provider Dealogic, two large US banks that are at most risk by reduced investment-banking fees are Wells Fargo, which derived about 15 percent of its investment-banking fee revenue in 2014 from the oil and gas industry, in addition to Citigroup, for which similar business areas accounted for roughly 12 percent of total revenues. 

As we move further into 2015, the climate remains uncertain for the banking and financial-services sectors. The effects of ECB QE will come into action in March of this year, but the true impact will only be revealed at a much later date. For now, the UK and US banking sectors and economies are showing stable outlooks; however, the combination of factors stemming from global vulnerabilities and volatilities have the potential to send shocks into the market and disrupt progress made in these and other regions that are showing promising growth trajectories. Lowered oil prices, contracting growth in China, uncertainty in Europe from QE as well as from Greece’s situation, combined with interest-rate cuts in Australia and a refusal to apply much-needed interest-rate cuts in Turkey, adds uncertainty to the increasingly interconnected global marketplace. The political turmoil across the globe only acts to exacerbate the situation. On the other hand, the ECB QE programme may create a significant turning point for the Eurozone economy, and this may also provide support to the global economy—creating upwards momentum and sustainable economic growth and development for the years ahead. As with all monetary-policy measures, only with time and careful and effective management will the results be revealed.

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