Sunday, June 29, 2014

Exim Bank Conference 2014 – Why do we need Exim?

The U.S. Exim Bank held its annual conference in Washington on April 24 and 25, 2014. When you watch the first minute of this event on the net, you immediately grasp the flavor of the conference, as you are invited to rise for the national anthem. If you would like to sing in front of your screen, please go ahead...
More seriously, the conference discusses why American exports and Exim Bank are so important and where the different experts expect the U.S. economy heading too. Overall, I must admit that I found the debate a bit superficial. Obviously, lots of symbolic events (A small business entrepreneur who creates jobs in rural America thanks Exim for its support and the like.) happened and nice business quotes were pronounced during the conference. But have I really learned something new?

Why is it important that Exim supports U.S. exports?

  • Develop new markets: If you sell abroad, you sell more. If you sell more, you produce more. If you produce more, you hire more (American) people.

Exports breathe new life into businesses. They transform whole communities through job growth. And that's what Exim delivers: global tools that reap lasting local benefits.
Fred P. Hochberg, U.S. Exim Bank, April 24, 2014

We made a lot of progress [in increasing U.S. exports]. We're exporting today a record amount of 2.3 tr USD of goods and services. But we need to continue.
Peggy Pritzker, U.S. Department of Commerce, April 25, 2014

  • Grow American small and medium sized businesses: This is linked to the above. If you find new markets abroad, you can obviously grow.

Gaining access to global markets is what empowers small companies to become big companies.
Fred P. Hochberg, U.S. Exim Bank, April 24, 2014

  • Compensate for foreign export support: Every country supports exports. That is why the U.S. has to do it too. Whether government support for exports is good or bad and whether it would be better to let only markets drive competition, doesn't really matter.

Supporting American job growth shouldn't be controversial. Keeping America competitive in the global economy shouldn't be controversial. And that, after all, is what we [Exim] do.
Fred P. Hochberg, U.S. Exim Bank, April 24, 2014

Everybody is entitled to their theories and dogmas, but theories, they don't pay bills. [referring to ECA critics in the U.S.].
Fred P. Hochberg, U.S. Exim Bank, April 24, 2014

  • Allow U.S. businesses to be competitive: In global markets, competition is huge, especially for U.S. companies. Exim helps U.S. companies in this cruel battle.

If you are an American exporter and you feel like you are wearing a big target, guess what, you’re not paranoid. Everybody wants to top the United States, so they’re pulling out all the stops to win trade deals and boost exports.
Fred P. Hochberg, U.S. Exim Bank, April 24, 2014

We [the U.S.] are competing in a voracious world – market and competitive-wise.
John Kerry, U.S. Secretary of State, April 24, 2014

We live in a competitive world. And, in order to compete, we need as many tools as possible. At the same time, we need to uphold our values and laws.
Peggy Pritzker, U.S. Department of Commerce, April 25, 2014

  • Globalization: Exports are an integral part of a more and more globalized economy. Supporting exports is, therefore, a necessary tool for economic policy.

As the world continues to globalize exports are increasingly vital to our economic success and job growth.
Fred P. Hochberg, U.S. Exim Bank, April 24, 2014

In the world we live in today, there are far fewer borders for trade and talent. And that means our companies have much more competition.
John Kerry, U.S. Secretary of State, April 24, 2014

  • Counter economic crisis: Supporting exports is simply an excellent means to boost your economy in times of crisis

The Exim bank has been a driver of economic growth [in the U.S.] for much of the past century, especially during difficult times.
John Kerry, U.S. Secretary of State, April 24, 2014

Is Exim a federal agency?
In a formal senses yes, Exim is part of the U.S. administration. However, in terms of functioning and values, the picture is completely different. This is, at least, the opinion of its chairman Fred P. Hochberg. He describes Exim as an organization that combines the best of both the world of public administration and the world of private entrepreneurship.

From the world of public administration, Exim adopts a special sense of responsibility towards the general public:

We [Exim] always take a responsible approach to risk.
Fred P. Hochberg, U.S. Exim Bank, April 24, 2014
On the other hand, Exim resembles its clients in terms of private initiative and dynamism:

We're [Exim] sleek, we're nimble, we're entrepreneurial-minded and we defy every tired stereotype about federal agencies; we deliver government at the speed of business. The reason for that is simple: we live in the world of business.
Fred P. Hochberg, U.S. Exim Bank, April 24, 2014

Fred can even do better:

At Exim we want to be the wind in your sails, equipping you with tools you need to venture out to new frontiers.
Fred P. Hochberg, U.S. Exim Bank, April 24, 2014

By the way, Exim partners with other U.S. administrations, even though this seems to be a special kind of partnership...

We go first. If we don't get the deal done, they [EXIM] come in after. So, this is a good and strong partnership.
Tom Vilsack, U.S. Department of Agriculture, April 25, 2014


U.S.EXIM Bank Conference on April 25 and 25, 2014

Sunday, June 22, 2014

The Banker's New Clothes – A call for more equity in banking

In October 2012, Anat Admati and Martin Hellwig have written a very good book about the banking industry called “The Banker's New Clothes”.

The authors’ principal claim is that, to make the financial system safer, banks should hold more equity. Not only a little bit more, but much more equity!

Here are the principal topics of the book:

Instead of borrowing, banks should raise more equity!

What exactly means more equity in the authors’ opinion? First, it means equity as compared to total assets, and not to risk-weighted assets. Second, it means not around 5 % as is often the case today but between 20 and 30 % as we usually see in corporates. Traditionally, banks were even organized as partnerships and, until the middle of the 19th century, they often held around 40 to 50 % equity.

“In the case of banks, in fact, requiring more equity produces large benefits at virtually no cost to society.”

In addition, equity should only relate to what it really is – money invested by shareholders who accept to receive exclusively dividends, if they are paid at all. The authors advise against banks issuing other financial instruments that are only convertible into equity such as Cocos (= contingent convertible bonds = long-term bonds that can be converted to equity when some trigger event occurs).

Will more bank equity diminish lending to the real economy?

Bankers say that a higher portion of equity would lead to less lending to the real economy. The authors write that this claim is wrong:

Capital (in the sense of equity) is not the same as reserve requirements; it is not something that the bank “sets aside” or “withholds”. Capital is simply a source of financing that can fund lending to the real economy.

Bankers reason as follows: Equity is more expensive than debt. Therefore, financing the real economy through equity is more expensive than financing it through debt. This is not true, say Anat Admati and Martin Hellwig: If a bank has more equity on its balance sheet, the expected return of shareholders will be lower and, thus, the price of the bank’s equity. As a result, a change of the debt / equity mix does not change the cost of funding for a bank. It only changes the distribution of risk and return among shareholders and debt-holders.

Higher equity requirements can distort the global level playing field for banks. And so what?

A common argument against stricter capital regulation is the famous “level playing field in regulation”: This simply means that, if Germany asks Deutsche Bank to raise proportionally more equity than the U.S. imposes on J.P. Morgan, this will create a competitive advantage for the latter and make it harder for Deutsche Bank to compete.

The authors mainly argue that, from the perspective of the general public, a competitive advantage for a bank has no merit as such. What counts is the risk that tax-payers incur (through implicit subsidies etc.) in return for the competitive advantage and whether such competitive advantage for a local bank is then still beneficial for the society. The answer to this question seems to be no.

In addition, for citizens in a country, the question is not whether local banks are successful in the context of global competition but whether local resources, namely people, find their most productive use.

Higher equity levels entail which other advantages?

Today’s “too big to fail” debate focuses pretty much on how to unwind banks in trouble. Two years ago, Anat Admati and Martin Hellwig wrote that this is wrong: We should focus more on how to avoid banks getting into trouble in the first place. And this is exactly what higher equity levels can do. They shift the risk from borrowers (or, through explicit or implicit guarantees, the general public) to the owners of a bank (i.e. shareholders) and, thus, make it less likely that a bank fails.

“If a bank has more equity and less debt, more of the downside of its activities will be borne by the bank and its shareholders rather than by creditors or taxpayers.”

If a bank runs short of liquidity, it might be obliged to sell its assets to generate cash. This type of urgent deleveraging can be very costly for a bank, simply because buyers will benefit from its desperate situation. More equity will soften this effect, as it gives banks more time to adjust its funding resources.

Finally, higher equity levels in banks could naturally reduce the size of the industry and the distortive effects of guarantees and subsidies that are predominant today.

What are the obstacles to higher equity levels in banks?

The book identifies five major impediments for higher bank equity:

First, interest paid to debt-holders is usually tax-deductible, dividend payments to shareholders are not.

“It is important to recognize that a corporate tax code that subsidizes debt and penalizes equity works directly against financial stability.”

Second, the banking industry relies excessively on ROE (return on equity) to measure performance. It then obviously makes sense for bank managers to lower equity as much as possible. For the society, however, this makes less sense, as it is the general public that ultimately bears the risk of low equity levels in banks.

Third, bankers often say that common considerations about equity levels and ROE cannot be applied to banking as this industry is “special”. Anat Admati and Martin Hellwig dispute this claim. They write that the only obvious difference between banks and other corporates is that, if the former are in trouble, they have a good chance to get government support. This is obviously no relevant argument in the discussion about higher equity levels in banks.

“There is a pervasive myth that banks and banking are special and different from all other companies and industries in the economy. Anyone who questions the mystique and the claims that are made is at risk of being declared incompetent to participate in the discussion.”

Fourth, banks using REPO transactions to fund their balance sheet favors borrowing instead of raising new equity. As a matter of fact, if lenders can benefit from the bank’s assets in the form of collateral, they feel more protected, keep on lending, and will deprive other creditors of these assets.

Fifth, the new Basel III regulation does not lead the way towards significantly higher equity levels: Required equity levels are still low and, in addition, rely broadly on complex risk-weighted asset calculations instead of the total asset levels. The new leverage ratio might help here.

Some additional quotes

At the beginning, the authors write that the purpose of their book is “to demystify banking and explain the issues to widen the circle of participants in the debate”. I would say that they have clearly achieved their goal.

The only thing I would criticize is that the authors primarily lead an academic debate without really taking into account the existing market situation. For example, the excessive focus on ROE in banking might be wrong. But, as long as investors ask for it, it doesn’t really matter whether ROE is a good or bad measure. It ultimately counts anyway. That’s a little bit like television: You cannot constantly complain about the low quality of the program, knowing that this is exactly what the public wants to watch…


Anat Admati, Martin Hellwig – The Banker's New Clothes

Tuesday, June 17, 2014

Christine Lagarde talks about inclusive capitalism. – “Ethical behavior is a major dimension of financial stability.”

On May 27, 2014, Christine Lagarde participated in the conference for inclusive capitalism in London. The Managing Director of the IMF spoke about economic inclusion and financial integrity.

My introduction needs some explanation.

First, what is inclusive capitalism? According to Christine Lagarde, it is a market economy in which trust, opportunity, and rewards for all prevail.

Second, inclusive capitalism faces which challenges, according to the IMF? Christine Lagarde says it’s the rising income inequality and the lack of an integer financial system.

Income inequality is on the rise.

“The 85 richest people in the world, who could fit into a single London double-decker, control as much wealth as the poorest half of the global population – that is 3.5 billion people.”

This is perhaps a shocking statement but, as such, not a major problem for inclusive capitalism. What matters more is, according to Christine Lagarde, the inequality of opportunities that comes with any inequality of outcome. Put differently: If you have less money, your education and health care will suffer; thus, you will get less opportunities in your life, compared to others.

“Fundamentally, excessive inequality makes capitalism less inclusive. It hinders people from participating fully and developing their potential.”

Another problem of income inequality is that it undermines solidarity and reciprocity in societies. Ultimately, this may threaten democracies.

The financial system is not integer.

“We are familiar with the factors behind the crisis – a financial sector that nearly collapsed because of excess. A sector that, like Icarus, in its hubris flew too close to the sun, and then fell back to earth – taking the global economy down with it.”

Every day, we can read in the financial press that the integrity of the financial system is a problem. So what can we do about it? Christine Lagarde presents four answers:

  • Avoid financial institutions becoming too big to fail: Increasing minimum capital ratios on systemic banks can reduce systemic risk significantly. In addition, an international agreement on a cross-border resolution of mega banks would also help.
  • Make better rules and better monitor shadow banks.
  • Make derivatives markets safer and more transparent.
  • Change the behavior and culture in the finance industry: Supervise banks stronger, allocate greater resources to independent supervisors, align incentives with expected behavior, and promote prudence and social consciousness as a core value of banking are the key words here.

“The true role of the financial sector is to serve, not to rule, the economy. Its real job is to benefit people, especially by financing investment and thus helping with the creation of jobs and growth.”

“Prudence has long been a byword of banking, and yet has been sorely missing in action in recent times.”

This is all nice and right. But it still remains pretty vague for me. And, in addition to being vague, Christine Lagarde says that the above topics will also take a very long time to be implemented:

“Just as we have a long way to go to reduce our carbon footprint, we have an even longer way to go to reduce our financial footprint”.

Something makes me think that this is not the last time that I write about these topics…

Some additional quotes


Monday, June 9, 2014

Financial innovation or threat to the financial system? - The IOSCO introduces to crowd funding

Crowd funding means a large number of investors spends small amounts of money to fund projects through web-based platforms.

By focusing on a fraction of the [bank] services, we can provide those services, and those services alone, cheaper.
Giles Andrews – Zopa – February 14, 2013

What is commercial crowd funding?

Commercial crowd funding (also called financial return crowd-funding or FR crowd-funding) can take two forms, peer-to-peer lending and equity crowd funding.

Peer-to-peer lending

Peer-to-peer lending is like traditional lending. Simply, people use on-line platforms to match lenders’ and borrowers’ demands.

Peer-to-peer lending platforms can follow two business models. In the client segregated account model, one individual lends directly to the other. The platform is simply a service, helping collect loan payments. In the notary model, a bank lends to the borrower. The peer-to-peer platform then refinances the loan by issuing notes which individual peer-to-peer lenders buy through the platform.

Equity crowd-funding

Today, there are only very few equity crowd-funding platforms, with the majority focusing on angel investors or sophisticated investors.

When you are involved in the on-line finance business, there is a pressure to grow very quickly.
Anil Stocker – Market Invoice – February 14, 2013

Commercial crowd funding market

Today’s total global market size is 6.4 BUSD. Since its beginning in 2006 in the U.K., the market grows very fast. This is mainly due to technological innovation and the inability of traditional credit providers to lend, in the aftermath of the financial crisis, to the real economy. However, despite strong growth, the commercial crowd funding market is still small, as compared to total bank-originated credit. For example, peer-to-peer lending only represents 0.01 % of the total bank lending market in 2013.

Most platforms act locally, in individual jurisdictions.

Pros and cons

Commercial crowd funding has five advantages:

  • It spreads risk.
  • It lowers the cost of capital for borrowers and increases returns for investors.
  • It contributes to economic recovery by financing small and medium enterprises.
  • It creates a new assets class, allowing investors to diversify.
  • As it is entirely internet-based, it is cost efficient.

The banks have this philosophy that for every service there should be a charge. And the charge has got nothing to do with the cost to doing this particular service.
Michael Joseph – Vodaphone – February 14, 2014

On the other hand, commercial crowd funding entails seven major risks:

  • Risk of borrower’s default: As such, this is nothing special, a borrower can always default. However, if you lend through a crowd funding web site, you don't have necessarily all appropriate information to invest. Available statistical data can be biased towards big platforms and, if carried out by the platform, the financial analysis of the borrower might not be critically worked through.
  • Risk of platform closure: If the platform is the only link between lender and borrower, this can directly lead to default, simply because contracts and payment systems disappear.
  • Risk of illiquidity: Today, there is no secondary market for crowd funding instruments, meaning that investors cannot sell their participations.
  • Risk of cyber-attack: If FR-crowd funding markets are on-line, this risk is obvious.
  • Risk of fraud: Identity theft, money laundering, and data protection violations are common problem in any lending business. However, as the Internet is particularly anonymous, they are enhanced in commercial crowd funding.
  • Systemic risk: Today, the industry is not big enough to threaten the financial system. But this might change in the future...
  • Circumvention of banking regulation: In my view, this can be bad if investor protection is abandoned or conflicts of interest of the platform are not properly addressed. However, as lender and borrower are directly connected, I don't see any potential problem for the economy at large.

Should we regulate commercial crowd funding?

The spectrum of possible regulation ranges from no regulation at all (for example Brazil, United Kingdom, and South Korea) to complete prohibition (for example Israel and Japan).

We have spent the last three years lobbying for regulation which is ironic.
Giles Andrews – Zopa – February 14, 2013

In-between, you can treat peer-to-peer lending platforms either as brokers, as banks (for example France, Germany, and Italy), or as collective investment schemes.

The IOSCO report is a very good introduction to crowd and definitely worth reading.


Monday, June 2, 2014

The European Investment Bank – “We can accept more credit risk than a commercial bank.”

What comes to you mind when you think about Luxembourg? My guess is that you come up with key words such as “tax heaven” or “investment fund industry”. The city-state is a bit less well known for its European institutions, among them the European Investment Bank (EIB) that I would like to present today.

What is the EIB?

Created in 1958 by the Treaty of Rome, the EIB is the long-term lending bank of the European Union. Its mission is to contribute towards the integration, balanced development, and economic and social cohesion of the EU member states.

“The EIB is both an EU body, accountable to the Member States, and a bank that follows best public and private sector practice in decision-making, management and controls.”

EIB is both an EU body and a bank.

As an EU body, its shareholders are the member states. Their equity participation corresponds to the economic weight of each member state at its time of accession. EIB's capital structure is somewhat special: Beyond subscribed paid-in capital (The member states have actually paid the nominal amount of their equity participation.), member states contribute subscribed unpaid capital (= callable capital, e.g. member states have a legal obligation to pay their share on demand at EIB's request.).

Even though the organization is politically deeply intertwined with the EU bodies and member states, it remains, as a bank, financially autonomous: To fund its operations, it borrows from international capital markets. In addition, it is an eligible counter-party in the Eurosystem’s monetary policy operations and has access, through the Central Bank of Luxembourg, to the monetary policy operations on the European Central Bank.

The EIB is also majority shareholder of the European Investment Fund (EIF). Incorporated on 14 June 1994 in Luxembourg as an international financial institution, the primary tasks of the fund are

  • to provide guarantees to financial institutions that cover credits to small and middle sized enterprises (SMEs),
  • to acquire, hold, manage, and dispose of equity participations, and
  • to administer special resources entrusted by third parties.

What does the EIB?

Lending / Guaranteeing

First and foremost, the EIB is a lending institution. When I write about loans here, I mean providing finance in a large sense. As a matter of fact, EIB usually only lends directly to big projects, exceeding 25 MUSD. But EIB can also grant finance indirectly, i.e. through private banks, if it guarantees loans endorsed by commercial banks. Some general criteria characterize EIB lending / guaranteeing:

  • As far as possible, loans are granted only on condition that other additional sources of finance are engaged.
  • EIB lends either if the debtor has the financial strength to repay or if a member state guarantees the loan.
  • At any time, loans and guarantees granted by the bank shall not exceed 250 % of its subscribed capital, reserves, non-allocated provisions and profit and loss account surplus.
  • As a multilateral institution, EIB has only vocation to lend to the extend funds are not available from other (private) sources on reasonable terms.
  • The execution of EIB's investment must increase economic productivity and promote the attainment of the EU internal market.

“The EIB is the world's largest multilateral borrower and lender.”

EIB finances

  • Infrastructure: Key initiatives in this field include the 2013 Project Bond Initiative, designed to enable infrastructure project promoters, usually public private partnerships (PPPs), to attract additional private finance from institutional investors such as infrastructure companies and pension funds, the Joint Assistance to Support Projects in European Regions (JASPERS) that provides advice to 14 EU member states and three enlargement countries to improve the absorption of EU structural and cohesion funds and, since March 2013, includes a networking platform in Brussels, and the Joint European Support for Sustainable Investment in City Areas (JESSICA) which has the vocation to improve the living standards of the urban population in the EU.
  • Micro-finance initiatives: Through its European Progress Micro-finance Facility, the bank and the European Commission support micro enterprises. The European Investment Bank does not provide micro finance by itself. It only lends to micro-finance providers such as MicroBank in Spain which then pass the funds to small enterprises in the form of micro loans.
  • Trade: Traditionally, short-term credit instruments such as trade finance have not been part of EIB's product portfolio. However, in the aftermath of the European sovereign debt crisis, EIB today supports trade finance facilities: More specifically, it guarantees domestic banks that have issued letters of credit. This alleviates cash collateral constraints otherwise imposed on SMEs and increases access to international trade instruments.
  • Research and innovation, carried out both by academic institutions and the private sector: Instruments include the Risk Sharing Finance Facility (RSFF – offered in partnership with the European Commission, it is a tool to encourage investment in higher risk long-term research, development and innovation), venture capital and growth capital support through the EIF, and the High Growth and Innovative SME Facility (GIF) under the EU Competitiveness and Innovation Framework Program (CIP), a tool offering innovative European mid-cap companies a spectrum of financing solutions ranging from direct debt to quasi-equity risk and mezzanine instruments.
  • SMEs
  • Climate action programs

The European Investment Bank is, above all, active in EU member countries. 90 % of its lending is spent on projects in Europe. However, projects outside the EU are also carried out if they support EU external priorities. In total, EIB is active in over 160 countries.

Additional tasks

Additional tasks include cooperating with international organizations and banking and financial institutions in the countries to which EIB's operations extend.

EIB's balance sheet

EIB praises the strong quality of its financial assets: For example, the impaired loans ratio is close to zero (0.2 % of the total loan portfolio by the end of 2013).

The Bank does not view its treasury activities as profit-maximizing, even though performance objectives play an important role. Investment activities are conducted with the primary objective of protecting the capital invested.

On the liability side, the bank does not hold deposits and refinances itself mainly through bond issues. These bonds can carry special features such as climate awareness bonds, structured for socially responsible investors.

In its role as an issuer, the bank can be seen as a conduit for investment from outside Europe into the Union, as roughly 40 % of its bonds are subscribed by non-EU investors.

EIB's Profit and Loss Account

The bank is not a profit maximizing institution. As the financial arm of the EU, it passes benefits on to its customers. More specifically, profits progressively build up a reserve fund of up to 10 % of EIB's subscribed capital.

The business model of the bank generates moderate profits from large volumes of loans financed at low margins. EIB has recorded a surplus in its statutory accounts in every year of its existence.

Some key figures

  • EIB Corporate Governance Report 2013
  • EIB Financial Report 2013