x Abu Dhabi, UAEThursday 27 July 2017

US banks stretch the bounds of irrationality

The plunge in major US bank stocks seems to border on the edge of total irrationality and panic.

The plunge in major US bank stocks, exemplified by the near collapse of Citigroup shares, until the US Treasury once more stepped in to acquire a US$20 billion (Dh73.46bn) preference-share stake in the bank, seems to border on the edge of total irrationality and panic. While most central bankers and regulatory sources remain highly pessimistic about the overall economic and financial outlook, others who know the banking system best argue it is essential to look at the most probable bank-performance scenarios, not just the most risky stocks that may be reflected in market pricing. In fact, the US commercial banking system is much stronger than the market thinks.

Anyone can find more reasons to panic, as exemplified in our own backyard with falling Gulf stocks. Who can now justify a near 10 per cent fall in a day in the Saudi stock market, in what is essentially one of the least affected financial sectors in the financial mayhem? It is easy to tell scary stories like children around the campfire, but it does not illuminate much. However, even the optimistic bankers concede the next six months are going to be tough for the financial system. Market sentiment and share prices may not turn around in the next few days or weeks. Hedge-fund redemptions will continue to weigh on stocks. The past two months of any year tend to be difficult at the best of times, and none more so than for Citigroup whose price has to close above $5 a share or the pension funds and other investment institutions holding equity will be obliged by law to sell the stock, causing an even bigger bloodbath.

Set against that, the interbank market has now stabilised. The massive short-term financial problems will not last forever, even if it feels as if they could. The economic outlook for 2010 may be just anaemic rather than gangrenous. If major banks can hold the line against through market panic for another few months, prospects look much better for at least 2010 and beyond. Far from being a serious weakness, commercial banks may be a defensive line for the rest of the economy, but the recent panic about Citigroup is precisely because it is a commercial bank that is being targeted by investors, rather than the investment banks, which to all intents and purposes have ceased to exist in the US.

Regulators doubt that bank lending to corporations and households will dry up, and dismiss allegations that banks will simply sit on new capital. Banks may not lend to the degree they did last year or before, and they won't make up completely for all the lending in the whole rest of financial markets. At the same time, governments that have pumped in so much capital through taxpayer's money will not sit idly by and watch banks cease lending to the private sector. Even if things do get worse in the short term, it is inconceivable the US government would let Citibank or one of its peers fail in a disorderly way and investment by the US Treasury in Citibank preferred shares testified to this, on top of the earlier $25bn injection last month. They did not allow Citibank to fail in 1989-90 when it got into capital deficiency troubles and they did not this year.In both cases, Saudi Prince Alwaleed bin Talal stepped in to buy Citibank shares.

No one can deny tht past losses for the banks have been horrendous. Still, the optimists argue there is a persistent tendency to underestimate future revenues. Bank analysts underestimated new revenue flow, and also how much capital the banks would raise. Looking forward, it is clear that US banks will suffer from deleveraging for some time. However, the situation differs greatly from the painful drawn-out deleveraging of Japanese banks in the 1990s. Remedial action was delayed for many years in Japan. And, more important, even in the good times the Japanese banks were hardly making money. In stark contrast, the US banks have relatively good prospects.

And what of the future for US banks? Most of their competition has just been wiped out. Mortgage brokers and many other non-bank financial entities are dead. The investment bank has been killed off or seriously injured, and the dazed survivors are scrambling for commercial bank licences since capital markets and securitisation may be damaged for years. The surviving banks will also be able to pick over the businesses of conquered rivals. Mergers have eliminated the weak, the problem players in the industry, although it will take a while to digest some of their remains. The troubled asset relief programme is likely to help stabilise the survivors.

The big banks still have weaknesses. Markets were rattled by worries about commercial mortgage backed securities, but those fears may be exaggerated. Prices of commercial real estate are falling, and there is almost certainly more bad news to come. Still, there is little sign of actual credit problems or defaults in commercial real estate portfolios. Markets just assume underwriting standards were as pitiful in commercial real estate as in the residential sector, but that is not necessarily true, and there are real estate players in the Gulf who are pinning their hopes on the same expectations.

There is also significant market concern about potential massive consumer lending and credit card losses for US banks. There will be bad news and significant losses in those areas, but in most cases the banks are making such a large margin that the net loss may be small. The banks are raising fees and rates on credit cards, and they can also cut back credit lines and close customers' accounts. Banks have plenty of control and discretion over how much risk they take, if they choose to use it, and in the Gulf they are doing exactly that - as some customers have found out.

There is some worry though that there may be more hits to hedge funds holding credit default swaps (CDS) and that may spread into the banking system. From the corporate world, any major defaults or bankruptcies could cause problems to the financial system as there could also be some exposures in CDS markets. It may be difficult to get through the next few months but, regulators from the US and elsewhere argue, the whole point of massive bailout interventions was to buy time. Time is the critical factor as to who has the upper hand in the tipping point between restoring public confidence or continuing with the current bounds of irrationality.

Dr Mohamed A Ramady, a former banker, is a visiting associate professor in the finance and economics department at King Fahd University of Petroleum and Minerals, in Dhahran, Saudi Arabia