The Independent Market Observer

9/20/13 – The First Question

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Sep 20, 2013 9:34:25 AM

and tagged Europe, Ask Brad

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You may have noticed a relatively new feature on the blog, “Ask Brad” (on the right side of the page). The first question that came in was a good one from Tim Bourdon, who wrote: “You mentioned that we are in better shape now than five years ago, but Europe is still in a much riskier position. If their market falls apart, are we strong enough to withstand that?”

This is a good question because it cuts to the core of how much risk has actually been reduced, post-financial crisis. The real danger, in 2008 and 2009, was that the financial markets around the world would seize up as banks refused to lend to each other. That would have led to a cascading series of defaults as banks, unable to get their money back from where they had lent it, would in turn be unable to pay their creditors. A downward spiral would result, bringing down the whole system. Europe was a key part of this, and it is this risk that I highlighted in my earlier post.

There are several ways to make this outcome less likely. The first is to ensure that the banks have a good capital cushion—that is, enough money to cover the risks when they get in trouble. As I mentioned the other day, here in the U.S., we have actually made good progress on this, but Europe hasn’t done as well.

The second is to make risk exposure more transparent. One of the biggest problems in the financial crisis was that banks couldn’t trust each other—they didn’t know how much risk their counterparties were taking. Here, we have made some progress, but not as much as we should have. The progress consists of the stress tests, which have required banks to quantify their risk under different scenarios. In addition to making the banks themselves more cautious, the tests provide valuable information to other financial institutions with whom they do business. Again, though, progress in Europe hasn’t been anywhere near as solid as in the U.S.

The third way—and this is not governmental—is simply to introduce the notion of risk into the system. Back at the start of the financial crisis, there was a much more laissez-faire attitude toward bank counterparties. Not that banks were ignoring the risks, but there wasn’t a presumption that default was a real threat. Post-financial crisis, that is no longer true. Default is considered a risk, and financial institutions are now more systemically cautious about whom they do business with.

To get back to Tim’s question, the short answer is that we don’t really know. Because European banks have not improved their capital base, and are not notably more transparent, we can’t be sure whether the U.S. system could weather a collapse. We do, however, know two things.

First, some progress has been made in Europe, and I suspect it is more substantial than what appears on the surface. That alone doesn’t make me feel much better, but at least it’s something. The second thing is that, per point three above, U.S. banks are more cautious about how they do business. European risks will be getting much more scrutiny than in 2008.

Note that more carefully watched risk doesn’t mean no risk. U.S. banks should, at the right price and with the right allocations, have exposure to Europe. Even during the worst of the financial crisis, U.S. exposure to Europe wasn’t going to bring down U.S. banks. It was the combination of the U.S. exposure and the European exposure, not to mention the rest of the world, that was the systemic problem.

Today, U.S. banks are stronger, U.S. risk exposures are under much better control, and risks from the rest of the world are given much more scrutiny. Although it might sound like I’m saying “trust the banks,” nothing could be further from the truth. The banks are now being more closely scrutinized and required to hold more capital precisely because they’ve shown they can’t be trusted.

If the European banking system were to suffer another crisis—which I am not predicting—it would damage the U.S. economy in many ways, and our financial system would certainly take a hit. What it should not do, though, is cause the kind of risk to the system as a whole that we had in 2008. Our improvements, though they could be better, have reduced risk to that extent.

Thanks for the question, Tim, and please let me know if I can expand on any of these points. If anyone else has any questions, I’d be happy to respond.

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