After the latest round of Quantitative Easing (QE) by the Fed and Long Term Refinancing Operations (LTRO) by the ECB, the interest rates in the US and the euro region have reached all-time lows. As a bond holder if you lend money to the US government for 5 years and 10 years by buying US Treasury, you get a yield of 0.64% and 1.63%, respectively. The yield doesn?t even compensate for inflation. The yield on inflation indexed Treasury for 5 years and 10 years are minus 1.49% and minus 0.81%, respectively. Likewise, the 5-year and 10-year yields in Germany are 0.52% and 1.46%, respectively. In the UK, they are 0.71% and 1.69%, respectively. The same is true for bank lending as well. If you lend in current times, you make a negative real return.
At the height of the subprime crisis, the then CEO of Citigroup, Charles Prince, famously remarked that ?As long as the music is playing, you?ve got to get up and dance.? To make sure that the regulators weren?t gnashing their teeth, he later clarified that he was referring to his job as a banker and what he actually meant was that ?It?s the job of a banker to keep on lending.? If we think of dance the Indian way where the pace is set by the taal, what he was implying was that even when you don?t want to lend, you probably still need to dance at least in the vilambit taal. For those to whom Indian dance and taal is gobbledegook, taal refers to the beats which set the pace of dance and are broadly classified as drut (fast), madhyam (medium) and vilambit (slow).
In times like these when the global economy is over-leveraged and banks are risk-averse, a banker does not want to lend but is forced to lend to keep the business going. Currently, interest rates are at rock bottom levels and the yield, carry and return on investment is so low that it cannot compensate adequately for the risk of lending. That is why banker?s dancing turns to a vilambit taal. When yields are too low, and acceptable risk spreads so narrow that the top line interest revenue is increasingly marginalised, then lending is at risk. Excessive historical overhead force financial and lending institutions to do one of two things?they lever up to cover those costs or they slow or shut lending down to preserve equity and the ultimate franchise. The levering up is indeed difficult given the intensified regulatory oversight. And so, what we are witnessing instead is the beginning of a vilambit taal, a dance where banks fail to reap the economies of scale so reminiscent of the prior era of leverage as opposed to the present one of risk-aversion. In the process, they lay off, close branch offices or even ATM machines by the thousands as did Bank of America recently; and yes, ultimately reduce the rate of lending or credit growth which propelled the global economy so effortlessly from the period of Great Depression of 1929 up until 2007.
For the current shipwreck perhaps we have the Fed and ECB to blame. Zero-bound interest rates according to their historical models should inevitably and inexorably lead to dynamic real economic recovery. What can be your maximum upside if you earn 0.7% for 5 years? Structured impediments such as regulatory risk standards for banks and fear of losing money from lending have thrown a monkey wrench into the monetary policy models. Central banks are agog in disbelief that the endless stream of QEs and LTROs have not produced the desired result. Bankers like Charles Prince are doing the vilambit taal, not drut, even with the Fed as the tabla player is playing in up-tempo.
What then is a banker supposed to do? In a new normal economy where lenders dance to the vilambit instead of the madhyam or drut, how should they move their own feet? Carefully, I suppose, and with the recognition that historic credit performance is just that?historic. Returns from both loans and bonds will be stunted. How could one argue otherwise with 10-year investment grade loans yielding less than 2%? How could one argue otherwise when it is obvious that central banks are likely to keep interest rates low for the foreseeable horizon, as painstakingly made clear by them? The banker is in a ?heads you win, tails I lose? situation. If the economy recovers, it would be growth accompanied by inflation because of excess of money supply, which would mean that if the banker lends at below 2% for 10 years, he will not even make the inflation rate over the next 10 years. If the economy indeed falters, then default risks increases substantially over the next decade. The Fed and ECB inadvertently have made ?dancing? for the bankers fraught with risk with negligible returns. His least damaging option is the vilambit taal.
The author, formerly with JP Morgan Chase, is CEO, Quantum Phinance
