As much as I would like to offer tidings of comfort and joy, I fear that 2012 is shaping up to be the year of extreme risks. These risks may not materialize into live problems, but it is best that bankers be prepared, particularly since at least some of the rotten plums are already baked into the Christmas pudding.
The jury is still out as to whether the latest European crisis solutions will prove adequate to stem the immediate funding pressures. However, if longer-run solutions remain focused almost wholly on fiscal austerity, rather than external imbalances and the need for growth, the results will be more like the Treaty of Versailles when what is needed is a Marshall Plan for growth.
Already European governmental and private sector budgets are contracting, and Europe could well be in recession next year, putting a drag on the U.S. economy, with some noted economists estimating an impact of between 0.5% and 2%.
In the U.S., political gridlock, the mortgage crisis, and insufficient confidence in the future have resulted in a sputtering economy. The fourth quarter may be better than expected, but most economists see at best weak growth for next year.
More troubling than political gridlock is the possibility of interbank gridlock. We may see aspects of this phenomenon in next year’s short-term lending markets, foreign exchange markets, or markets for sovereign credit default swaps, such as through valuation disputes or collateral moves. Over the last several years, trust has clearly been shaken in national and bank balance sheets alike, and there is reason to doubt sovereigns' willingness and ability to support financials and financial markets.
The Middle East is a pot that keeps simmering, and could boil over in ways that affect the oil supply and oil pricing. Perhaps of even greater importance, as political stability in the Middle East remains aspirational, it is hard to reduce military funding, though doing so is crucial to bringing down long-term fiscal deficits.
Then there is the panoply of extreme risk potentials that seem always to be with us—pandemics, terrorist attacks etc.
And, finally, there is a host of uncertainties that in and of themselves do not fall into the tail event category, but still could put a drag on a more vigorous economic rebound; constraints that may arise from the proposed new rules and supervisory actions fall squarely in this category.
So what should we do about this plethora of major challenges facing the banking industry and the world?
The most important opportunity and challenge is macro-prudential. It is what the government should do and should not do.
What government should do—what is desperately needed—is to implement pro-growth governmental initiatives. To my mind, a serious shorter-term cocktail of payroll tax elimination, infrastructure spending (including highways, high-speed rail, airport improvements, and educational revitalization), and longer-term budgetary prudence moving toward balance will head us in the right direction.
We would do well to separate for the country what are in essence capital budget obligations that build for the future—schools, roads, energy alternatives, high-speed rail etc.—from a short term operating budget and ordinary expenditures, which though they must be made, do not build for the future.
What the government should not do is swing to excess, especially with respect to new regulatory initiatives. Macro-prudential concerns require balancing the pace and extent of remaining Dodd-Frank and Basel financial reforms against the risk that those initiatives may negatively impact financial conditions.
In light of the upcoming potentially very tough year, regulators should be especially careful to avoid excess burdens. A moratorium on new regulations goes too far and is not possible in light of the demands of Dodd-Frank, but an analogy to good medical practice has some virtue in these circumstances—in administering medicine, one of the doctor’s prime responsibilities is to do no harm.
What individual banks should do, first, is focus on liquidity as their first line of defense. Many community banks are awash in deposit-based liquidity and given current market conditions, this is a good thing. However, all banks have to be careful of illiquid positions and short-dated market exposures used to fund core assets.
Second, I strongly advise every bank to maintain a strong balance sheet. The American banking system has been strengthened over the last couple of years and we can all take pride in that. Many banks are in a good position to support prudent loan growth. But for a few a fortress balance sheet is still a work in progress and progress should continue to be made.
Third, maintaining credit quality is of course highly advisable. There are opportunities for loan growth in some sectors of the economy. But prudence must continue to be a watchword.
Fourth, banks must be especially careful to protect their reputations. Increasingly, reputational risk is a key driver of the availability of liquidity as well as increased regulatory and litigation risks.
Fifth, in my experience, extreme risks do not typically blow up all of a sudden. They emerge over a period of time. With vigilance and foresight, there is often time to mitigate risks and build a stronger fortress before the storm hits.
Even if we are fortunate and next year is better from a growth and financial profitability standpoint than circumstances suggest, one thing is certain: Next year’s markets are likely to suffer a considerable amount of volatility.
Even strong institutions can be caught out badly if they do not plan for sharp market corrections.
If even one tail risk to the banking sector comes to life, most will not be able to say they fully projected the resulting credit and market-risk challenges. It is hard for anyone to perfectly predict the future. But the firms that anticipate stress and build up financial cushions to deal with it will fare better than others. The game over the next couple of years will not be won by the most profitable, but by the most prudent.
I know this is not the holiday cheer that we all would like, but this year it is probably better to face up to the fact that the eggnog is laced with bitters.
Eugene A. Ludwig is a founder and the chief executive of Promontory Financial Group LLC. He was the comptroller of the currency in the Clinton administration.
