Photo: Transparency International EU Office/Creative Commons
Opinion: There is a reason why valuations cannot rely on cognitive dissonance, says contributor Chitro Majumdar. The first of a two-part series on the collapse of the Cypriot banking sector and speculation that the Grand Duchy is “next”.
Is this a time for concern? Many quiet observers are troubled by the proliferation of articles that compare the weight of the banking system assets of a nation to the GDP and then “mechanically predict” which candidate is next in line to fall in the “dominos” of the European banking system.
Today we have Cyprus, tomorrow will it be Luxembourg?
While these are two small nations with “well developed” banking sectors that outstrip their GDPs, and also the fact that they are both part of the EU, they are not the same.
Recently and curiously, despite the real quantitative and qualitative differences of two nations, this ill-informed shrill has reached Luxembourg. There is a contradiction.
To date, according to the highest authorities such as World Bank reports to European Investment Bank analysis and all points in between, Luxembourg has consistently scored in the upper 5% of banking diversification and solvency systems. Those are the facts.
So, why is there an increasing din of questionable punditry?
Comparing Cypriot and Luxembourg banks
Banking in Luxembourg is largely based on “custodian businesses” that falls under the strictest regulatory environment in the EU. Specifically, Luxembourg has 66 depository banks, over 3,800 investment funds sold in 70 different countries and 139 central administrations closely monitoring the whole affair.
Of course there is room for error; however, in comparison to other territories, one can comfortably conclude that the overall risks of malfeasance are significantly lower.
For starters, the solvency ratio of their banking system is just a tad below 18%. In comparison, Germany’s banking system solvency ratio is only slightly lower than that of Luxembourg’s at 15.75%. Nonetheless, the voices in the chorus of hysteria persist with an increasingly off-key tenor.
The raw calculation of assets to GDP ratios that places Luxembourg at 19.8 times GDP--although debt/GDP ratio in 2012 was a mere 21.3%--includes, brutally, assets in a custodial capacity belonging to investment funds. Those assets are almost entirely invested in securities, maybe five dollars for every 100 are held in liquidity (cash).
Then, last but not least, banks in Cyprus remunerated deposits at 6.5% on euro deposits--remarkably generous--forcing the banks to go and put the cash in risky assets to pay that remuneration.
In contrast, banks in Luxembourg remunerate liquidity as a big fat zero! Nothing.
Investment funds are moreover obliged by UCITS regulations to use the liquidity in marketable and liquid securities as soon as possible, and the rule is enforced.
Evaluating banking and financial risk is not exactly a mechanical science that renders easy and quick answers. The reality is that risk measure is the systematisation of ever closer approximation of outcomes out of a given myriad of inputs. Thus, risk in this environment can elude even the most sophisticated accounting concepts and applications of debits and credits.
Worst still is the reality that, as the complexities of the inputs increase, the number of individuals and groups qualified to identify those risks decreases. Pure accounting solutions are increasingly producing, at best, only partial answers.
Banking risk emanates from the type, quality and dynamic interplay of the assets containing in and across an identified bank’s portfolio. Thus, by definition not all assets and therefore portfolios are the same from the point of view of quality, stability and eventually overall risk.
Nonetheless, the chorus is still attempting to harmonise around the low octave notes: leverage and de-leverage. While these two notes--low and high--harmonised might sound good for a given instant, it is far from a symphony.
Where does that leave us? Simple, the perfunctory low note of leverage is the problem, thus the next octave up is where the high note of de-leverage is the solution. One is left wondering, while the octaves are different but the notes are the same, symphony will turn into a cacophony. The problems are many while the solutions are few.
On another note, it is clear that banks and bankers need to be regulated. The current environment of deregulation has proven to be problematic, to say the least.
However, regulation needs to be understood in the context of the complete tonal composition of risk harmony. Otherwise, sounding an “off-key” note of regulation for its own sake will merely serve to destroy what good banking does for the general economy. Brutal de-leveraging is not a solution.
Chitro Majumdar is chief science officer at R-square RiskLab, an independent strategic consultancy to financial services firms and departments. He prepared this article in collaboration with Maurizio Piglia, who is an advisor to R-square RiskLab and a director of independent funds management company Savings & Investments in New Zealand.