FRA Co-Founder Gordon T. Long interviews Jeff Davis of Mercer Capital, and
discusses financial repression and its effects on the banking sector.
Davis is currently a Managing Director of Financial Institutions Group at
Mercer Capital. Davis also provides financial advisory services primarily related
to the valuation of privately-held equity and debt issued by financial services
companies and advisory related to capital structures and M&A.
Financial Repression's Effect on the Us Banking Sector
"Financial repression is a price control that relates to all facets of the
economy and has profound impact."
The 3 major cycles: Business Cycle, Credit Cycle and Rate Cycle.
"The banks straddle all 3 to be a key contributor of capital in the US economy.
Financial repression impacts at a very base level for all 3 cycles."
"Financial repression has artificially pumped up asset value.
"Commercial real estate values really pivoted in 2010. There is additional
risk in the system now that asset values are pumped up"
Commercial Real Estate Values
Leverage Ratio
"If you look at the leverage ratio we can see that over the last 20 years
the industry has been raising capital. I don't think that's a bad thing. We
are significantly much better capitalized than Europe which is a good thing,
but as it relates to an investor there is a lower return on equity."
"Regarding financial repression, if you think about interest rates today,
it is very painful for an institution to hold cash. There is significant risk
taking occurring amongst commercial banks in taking additional credit risk
and duration risk. Structurally banks aren't as spread in terms of their assets
relative to their borrowings that fund these assets."
"Companies don't go broke because they don't make money. Companies go broke
when they have no liquidity, so what financial repression has done is push
liquidity into the system. So now heavily indebted companies are able to borrow
money and we will soon see the consequences of that."
How banks Function
"The banks are special for being separated from commerce."
"The objective for a bank is to earn a spread on assets. Loans being the highest
yielding asset, followed by bonds, and finally cash. The banks role is to take
the deposits and prudently while still taking risk, lend the money into the
economy to help finance the economy."
Shadow Banking
"Over the last several decades the shadow banking system has developed
into an alternative lender as well as another place for people to put their
money."
The term "shadow bank" was coined by economist Paul McCulley in a 2007 speech
at the annual financial symposium hosted by the Kansas City Federal Reserve
Bank in Jackson Hole, Wyoming. In McCulley's talk, shadow banking referred
mainly to nonbank financial institutions that engaged in what economists call
maturity transformation.
Commercial banks engage in maturity transformation when they use deposits,
which are normally short term, to fund loans that are longer term. Shadow banks
do something similar.
"Shadow banking system is separate from commercial banking system, but is
a very large piece of the credit allocator. A lot of risk has been pushed out
of commercial banks and is now in the shadow banking system, where it is not
as opaque as a commercial bank."
Concerns with Sustained Low Interest rates
One day there will be a reckoning. It's simply a buildup of risk; an
attempt by central authorities to guide the economy.
Malinvestment: A mistaken investment in wrong lines of production,
which inevitably lead to wasted capital and economic losses, subsequently requiring
the reallocation of resources to more productive uses.
"A delay of lost recognition and mass malinvestment which is all a credit
risk within the banking systems. However, my biggest concern is a dramatic
slowdown in the economy, short rates at zero."
~ FRA Contributor: Karan Singh karan1.singh@ryerson.ca
