A tale of two types of banking systems – weak and strong

The weakness of banking systems in Western Europe, the United States, Japan, the Baltic states, Iceland and much of Eastern Europe has caused economic growth in these areas to slow dramatically.

There has been much reporting of the events of the past two years in the world press that backs up our view. Some banks in these regions were so devoid of common sense that the creators of toxic assets held the junk they had created in their own portfolios. Lehman Brothers Holdings Inc. comes to mind, among many other institutions.

The banking crisis was fueled by a failure of common sense, combined with inadequate regulation. The catastrophe was promoted by politically driven wishful thinking and fraud by participants at all levels.

Further, the problems that caused the crisis have not been remedied. The same regulators continue to coddle the banks and allow them to go on creating destructive and toxic derivative instruments.

Taxpayers have been penalized, while the foolhardy, destructive and ignorant have been rewarded with bailouts.

The overall consequence of this banking crisis is a long-term slowdown that may take years to remedy. Many nations will continue to experience consequences for their weak banking systems, and the capital needed for companies to grow will not be readily available in these regions for some time.

Canada, Brazil, Hong Kong, Singapore, India, China, and many other places in Asia have strong systems in place. Not all of them acted foolishly. Some were either smart, lucky or both.

When evaluating the situation, we notice that there are two kinds of regions with strong banking systems.

These are the ones that were wise and willing to resist temptation of leveraged derivatives. They included Canada, Australia, Singapore, South Korea and Hong Kong. They were conservative in their banking practices and did not spend their capital on derivatives-backed bonds based upon the real estate market and associated bond instruments.

They did not make many subprime loans, and they did not package these loans into syndicated piles of toxicity that were sold to the naive and unsuspecting. The regulators in these nations acted to prevent those who wanted to leverage their balance sheets to dangerous levels from doing so.

The second group of strong banking-system nations, including China, India and Brazil, also refrained from dabbling in highly leveraged derivatives. Instead, they prioritized making loans to their own citizens to foster growth in their own nations and did not have the need or political inclination to make loans to real estate borrowers who would not be able to repay.

Quite intelligently, banks in these countries have been busy lending to build the infrastructure in their nations, to finance the growth of business and consumer spending, and to do the rational, conservative banking that will foster growth and raise the standard of living for their people. In these cases, there was no need for regulation against unwise behavior except the normal capital requirements traditionally required of banks.

CAPITAL REQUIRED

It is not difficult to see that a strong banking system is a necessary component of a healthy economy with strong economic growth. Capital is required for companies to be formed and to grow.

Without capital being distributed in the form of loans through the banking system, there can be no steady and durable economic growth. Capital distribution can also take place through the banking system in the form of stock sales by companies to the banks’ customers. The above can happen in countries with struggling banking systems, but only at a reduced level.

Investors are used to thinking of developed countries as more stable than their developing counterparts. In the last two years, however, everything has been turned on its head. Today, we see that some developing countries have more stability and something many developed countries lack — a strong banking system.

An example of a developing country with a solid banking system is China. Chinese companies are able to raise record amounts of capital through foreign investment, stock sales and retention of payment surpluses.

At the same time, most developed countries are relying on debt financing to fund their financial bailouts and budget deficits.

The United States, for example, is floating so many bonds to finance its budget deficit — expected to approach $1.6 trillion by Sept. 30, the end of this fiscal year — that it is crowding companies, cities and states out of the debt markets. When the federal government is borrowing that much money, it is very hard for a small city or a state to sell bonds. Many buyers are getting their fixed-income needs satisfied by U.S. bonds.

A combination of low to no bond sales and low tax collections for states and cities means low capital formation, and without sufficient capital formation, economic growth is very difficult.

When will strong regulation emerge? So far, it is not looking good. If the Obama administration caves in to the banks and traders, and does not regulate derivatives, a much bigger derivatives crisis will occur in the near future.

In light of the above, it is not difficult to see the logic of economists who predict slow growth in those nations with weak banking systems.

Monty Guild is chief executive and chief investment officer, and Anthony Danaher is president, of Guild Investment Management Inc. of Los Angeles. This article is excerpted from the firm’s newsletter, Guild Investment Global Market Commentary.