A Former Banker's Stark Warning?

Tim Boreham of The Australian reports, McFarlane issues storm warning for banks:

Former ANZ Bank chief executive John McFarlane, eyeing the financial storm engulfing Europe, has urged Australian banks to resist risky activities as they chase growth in a "constrained" domestic market.

Labelling the crisis as "very serious", the respected executive predicted that most European banks would not survive the continent's debt tailspin, or would emerge as only a "shadow of their former self".

"This is going to take a long time to work out," Mr McFarlane said of the European problem.

"These events have crystallised the importance of a healthy banking sector," he added, noting that "Australia has held up incredibly well. The Australian economy remains incredibly robust."

Mr McFarlane said the overseas sovereign debt problems would have an impact on Australian and Asian banks, but it was unclear how.

In his first local address to the business community since leaving ANZ in 2007, he said that, in their quest for growth, banks -- particularly in the northern hemisphere -- had unwisely entered upscale wholesale and investment banking activities.

"It was all the things we shouldn't have been in that caused the GFC," Mr McFarlane told a gathering of delegates of the Financial Services Institute of Australasia in Melbourne.

"In Australian financial services it means getting back to a core focus on economic returns and away from a series of non-core investments stimulated in good times."

He acknowledged that low-risk local growth would not produce the requisite growth opportunities. But Asian growth -- a key tenet of the bank he once headed -- remained "difficult" if attempted in a piecemeal way and was unlikely to succeed without a big-hit acquisition.

"Planting flags will have no result," Mr McFarlane told the audience celebrating FINSIA's 125th anniversary. "You have to buy a domestic leadership position in those markets.

"But you have to buy when Australia is strong and Asia is weak, and we have never had that."

Under Mr McFarlane's successor, Mike Smith, ANZ has set a target of deriving 20 per cent of earnings from Asia, but has not specified whether this will be via acquisitions or organic growth.

In 2003, ANZ had the chance to buy the Thai Military Bank for $200 million, but the cautious board opted for the $5 billion purchase of the low-risk, low-growth National Bank of NZ.

History shows that ANZ would have recouped its money many times over with the Thai option, while New Zealand banking growth has stagnated. "We won't get that opportunity soon, but Asia is cyclical and we will eventually get that opportunity," Mr McFarlane said.

Locally, Mr McFarlane said, sustainable growth meant avoiding the riskier mortgages held by British and US banks. While British mortgages were commonly struck on a ratio of 125 per cent of the value of the property, in Australia they averaged a conservative 80 per cent.

"Mortgages today are half the assets (of a major bank) and they are virtually riskless," he said. But some lenders were again making the "serious mistake" of lending on ratios as high as 95 per cent.

"It will end in grief," he said. "If we make mortgages risky it will require more capital."

He said unsecured retail lending was also a "deadset way of losing your money" because of the bank's lack of familiarity with the customer. "We did a product once and wrote 90 per cent of it off."

Mr McFarlane also took aim at the banks' tendency to compete on price alone. "The one thing you don't do in a market with constrained borders is lower the price," he said. "It denies the returns of the industry as a whole."

On the flip side, he called for the abolition of "unsustainable fees" in both banking and funds management. "Some of the super fees on super funds really need to come down and some of the transactions are really unsustainable," he said.

Reflecting on ANZ's near-death experience in the early 1990s, the result of poor corporate lending in the late 1980s, Mr McFarlane said it took nine years for the bank to "normalise" its earnings. "It just shows you don't want to be there," he said. "The key is not to screw up in the first place. It takes forever to bring a bank back from the brink. It's almost impossible."

He mused that bankers were eternal optimists who needed strong leadership to rein them in. On that count, he paid homage to dinner attendee Don Argus, National Australia Bank's former CEO who was famous for a risk-averse approach as chief credit officer in the 1980s.

"I have never seen a set of cashflows that don't go up in my life," Mr McFarlane said. "I have never seen a loan proposal that doesn't get repaid. Someone has to be there and say 'what don't you understand about no'!"

Currently, The Scottish-born Mr McFarlane divides his time between Australia and Britain, where next year he will become chairman of life insurer Aviva. He is also a Westfield director and a non-executive director of the Royal Bank of Scotland, a role he must cede under British prudential rules.

Reflecting on his decade-long reign at ANZ -- a stint generally seen as highly successful -- Mr McFarlane said he was surrounded by impressive operators, including CFP Peter Marriott and Elmer Funke Kupper, who went on to head Tabcorp and the ASX.

Mr. McFarlane is a rare banker. He has common sense and tells it like it is. These are not good times at banks, especially in Europe where Tracy Alloway of the FT reports that bank funding slows to a trickle:

A recent Bank of Italy warning on funding of the country’s banks is starting to come true.

Just last month, the central bank said a persistent shortage of long-term financing could “distort” the strategies of commercial Italian banks. On Wednesday, UniCredit, Italy’s biggest bank, announced a retrenchment in its investment banking business as it seeks to shore up its balance sheet. Then Federico Ghizzoni, chief executive, urged the European Central Bank to increase access to its financing for Italian banks.

The worsening sovereign debt crisis in Europe has alarmed investors in eurozone bank debt. Many have simply backed away from funding the region’s lenders, stoking fears of a self-fulfilling funding squeeze. Even run-of-the-mill depositors – who historically have acted as a ‘sticky’ or safe form of funding for banks – are becoming more fickle.

Unicredit’s plea to the ECB in Frankfurt, on behalf of Italy’s banks, is “a sign that there are significant funding difficulties for European banks and they are escalating,” says Suki Mann, Société Générale credit strategist. He says that European banks have raised just €10.5bn of euro-denominated debt since July, a fraction of their usual financing needs.

With public markets effectively closed or prohibitively expensive for many European banks, lenders are having to look at different financing options. These include issuing more secured debt, such as covered bonds, or striking private funding deals. Banks can also attempt to increase their deposits, or tap the ECB for fresh loans.

The scale of refinancing is immense. Europe’s banks have raised about €295bn in the capital markets so far this year, according to Dealogic data. At the same time, the banks have €485bn of debt due to mature next year, meaning Europe’s lenders will have to scramble simply to replace their bonds.

At the same time, Italian banks are spending more to lure new money. The cost of selling bonds to small investors – once a cheap source of funding for the lenders – has more than doubled since the start of the year, according to BarCap. The cost of selling bank debt to professional investors has also increased, when it happens at all.

And, as far as “peripheral” eurozone countries are concerned, market participants are already on the look-out for a deposit flight – one of the more serious signs of bank funding nervousness – that would add to banks’ problems.

In Greece, for example, deposits have fallen by almost €50bn, or more than a fifth, since the start of 2010. The country’s banks now rely on the ECB for €89bn worth of net funding, according to CreditSights. Now all eyes are on Italy and Spain.

“We cannot confirm that there is a deposit run in Italy at this stage,” say Barclays Capital’s Antonio Rizzo and Jeremy Sigee. “However, the deposit growth of corporates and households is close to zero and the trend might accelerate further.”

In Spain, the drive for more deposits is in full swing, prompting the finance ministry to put a ceiling on the interest paid to customers. Spain’s lenders still expect to meet about half their 2012 wholesale refinancing needs by increasing their deposits, according to BarCap. But that would require growth of 4 per cent, compared to the 2 per cent deposit decline experienced so far this year, it says.

Covered bonds, a type of packaged debt considered ultra-safe by investors, could replace about €180bn of the European bank debt redemptions coming up, says SocGen’s Mr Mann. But banks will still need to be able to sell so-called senior unsecured debt – the bread and butter of bank funding – to investors.

European authorities have also recognised the problem, promising to come up with a fix for the region’s funding woes at last month’s European Union summit. An EU-wide guarantee for bank debt might help thaw the market. But the EU has yet to announce details of its proposed plan and co-ordinating any such programme is likely to be difficult.

“An effective scheme could unfreeze bank financing and change the banks’ behaviour from ‘crisis’ to ‘managed decline’,” says UBS’s Alastair Ryan. “However, we believe that the EU as yet has little concrete to offer by way of an actual scheme.”

With investors backing off, Europe’s banks are left with two other options. They can turn to the ECB for funding or simply shrink their balance sheets; cutting unprofitable lending or exiting some businesses altogether.

“A bank is a highly leveraged entity. For every unit of equity you need six to eight units of debt,” says one senior banker. “If you can’t get this, the old business model just falls over.”

Indeed, Reuters reports more banks are set to tap ECB on dollar funding woes:

It's looking increasingly likely more European banks will be forced to tap the European Central Bank's US dollar facility, as stress in the cross currency basis swap market has once again become acute this week.

Few banks have opted to tap the ECB's dollar facility so far, but a combination of foreign investors continuing to shun European banks and swaps markets fast becoming prohibitively expensive may soon spur a larger drawdown at the ECB's weekly unlimited dollar auction.

"We are more or less at levels where banks are indifferent about going to the ECB or the FX market for dollar funding. Over the last few days spreads have widened dramatically in the FX market, making dollar funding more expensive. As a result, banks may well want to start tapping the ECB dollar facility more," said Pavan Wadhwa, global head of rates strategy at JP Morgan.

The dollar funding issues for European banks have been well publicised over the past few months. Fearful of the worsening Eurozone crisis, vital sources of dollar liquidity like US money market funds reduced their exposure to European banks in the third quarter.

Many European banks reacted by selling dollar assets and entering into secured funding transactions to alleviate their funding stress. At the same time, coordinated central bank action announcing the introduction of new dollar swap lines in mid-September helped to significantly ease markets.

However, signs of dollar funding stress have returned over the past fortnight, as the Eurozone crisis once again stepped up a gear. The three-month EUR/USD basis swap is currently trading at 129bp below Euribor, compared to around 103bp below three weeks ago.

According Wadhwa, the cost for European banks of getting dollars in the open market has traditionally been in the region of five to 20bp lower than going to the ECB (which charges 100bp over the Federal Funds rate). Now, the increased stress in the market is starting to make it economically unviable for European banks with dollar funding shortfalls to rely on the open market.

"The way that the market is going, pressure is increasing for people to start tapping the ECB dollar line, both because the FX forward markets and the cross currency markets are drifting in the wrong direction making it more expensive to roll funding in the open market through the FX forwards, and because the banks themselves in Europe are under increased funding pressure as time goes by," said Nick Hallett, head of cross currency swaps at Barclays Capital.

There is a stigma attached to tapping the ECB's facility, and so banks try to avoid doing so if possible, despite the auction process being anonymous. Use so far has been limited: this week two bidders took down USD552m at the auction, compared to four bidders taking USD395m the week before. Participants believe the basis swap market may have to get even more stressed before there are significantly more bids.

"Banks will only go to the ECB if they are forced to. I think the basis swap market will have to get around 25bp more stressed before people abandon the market completely and start going to the ECB," said Wadhwa.

Meanwhile, central banks will likely continue to monitor the situation. Some market participants have suggested the ECB may look to lower the rate it charges for tapping the facility, with some observers estimating a 50bp cut would attract far more banks and alleviate the stress in the market.

Participants believe central banks have already shown their willingness to act, following the unprecedented announcement from the Bank of England, European Central Bank, Bank of Japan, Swiss National Bank and Federal Reserve in September of offering three three-month unlimited dollar auctions.

Clearly central banks will have to play a major role in stemming a funding crisis at European banks. Fear of banking contagion is what's keeping everyone on edge. A senior VP at a large Canadian pension plan told me that they see trouble ahead and are cutting risk across the board. He also told me investors have to be careful with hedge funds and private equity funds waiting to turn trash into treasure.

Finally he told me that it looks like European leaders are dragging their feet, much like American politicians were doing back in September 2008, when it took Lehman's collapse to propel them into action. Hope he's wrong, but like he said, "human nature being what it is," people do not act until catastrophe strikes. The question is, will it be too little, too late?

Below, leave you with a Bloomberg interview with William Cohan, author of "Money and Power: How Goldman Sachs Came to Rule the World" and a Bloomberg View columnist, discussing the exposure of U.S. banks to Europe's sovereign-debt crisis. Cohan talks with Stephanie Ruhle and Scarlet Fu on Bloomberg Television's "InsideTrack."