Credit Suisse unveils another change of course
After a good first quarter, Europe’s most troubled banks are looking healthier
Print edition | Finance and economicsApr 27th 2017
EUROPE’S most troubled big banks may at last be on the road to recovery. Not only is economic growth perking up; uncomfortable decisions, put off too long, are also being taken. In recent months UniCredit, Italy’s largest lender, has written down bad debt by €8.1bn ($8.7bn) and tapped shareholders for €13bn. Deutsche Bank, Germany’s biggest, has raised €8bn in equity and decided to keep a retail business it had hoped to sell. On April 27th it reported first-quarter net income of €575m, up from €236m a year earlier, although revenue fell.
Like Deutsche, Credit Suisse is freer to make plans after a recent settlement with American authorities over mis-selling mortgage-backed securities before the financial crisis. On April 26th Switzerland’s second-biggest bank reported first-quarter net income of SFr596m ($594m), far better than forecast, reversing a SFr302m loss a year before. Along with most of Wall Street, which published earnings earlier in the month, and Deutsche it benefited from a good quarter for fixed-income trading. It expects to wind up a unit in which it has dumped unwanted assets by the end of 2018, a year ahead of schedule.
Credit Suisse’s chief executive, Tidjane Thiam, has also ditched a plan to float 20-30% of the group’s Swiss universal bank—part of a scheme, conceived in 2015, to raise SFr9bn-11bn of capital. He now intends to bring in SFr4bn through a rights issue. (Share sales in 2015 raised SFr6bn.)
Shareholders had never been keen on the flotation, which would have diluted their returns from the division that contributes most to Credit Suisse’s profits. A climb in the share price, by more than 50% since July, has made a rights issue more attractive. The issue will lift Credit Suisse’s ratio of common equity to risk-weighted assets (a key gauge of banks’ strength) from 11.7% to 13.4%. That boosts it from a middling position among its European peers, but still leaves it behind Deutsche and UBS, its bigger Swiss neighbour.
Mr Thiam claimed the quarterly figures endorsed a strategic shift towards Asia which he announced 18 months ago. He considers the region’s newly rich to be ideal clients for a bank which can meet the needs of both their businesses and their families. Credit Suisse’s Asian division, like the Swiss universal bank, provides wealth management and investment banking locally. Functional divisions serve the rest of the world. To many, this structure looks lopsided. Mr Thiam is sure that it is working. The Asian wealth-management business saw profits rise by two-thirds in the year to the first quarter. The region’s markets business tumbled into loss, but Mr Thiam insists that a change of management will help turn it around.
All this should placate shareholders, who have had plenty to grumble about—and whom Mr Thiam faces at the annual meeting on April 28th. This month he and other executives gave up 40% of their latest bonuses, which had been criticised by advisers to institutional investors. The bosses had hit their targets, but the bank lost money in 2015 and 2016. Better luck this year.
The threat of war can bring much-needed investment
Whereas at times of peace, governments grow complacent
Print edition | Finance and economicsApr 27th 2017
PONDER the dire state of infrastructure in America and some other advanced economies, and their governments’ fecklessness boggles the mind. Time was when they were able to make badly needed investments; the roads and the universities were a priority. What changed? Not for nothing do pundits cite the hustling governments of China and Singapore as evidence that liberal democracies are no longer fit for purpose. But democracy is not the problem; rather, governments may lack motivation in what is, despite appearances, an unusually peaceful world.
War is hell; the less of it the better. Yet it has also been a near-constant feature of human history, and a constant stimulus to political evolution. Defence is a textbook example of a public good. Security benefits all residents of a country, and cannot be denied to citizens who prefer not to pay for it. There is little incentive for private forces to provide defence—unless by doing so they can take over the right to extract compensation from the society they protect. Throughout history, the legitimate government is the one that can best defend its people.
As populations have grown and technology has advanced, the job of defending societies has become more complex. That, in turn, has spurred the proliferation of government responsibilities. Research by Nicola Gennaioli and Hans-Joachim Voth suggests that the growing financial demands of warfare after 1500 helped drive the formation of large, strong nation-states in Europe. The rising cost of war meant that keeping a state secure required a powerful, centralised government capable of raising large sums of money—through tax, or via modern, central bank-tended financial systems. Their work draws on research by Timothy Besley and Torsten Persson, who reckon state power built to improve defence can yield better economic policy; the capacity to use the tax system to transfer wealth directly, for instance, means society relies less on inefficient sorts of redistribution.
Military competition has long given states an interest in technological progress. But the industrial revolution and the era of total war led to dramatic changes in the reach of the state. America’s federal government was slow to get involved in the education of its young people, a matter it left to state and local governments. That changed in 1958, when Dwight Eisenhower signed a law committing roughly $1bn (more than $8bn in 2017 dollars) to improving education in science, mathematics and foreign languages, and to providing new federal loan assistance to university students. The law, the “National Defence Education Act”, was a response to the launch of Sputnik and fears that America risked losing its technological lead over the Soviet Union, a critical matter of national security in the era of the nuclear-tipped ICBM.
America’s experience was representative. Mr Persson, in work with Philippe Aghion and Dorothée Rouzet, examined investments in primary education across countries over the past 150 years. They found that substantial investments tend to be made at times of sharpening military rivalries or in response to recent wars, and that democratic governments are especially given to answering strategic threats with investments in schooling.
Education was not the only beneficiary. Both DARPA (an American defence-research agency responsible for the creation of the early internet, among other things) and NASA date to Eisenhower-era efforts to foster new technologies with potential strategic applications. So does the law to which America owes its expansive highway network. In the 20th century it became clear that maintaining a strategic edge required a strong, industrialised economy and a highly skilled workforce. When confronted with vulnerability, governments responded.
Despite interminable warfare in Afghanistan and the Middle East, conflicts and battle deaths have dropped since the 1990s; and the end of the cold war removed the most serious potential source of global conflict. No tears need be shed over that; besides the toll in human suffering, wars impose huge economic costs. New research by Stephen Broadberry and John Wallis finds that long-run economic advance has less to do with higher growth rates than with reduced frequency and severity of episodes of economic contraction (fighting fewer wars, for example).
Yet in the absence of acute security threats politics in many countries may have become less effective. Good economic reasons argue for investing in public goods, and for building fiscal capacity and a social safety net. But in most societies, preferences for a particular level of infrastructure investment vary far more than views of what constitutes adequate national security. Disagreements can rule out all but the easiest political bargains.
Fight plan
Must societies choose between existential military fear and functional government? Not necessarily. Countries could get smaller. In their book “The Size of Nations”, Alberto Alesina and Enrico Spolaore note that safety in numbers (ie, bigger military budgets) comes at a cost: big countries tend to be more heterogeneous politically, making it harder to satisfy voters. If a country faces fewer security threats, it pays to be smaller, with a more like-minded population. But breaking up countries can itself spark new conflicts. A non-military threat such as climate change could provide an incentive to co-operate. But reduced emissions to tackle climate change represent a global public good. Without global co-ordination, deadbeat countries have an incentive to free-ride on the helpful steps taken by other governments.
A peaceful world with inadequate infrastructure is preferable to one at constant risk of war but with pothole-free highways. The risk is that political frustration empowers nationalist leaders and inflames geopolitical tensions—and that governments resort to the bad, old-fashioned ways of resolving them.
Exchange-traded funds become too specialised
One even invests in the shares of ETF providers
Print edition | Finance and economicsApr 27th 2017
THERE comes a time when every financial innovation is taken a bit too far—when, in television terms, it “jumps the shark” and sacrifices plausibility in search of popularity. That may have happened in the exchange-traded fund (ETF) industry. The latest ETF to be launched is a fund that invests in the shares of ETF providers.
The notion has a certain logic. The ETF industry has been growing fast, thanks to its ability to offer investors a diversified portfolio at low cost. The assets under management in these funds passed $3trn last year, up from $715bn in 2008. Some investors might well want to take advantage of that rapid expansion.
But by no stretch of the imagination would this be a well-diversified portfolio; it would be a focused bet on the financial sector. And many of the companies in the portfolio, such as BlackRock, a huge fund manager, and NASDAQ, a stock exchange, are involved in a lot more than just ETFs. Even if the ETF industry keeps growing, the bet could still go wrong.
The new fund (with the catchy title of the ETF Industry Exposure and Financial Services ETF) is just the latest example of the industry’s drive to specialisation. The earliest ETFs bought diversified portfolios that track indices such as the S&P 500. But there are now some 1,338 specialist funds worldwide, with $434bn in assets, according to ETFGI, a research firm.
Some of these specialist funds are based on industries, such as energy or media. They appeal to investors who believe an industry will outperform, but who do not want to pin their hopes on an individual company. But others are pretty obscure: an ETF that invests in founder-run companies, with just $3.1m in assets, for example; or another which buys shares in companies based near Nashville, Tennessee, with $8.5m. A recent fund was launched to back companies involved in the cannabis industry.
Heady stuff. But the more specialised the fund, the fewer companies it has to invest in. So these funds will probably be more volatile and less liquid—not the ideal home for the savings of small investors.
The financial industry has been down this road before. In the early 2000s Britain suffered a crisis in the investment-trust sector. Like ETFs, investment trusts are managed portfolios that are traded on the stockmarket; they have been around since the 19th century. But a craze developed for so-called split-capital trusts, which had different classes of shares; some received all the income from the fund, others all the capital growth. These shares had some tax advantages and were snapped up by small investors. However, some split-capital trusts only invested in the shares of other trusts. When problems emerged in some funds, they rippled right through the asset class, eventually requiring nearly £200m ($258m) to be paid out in compensation.
A similar pattern emerged, on a much bigger scale, with mortgage-backed securities (MBS) in America. The idea of issuing a bond, backed by mortgage payments, dates back to the 19th century, but the residential MBS market took off in the 1980s. The market jumped the shark only in the early 2000s, with the rapid growth of vehicles known as collateralised debt obligations (CDOs) that grouped mortgage-backed bonds together, giving different investors different rights over the assets and cash flows of the portfolio. Doubts over the creditworthiness of these securities in 2007 triggered the financial crisis.
The ETF sector has not yet reached the extremes attained by split-capital trusts or CDOs. By and large, funds do not invest directly in other ETFs; although there are a few “leveraged” ETFs, where losses and gains are magnified, they represent only 1% of the industry’s assets.
Still, there are signs that rapid flows into some ETFs can lead to price distortions. A rush of money into gold funds in recent years has caused the VanEck Junior Gold Miners ETF to be the largest investor in two-thirds of the 54 companies it owns, according to Factset, a data provider. The fund’s assets grew by more than half, to reach $5.4bn, between January 1st and April 17th. The rush was accelerated by another fund which made a leveraged bet on the performance of the VanEck ETF.
The danger is of a feedback effect: as the fund pours money into the smaller companies in its portfolio, their prices rise, attracting more money into the ETF. But should investors change their mind and want to withdraw their money, there could be a sharp fall in these mining shares. VanEck is allowing the fund to invest in larger companies in an attempt to solve the problem. But the more the ETF industry specialises, the more often such difficulties are going to arise.
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