March 13, 2012

Largest central bank balance sheets have tripled in 6 years. And so?

March 13, 2012

Largest central bank balance sheets have tripled in 6 years. And so?

Union Bank, owned by Mitsubishi UFJ Financial Group and California’s fourth biggest bank by deposits, is buying the parent of the state’s 20th biggest deposit holder, Pacific Capital Bancorp. Pacific Capital has $5.9 billion in assets and 47 branches, compared with UnionBanCal’s $90 billion in assets and 414 branches.

For deposits in California, BofA is #1 with 26%, Wells is #2 with 19%, Chase has about 7%, and Union Bank has 6%.

I don’t know if this acquisition will result in layoffs, especially on the mortgage side of things, but that seems to be the trend.

For example, Friday’s BLS jobs report showed that mortgage companies cut 3,200 full-time employees from their payrolls in January. The total went from 265,300 in December to 262,100 positions in January. Overall, the number of jobs in the mortgage banking and broker sector fell nearly 4% from a year ago, with some big chunks coming from MetLife and Bank of America.

The Union Bank news also points to the fact that banks and central banks around the world have more cash and liquidity than they’ve ever had before.

Focusing on central banks, because of collective quantitative easing, the balance sheets of the Fed, ECB, BOE, BOJ, Bundesbank, and others are all at record levels. The total size of the 8 largest balance sheets have almost tripled in the last 6 years from $5.4 trillion to more than $15 trillion (and still growing).

The result of this build up in central bank reserves is that it artificially lowers rates and makes asset classes like fixed income securities, relatively overvalued.

One would hope that the low rate environment also provides incentives for banks to take on riskier assets in the form of loans. And to some degree this is taking place, although not as much as many would like, but if one looks at the recent performance of different bank asset classes (commercial and industrial loans, credit cards, mortgages, and so on – even stocks) they’re all doing pretty well return-wise – even though they’re not necessarily related! Economists believe that this unprecedented correlation in returns is due to the availability of cheap money, and it is overriding most microeconomic aspects of various industries.

For bankers, this presents a huge future risk: “Will this unwind?”

At some point central banks have to pull trillions of dollars out of the economy, both in terms of physical money and in terms of leverage. Smaller banks’ management needs to understand that until a global exit strategy is articulated, volatility will remain high because of leverage, which also means that risk management becomes more important than ever.

To sum things up, some smart folks out there think that credit is being artificially supported (look at the Fed buying agency MBS’s every day, helping to keep prices high and mortgage rates low) thus if given the choice between quality assets at low spreads and riskier assets at wider spreads, the former is preferred but the latter is often chased to support margin. Many asset classes and geographies are performing at above zero return levels only because of this liquidity support.

In addition, excess liquidity will keep commodities and equities well supported – asset classes that will also act as bellwethers when this reverses.