Reduce liability for losses on commercial accounts by adhering to four requirements.
The Fedís Balance Sheet Unwind: When? How?
I think the central rationale behind the Fedís historic $2.7 trillion quantitative easing programs was to ensure that deflationary forces would not propel us into another Great Depression as they did in the 1930s. After all, Fed Chairman Ben Bernanke is considered one of the most knowledgeable experts on the Great Depression as evidenced by his book on the subject, which I read recently.
If you know in advance that prices of goods and services are going to keep falling, it is only human nature to postpone those purchases. In periods of high unemployment, this can create a devastating deflationary price spiral Ö as it did between 1929 and 1939.
The psychological benefit of knowing that interest rates will not rise has been a powerful antidote for the markets coming out of the deepest recession of our lifetime, caused mostly by excess mortgage debt. Record low interest rates allow problem debt to be restructured more affordably and eventually encourages risk-taking rather than risk aversion as was seen in the 1930s. In theory, the unemployment rate, as part of the Fedís dual mandate, should fall as companies gain confidence about the future and start hiring again.
The normal target size of the Fedís balance sheet has been security holdings well under $1 trillion, usually comprised mostly of Treasuries for maximum liquidity. Today, that balance sheet has more than tripled in size due to its purchases of Treasuries, agencies and mortgage-backed securities as part of the Fedís various QE buying programs. What I worry about going forward into a new year and beyond is how the Fedís record holdings of bonds can eventually be unwound without triggering a sell-off in bond prices. Can it be downsized in an orderly fashion without spooking the markets?
Will the unwind be in 2013, 2014 or even later? No one really knows.
Complicating this risk for bankers is the fact that Basel III as proposed would require us to subtract losses in bonds from Tier I capital. You can model the implications for your institution easily by performing a rate shock in several stair-step intervals of rising interest rates. Now would be a great time to perform this shock test, in my opinion, as we are starting a new year and the worst appears to be behind us.
We already know the process (but not exactly the sequence) the Fed will use when it finally taps the monetary brakes (click here for the list). The big question is when and how this reversal might occur.
The average time from an economic peak to the valley and then back to the peak over the past 30 years by my calculation has been about five years. We are now entering year six in the cycle so hopefully we will see our economy continue to improve this year Ö and less need for Federal Reserve support.
Hereís hoping that you and your bank have a great year in 2013. A special thanks to BankNews for the privilege of writing in this space for so many years. Thank you as readers for your kind words and comments throughout the year as this will be my 24th year of writing this column.
I hope I have helped you sleep a little better at night.
Investments Jeff Goble is executive vice president and managing director, investment banking, at UMB Bank, n.a., Kansas City. His email address is Jeffrey.Goble(at)umb.com.
Copyright (c) January 2013 by BankNews Media