One of the most interesting and rewarding investment opportunities currently available trades on the reform of the banking sector. We live in a world where, unfortunately, pragmatism has for too long trumped ideology. This lack of a guiding philosophy had led banks to myopia and to overreach themselves resulting in over-levered balance sheets and inappropriate operating practices, culminating in the financial crisis of 6 years ago. Regulators are still trying to reform the banking system and this has produced a host of investment opportunities. 

What is the raison d’être of a bank; why does it exist and what is its place in the economy? A bank exists to borrow money from those who have more than they can currently spend or invest and to lend it to those who have less than they can currently spend or invest. A bank is therefore no more than an intermediary. From this function, pragmatism and the profit motive led banks to turning their credit expertise to bond arranging and underwriting and ultimately to trading and hedging. From bonds, this same capability was extended to equities, commodities, foreign exchange and pretty much anything for which a market could be created. The liquidity provided by banks trading serves a useful purpose in price discovery and risk transfer. However, as is often the case, when competency trails behind the state of the art, or complacency or hubris develops, banks can and have overreached themselves leading to credit crises. Glass-Steagall in 1933 and more recently Dodd Frank are legislation enacted to manage this tendency for efficiency to dominate stability and governance, especially when clever minds are at work.

One of the primary sources of instability is not just the commingling of principal and agency activities in a bank but rather the liquidity mismatch between its assets and liabilities. This mismatch arises because banks borrow short term from depositors and each other, and lend longer term to businesses and homeowners. Normalized interest rate term structures mean that banks earn a higher interest rate lending long and pay a lower cost of funds borrowing short. This is efficient but inherently unstable. So far, no rules, limits or regulatory device have been able to mitigate the force of fear during a bank run. One way by which the financial industry has sought to address this liquidity mismatch, is the so-called Shadow Banking system. This is a parallel funding system where it is hoped that the liquidity or maturity between assets and liabilities can be matched. More cynically, they are a means of circumventing regulatory capital requirements. Generally, Shadow Banks are thought of as any non-bank institution conducting a banking business. Structured Investment Vehicles, Collateralized Debt Obligations, Collateralized Loan Obligations, Private Debt or Private Equity funds, indeed even mutual funds, can be considered part of the Shadow Banking system.

In the run up to 2008, banks who witnessed demand outstrip capital saw Shadow Banking as an outlet, but as with trading and hedging before, competency and circumspection trailed the state of the art and avarice, and before long the Shadow Bank’s collapsed, and collapsed onto the banks themselves. Regulators were quick, though late, to step in to regulate the financial system and in such a way as to limit banks to focus on their core reason for being, that is to borrow and to lend safely. This regulation, unlike the singular Banking Act of 1933 is a raft of international sanctions. As such they will be more difficult to dismantle than Glass-Steagall which was repealed by Graham-Leach-Bliley in 1999. Basel 3, Solvency 2, Dodd Frank and the Volcker Rule are some of the fragmented rules that banks will have to navigate in future.

Herein lies the investment opportunity. New leverage and capital rules will discourage banks from certain types of lending, from many types of trading, and encourage banks to restructure their balance sheets through asset sales, new methods of funding and accounting acrobatics.

Where banks are retreating from lending, returns can be earned for replacing them. Examples of this are private debt funds that lend directly to small and medium sized enterprises, to fund infrastructure or to real estate development and do so flexibly to the benefit of both borrower and lender. Many of these funds work with banks, to reduce the leverage of the bank’s funding, enabling them to lend efficiently while complying with the new regulations. Investors in such funds can reap a liquidity premium in addition to the credit spread.  Returns to secured lending can be as high as the mid teens.

Where banks are no longer trading, the public traded capital structures of companies have become improperly priced leading to arbitrage opportunities. Capital structures used to be policed by bank trading desks as they trade across equities, preferred shares, bonds and loans. Mutual funds tend to segregate trading of such securities so that the pricing of one segment relative to another is not arbitraged away. Only a small group of hedge funds did this. They are now growing as banks shutter their trading desks and traders have to find a new home. Capital structure and credit arbitrage hedge funds generate very attractive risk adjusted returns.

Banks own capital structures are inefficient. The financial crisis led to bank bailouts and rescues that necessitated emergency capital structures. As the crisis has waned and new regulation is implemented these capital structures are no longer efficient. Some capital securities will be reclassified as debt. Some apparently dangerous securities such as CoCos (contingent convertibles) are being deleveraged making them safer than the market thinks. Some of the most lucrative trades will be in the trading of bank securities across their capital structures. Some mutual funds and hedge funds are active in these securities.

Asset sales are another means of deleveraging bank balance sheets to comply with new capital rules. These assets need a new home and, at the right price, even apparently poor assets can make good investments. Distressed asset funds are on the prowl for such assets.

Lending to banks in creative ways can also be lucrative. Some private debt funds do this. By providing capital relief on assets that remain on the borrowing bank’s balance sheet, these lenders release capital allowing the bank to continue to lend. For this service they exact a high yield on their capital. Some very specialized funds invest in this area. There is even one such fund based in Singapore.

The strategies arising from bank regulation are diverse and offer rewards to risks other than market risks and therefore are a useful diversifier in any investment portfolio. The issue with these strategies is that they are often either illiquid and thus require term capital or they are complex and require special analysis. The shame is that these opportunities will likely not be made available to retail investor but will remain the preserve of institutional investors.

If we stop thinking about QE as an expansionary policy but rather as a treasury refinancing operation and debt monetization, the behavior of the Fed becomes clearer. For one, the Fed surely understands that without reducing the banking system’s reserve requirements, the money multiplier and the velocity of money cannot accelerate and thus asset purchases have very little impact on real or nominal output. Indeed by increasing capital requirements, the Fed is effectively neutralizing any expansionary effects of QE. A side effect of refinancing the treasury is an expanded balance sheet which risks runaway inflation should the velocity of money pick up. Any sign of improved fiscal position must encourage a corresponding reduction in asset purchases.

The impact on pricing of the term structure due to the Fed going forward should be regarded as at best neutral.

Current economic wisdom is that geographical labour mobility is an almost unqualified positive and an inalienable right. This should not go unquestioned.

Labour mobility is responsible for improved employment, lower costs, greater efficiency and is associated with an overall increase in welfare. Other considerations should include factors such as overcrowding in cities, hollowing out of secondary cities, towns and villages, infrastructure requirements, distribution and allocation of resources, and the equitable distribution of wealth.

One metric of welfare should be population density. There is an optimal density in the welfare function below which the incumbent population regards an increase in population a good thing and beyond which it regards it as a bad thing. A local population deserves certain rights to control the population density in their area. The problem lies in determining the appropriate level and nature of the controls.

Different groups within a local population have different objectives regarding population. Business owners and employers seek the import of skilled or cheap labour. Owners of land seek demand for labour storage. Governments may see immigration as a means for maintaining demographic characteristics and as a source of tax revenue. Employees may regard immigration as competition for jobs and resources, as demand for goods, services and housing drive inflation. The representation of various groups in government will drive immigration policy.

Sprawl has infrastructure costs related transport and communications. Some of these costs are public and some private, but the public cost is significant. Countries are collections of local populations. National policy can affect the cost of doing business in a country creating divergences between countries. Most countries are evidently operating productivity accretive immigration policies, subject to the tolerance of the majority of the incumbent population who prefer less immigration. This is indicative of the representation of the various groups in most governments. Priority is unlikely to be given to policies where the costs are not associated with commercial gain in the most direct, immediate and evident ways. That the factor of population density in the welfare function is often subordinated to more commercial interests or is omitted altogether, it is not surprising that current policies encourage concentration of population, in particular productive labour in urban centres, while less productive groups are left in suburban towns and villages. If valid, this will be evidenced by larger cities getting larger and more dense while smaller cities shrink and get less dense in a ‘winner’ take all dynamic.

The concentration if population in cities leads to potentially major disparities in real estate prices as well as rapidly inflating prices. As overcrowding sets in, proximity to resources and infrastructure also command significant premia. Foliage, water, aesthetically pleasing surroundings and locally lower population density are goods that can command significant premia. River side and park side housing show evidence of this.

As a scarce resource, real estate can become a source of rising cost for both residents and businesses in a city. Costs should rise as long as people continue to move in to cities, pushing up prices until they reach the limits of affordability. Availability and cost of credit can increase demand by spreading the cost of ownership over time and easing affordability at least in the short term. Excessive credit can create real estate bubbles if credit underwriting is too lax and or loses sight of rationality. Principal agent issues in mortgage markets where mortgage loans are sold or securitized and sold by originating banks can exacerbate the problem. Artificially low interest rates also add to the problem, enabling unsustainable real estate prices. Such interest rate policies may or may not be integral to housing policy.

This analysis is incomplete and some of the hypotheses untested. It is built on expectations and understanding of human behaviour, an approach that has worked elsewhere, such as in economics and financial markets. The above should therefore be regarded as interesting speculation rather than an academic study or survey.

It is almost elementary to professional investors that when investment decisions are made, the appropriate sizing of the investment is based on the quantity of risk that is taken and not the quantity of capital. This has a parallel in the Sharpe Ratio measurement of investment performance. Returns are only useful in the context of the risk associated in obtaining them. Similarly, returns are obtained at a price, which is risk. To obtain returns, one should allocate risk and not capital.

Here is a practical example. Say an investor would like to invest 100 USD and allocate equally to equities and bonds. If they were to allocate capital, they would invest 50 USD in equities and 50 USD in bonds. The volatility of equities, however, is roughly twice that of bonds. As a result, the investor is inadvertently taking more risk in equities than in bonds. If the investor intended to have an equal exposure to the returns and the risks of equities and bonds, they should in fact allocate twice as much capital to bonds as to equities, so that the contribution of risk to the portfolio from equities and bonds is equal. That means a 66 USD allocation to bonds and a 33 USD allocation to equities. We have made a simplifying assumption that bonds and equities are independent and thus uncorrelated.

Mean variance optimization in portfolio construction is the full blown implementation of this concept. It allocates capital (not risk) in such a way as to minimize the risk for a given target return, or conversely, it allocates capital in such a way as to maximize the expected return for a given level of risk. The generalization in mean variance optimization means that the interdependence of assets in the portfolio is accounted for in the allocation decision, but the principle is the same. If all the assets in the portfolio were mutually independent and the expected returns of each asset were equal, then a mean variance optimization would result in the efficient portfolio comprising assets sized inversely proportionately to their volatility, which is a proxy for risk.

Despite the widespread acceptance of mean variance optimization in portfolio construction, it is surprising that many professional investors continue to allocate capital instead of risk in their asset allocation.

Inequality has decreased globally, yet this aggregate phenomenon hides a more disturbing picture. As countries have become less unequal, the distribution of wealth and income within countries has become more unequal. If the material and commercial motivation for conflict between nations has receded between nations, it has certainly risen within each country.

A disinterested flavor of capitalism both requires and promotes inequality. Absent some form of social safety net, the juggernaut of capitalism crushes the weak and exalts the strong. Diversity feeds the system, and natural selection drives aggregate efficiency and productivity.

There are two reasons why social safety nets have been enacted in many developed capitalist countries. One is human charity and an innate sense that all life is precious and the neglect of the weak is too cynical a position. The other is that a sustainable system, however capitalist, requires a sustainable underclass. A parallel argument supports the saving of the environment as well as the diversity of animal and plant species. You never know when you might need them. The need for an underclass is clear and present.

To take the less cynical view, progress requires that effort and results are rewarded and sloth and failure are not rewarded. A certain level of inequality encourages effort. It is hoped that such effort promotes the common good as the profits of the successful are spent and reinvested leading to the distribution of wealth. This distribution is not always equal. It tends to concentrate business and industry rather than diversify. And marginal propensities to consume fall with higher income and wealth resulting in a wealth trap. It is possible that overly unequal economies over save. One could envisage such a definition of over saving. Another measure of over saving is to define the optimal level of savings as that amount that will allow a person to smooth their consumption over their life, with allowances for uncertainty, to a target terminal wealth of zero. Inheritance becomes topical. Is it fair to target zero inheritance? Would acutely high inheritance taxes be useful or practical?

The accumulation of wealth for wealth’s sake is an important motivation that should not be totally discouraged. Thus, a target terminal wealth of zero may be undesirable. However, inheritance taxes can still transfer some wealth without impairing ambition too much. Practicality is another matter as high inheritance taxes only encourage tax avoidance strategies such as pre mortem transfers.

It seems that while a certain level of inequality encourages progress, inequality is neither an unmitigated good nor an irredeemable bad. As long as inequality is not synonymous with unfairness, then it is a good thing. Fairness would require that each new entrant into the economy does so on equal terms. But what does equal terms mean and how far does it go? Does it require equal initial endowments of wealth and capital? Is equal access to education sufficient? Is the limiting or prohibition of extra curricular education too far to go?

The cynical view would maintain and encourage inequality subject to the constraint that such inequality does not threaten the status quo. A minimal level of social security and welfare would be provided to appease the middle to lower classes to prevent a revolt. In the meantime policy would focus on maintaining the wealth accumulation of the influential and wealthy. Bailouts of asset markets, ostensibly to avoid damage to Main Street at cost to employment and household income and consumption, support the cynical view. The increased inequality post crisis is further evidence.

Unconstrained free market capitalism tends towards extreme inequality of wealth. The accumulation of physical and intellectual capital makes wealthier households more productive than others in a perpetual cycle. Eventually inequality becomes acute and needs to be addressed. Current solutions are overly complex and politicized and treated as a necessary evil. They only slow the rising inequality without establishing basic principles and facing the primary issues. Is inequality to be embraced or tolerated? Is inequality a bad to be actively reversed? On what basis is inequality measured and what are the metrics? What are the side effects of whatever route and policy is chosen and what is acceptable?