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Don't count on banking being as strong as supervisors say

Logica/CMG; P & O Princess

Jeremy Warner
Wednesday 09 October 2002 00:00 BST
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There are lots of reasons why the business downturn has not so far been reflected in a wider economic recession, but one of the main ones is the apparent resilience and strength of the banking system. In nearly all post-war downturns to date, the banking system has come under severe strain, resulting in near death experiences for many banks and a consequent credit crunch which has only succeeded in making matters even worse. That's plainly not happened this time around, or at least not so far. Why is that?

In a thought provoking speech this week to the American Bankers' Association, Alan Greenspan, chairman of the Federal Reserve, gave a range of different explanations. In part, he points out, it is because the nature of the downturn is different. Despite the destruction of wealth in the stock market, households have maintained their spending because of increases in income and housing wealth.

Consumer and mortgage loans have not suffered the sharp increase in bad debt experience that the business sector has, and they have contributed significantly to the earnings of the banking system and its ability to absorb losses elsewhere. Mr Greenspan was talking about US experience, but the position is largely mirrored here in the UK.

Just as important in Mr Greenspan's view are improvements in banking supervision, capital requirements, and risk management. As a consequence, banks had generally built up impressive earnings and balance sheet strength going into the downturn. The growth in markets for securitised assets and the emergence of a wealth of different derivative instruments have also allowed banks to disperse credit risk in a way that in the past was next to impossible. Big exposures to telecommunications companies were laid off through credit default swaps, collateralised debt obligations and other financial instruments. Other risk transfer techniques have included sales at discount prices as loans became riskier. Again, such mechanisms for spreading risk were not available in past downturns

So is Mr Greenspan hailing the death of the banking cycle, in the same way as some once pronounced the business cycle dead and buried. Well up to a point, yes he is. "We can have little doubt", he says, "that we have seen a new response mechanism that has contributed to the health of the banking system, one that I trust will be more than transitory." Mr Greenspan's contention is that the banking system has undergone profound structural changes that have succeeded in reducing its susceptibility to shocks on a possibly permanent basis. He doesn't deny there are still substantial problems and large losses yet to be recognised. But basically things are OK, he says.

Mr Greenspan argues his case in characteristically compelling fashion, but I suspect he's being too sanguine. One of the reasons why a more serious recession has been kept at bay is that exceptionally low inflation has enabled central bankers to cut interest rates and print money on an unprecedented scale. This has been as valuable in preventing a bigger bust in the banking system as it has been everywhere else. Risk dispersal by banks is important, but it is not nearly as important as low interest rates. Just imagine how serious the position would be for most businesses, and by extension their bankers, if interest rates were as high as they were at the time of the last recession. One shudders to think of it.

The present downturn has not yet run its course and I'd be amazed if we come out the other side without a major casualty in the financial services sector, whether it be in insurance or banking. In recent months the rumour mill has been in overdrive. JP Morgan one day, Commerzbank, Dresdner and Credit Suisse the next. Yesterday's renewed cost-cutting drive by John Mack, chief executive of CSFB, only confirms the pain being felt in large parts of the investment banking community. Blame the renewed bout of nerves on the exaggerated pessimism of a bear market if you like, but stock markets have a nasty habit of being proved right. As things stand, they are not nearly as certain about the strengths of the banking system as Mr Greenspan is.

It wasn't the subject of Mr Greenspan's speech, but regardless of banking's new-found strengths, a state of paralysis has taken hold which does not bode at all well for future economic growth. Across markets and into the banking system, there has been an almost unprecedented flight from risk, risk of any sort, whether it be in equities, currencies, lending or just crossing the road. Investment of almost any variety is regarded as too risky to make in this environment. Cash is king and, outside the consumer sector, it simply isn't being spent. Those that have it are keeping it under the mattress, figuratively speaking.

Businessmen are meant to be optimistic types, but it is hard to recall them ever as gloomy as they are now. The appetite for risk has gone, to be replaced by a focus on survival, which is constantly stress-tested against worst case scenarios. Many are preparing for the sort of nuclear winter that has already engulfed the telecoms sector. This may seem seem like an over reaction, but the way things are going it could yet become a self-fulfilling prophecy.

Logica/CMG

There's many a slip, but given the warm welcome afforded by markets yesterday to the prospect of a merger between Logica and its main rival in text messaging software, CMG, the two would be mad to allow the chance of a deal to evade them.

Two years ago, the chairman of CMG, Cor Stutterheim, said there was very little chance of a merger between the two, logical though it might seem, because CMG was driven by a consensual approach to management while Logica was a one man band otherwise known as Martin Read. That was always a touch unfair, but much has changed since, not least an almost total collapse in the two companies' share prices.

Both companies started life as straight software solutions enterprises for business and government, but it wasn't until they began developing systems software for the fast-growing mobile phones industry that they hit the big time. Bizarrely, they had the market for text messaging software largely to themselves and their share prices soared. That market is now mature and declining, while the next generation market in multi-media messaging is proving slow to develop and much more competitive.

Merging the two would take a huge chunk out of the cost base as well as addressing the long-term problem of over capacity in mobile telephony software. If Mssrs Read and Stutterheim have got as far as agreeing both the outline terms of the merger and the division of responsibility between them, then the main work is already over. Due diligence could yet scupper the deal, but there seems a real will to make it work. Good news for battered shareholders, not such good news if you happen to work for either of them. Up to 4,000 jobs are expected to go in the subsequent cull.

P & O Princess

Where are the customers' yachts? In these work starved times for the investment banking industry, it's reassuring to know that at least no one is cutting their charges. P&O Princess yesterday admitted that the cost in banking and legal advice of dealing with two rival takeover bids had risen to an astonishing $55m. It can safely be assumed that Carnival, the likely winner has spent something similar. On top of that it will have to pay a $62.5m break fee to the original merger partner, Royal Caribbean, bringing the grand total costs of the bid to $172.5m, or approximately 37 per cent of P&O's pre-tax profits for last year. There are big cost cuts to be had from this merger, as well the enhanced pricing power of a larger share of the world cruise market, but can it really be worth as much as this? No wonder everyone has become so cynical about who really benefits from big corporate mergers.

jeremy.warner@independent.co.uk

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