Bank Recapitalization and Interest Sensitivity Explained in 178 Words

Saturday, May 01, 2010

Bronte Capital Chief Investment Officer John Hempton recently came up with the most concise explanation how a Japanese-style bank recapitalization based on near-ZIRP (zero interest policy) can work. But raise the interest environment to higher levels and it's game over.
From John Hempton's email: 
Suppose you have an insolvent bank. Assets 100, liabilities 90 - but 30 of the assets are not worth ANYTHING. Further suppose rates are zero to fund the bank, 3 percent to lend, 1 percent of costs - spread after costs of 2%. Costs are on total assets (100) at all times.'' 
The insolvent bank will have interest revenue of 2.1 (3 percent of 70). It will have funding costs of zero (0% of 90). It will have operating costs of 1 (by assumption). 
Therefore it will make 1.1 in CASH PROFITS EACH YEAR. 
Run this bank for 20 years and it recapitalises. This happened in Japan. 
By contrast presume rates are 10% to fund and 13 percent to lend - the same 3% spread. 
Assume operating costs are the same. 
The bank will have interest revenue of 9.1 (13 percent of 70). It will have funding costs of 9 (10% of 90). It will have operating costs of zero. 
It will have - pre-credit losses - an OPERATING LOSS of 0.9 per year. The bank NEVER recapitalises. 
Remembering that Eurozone inflation has surpassed the European Central Bank's main refinancing rate of 1% by 40 to 50 basis points in the last 3 months - latest Eurostat figures (pdf) put Eurozone inflation in April at 1.5% this paints a black picture for a recovery a la Japan which was able to deflate for 2 decades.
As the ECB's sole mandate is to keep inflation below 2% annually a further strengthening of Federal Reserve Notes (FRN) vs. the Euro coupled with steady high oil prices and food inflation on the horizon may lead to scenario 2.
Hempton writes the Brontecapital blog, which was temporarily taken down by Go ogle last January over a post headlined: "A dark privatised social security story: Astarra, the missing money and how examining a fund manager owned by Joe Biden’s family led to substantial regulatory action in Australia."

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