The Partnership for a Secure Financial Future Release of July 2012 Hamilton Financial Index July 16, 2012

10:30 am ET

Coordinator:

Ladies and gentlemen, thank you for joining the Partnership for a Secure Financial Future and Hamilton Place Strategies for the release of the Second Hamilton Financial Index. The report is released twice annually in advance of the Fed Chairmans Humphrey-Hawkins testimony before Congress. On todays call, our speakers will release the results of the index report on the current health of the financial services industry. They will also provide analysis of the European debt crisis and the impending fiscal cliff.

Before I turn the call over to your host, please note that all telephone participants are in listen-only mode at this time. Later we will conduct the question-and-answer session where you will be given the opportunity to ask questions about todays discussion. If you have not received the report, please visit www.ourfinancialfuture.com to download a copy.

If you should require assistance during the call, please press star 0.

Todays conference is being recorded. If you do not wish to participate, you may disconnect at this time.

With that, I will now turn things over to your host, Mr. Steve Bartlett, President and CEO of the Financial Services Roundtable. Joining Steve are two of the report authors, Matt McDonald, partner Hamilton Place Strategies, and Steve McMillin, partner US Policy Metrics.

Mr. Bartlett?

Steve Bartlett:

Thank you very much. We are gathered to present the findings of the Hamilton Financial Index that is a onceevery-six-month report on the safety and strength and soundness of the financial services industry and its effect on the economy. This also coincides with the second-year anniversary of the passage of Dodd-Frank. If you dont have a copy of the report, you can download it on our Web site, ourfinancialfuture.com, or just e-mail right now to richard@fsround.org, and well send you a copy of it.

The Partnership for a Secure Financial Future, which is sponsored by The Financial Services Roundtable and several other trade associates, has commissioned this report to get the facts to correct myths and to clarify erroneous assumptions about the industry. The report - its a long report. And were going to go into some of the details, a few of the findings sort of jumped out of me. And then Ill turn it over to the authors of the report. And we expect to be concluded by 11 oclock, including the questions and answers.

One is that in the financial services industry, safety and soundness is now 22 percent higher than the historical norm as measured by the Hamilton Financial Index. So thats Number 1, is the capital levels in safety and soundness are quite high. But the second is, weve identified a potential risk in the future. Its not a fact today, but a risk in the future, and that theres a tradeoff between capital levels and lending. That is to say that more is not always better. And in some cases, too much capital can result in a loss of lending. We dont find a loss of lending at this point. But that is a potential negative in the future.

Third, business lending in fact has increased rather dramatically. The current business loans totaled $2 trillion, which is near an all-time high.

Fourth is we did examine the exposure of the industry in terms of safety and soundness to Europe and found that US banks have significantly reduced their exposure to the crisis in Europe. And then last, and perhaps most important, is we find as weve said in the past that the impending fiscal cliff of the debt limit, tax hikes and sequestration, if its left untended or unresolved, would be the largest fiscal contraction in over 40 years. We find that fiscal cliff, both the reality of it and the threat of it, to be the highest risk to the economy today by a large amount. So to discuss those findings in detail, Im going to turn it over to Matt McDonald of Hamilton Place Strategies and Steve McMillin of Gramm Partners, LLC.

Matt?

Matt McDonald: Thank you, Steve. And thank you, everyone, for joining the call today.

The highlights of the HFI, the Hamilton Financial Index, from the fourth quarter of last year to the first quarter, we saw the index rise. It went up from 1.15 to 1.22. As a reminder, the index is a combination of firm-level risk and then systemic-level risk. We combine the common capital ratio with the St. Louis Financial Stress Index to take a look at the whole of the industry to see how its doing. And if you look historically, that index has averaged around 1. What we see today is that that is up to 1.22. During the worst of the crisis, that index was down to 0.46.

So what you really see is a dramatic improvement in terms of the safety and soundness of the industry as demonstrated through the index. And what we found is that that is actually being driven by higher capital levels at the banks. So we did a little bit of sense-testing. And in the report, you can read about this. But we wanted to see given events in Europe, given systemic risks and whats out there, what would happen to the index today, the highest point of Quarter 2 systemic risk, the index would still be at 1.15.

And what we actually found is that for the index to dip below that historical average of 1 is that financial stress would have to be five times higher than it was during the second-quarter high. So really were looking at a situation where the systemic risk gets so much lower than what you would need to see, to see the index dip below its long-term average.

Another piece that we go into is the fact that the high index is being driven by the higher capital levels raises a question of choice, both for the industry and for regulators and policymakers. And that choice is the fact that higher capital levels are not necessarily always a good bank.

So a bank that has 100 percent capital level is not a bank; it is a pile of money sitting there. And effectively, the capital should be used to balance the risk to the institutions with the need to grow the economy. And if that balance is out of whack, if the capital levels are too high, then the banking system wont be supporting the economy the way that it needs it.

In the value section of the report, we actually explore whether that is the case or not. And what we find, as Steve alluded at the beginning, is that loans are up. We see total loans up to $6.8 trillion and then business loans at $2 trillion. The loan availability is up. People are getting the loans that they need. But the important thing to note is that this is in a context of reduced demand because of the soft economy.

So the question is that we have higher capital levels now that are helping to protect the industry, protect our economy from risks that are out there. But as the economy returns to growth, is that those higher capital levels can actually hold back the economy if the demand for loans increases. And thats the choice and the challenge that we explore in there. And I think that the headline from that is simply that higher capital levels are not always a good thing. And then the final piece that Ill touch on in the safety and soundness section is the question of European exposure. And that is driving some of the systemic risk that we see out there. Its obviously a major problem for Europe, a major problem for the global economy, and the knock-on effects that the US could be substantial as well. We wanted to dive in a little bit to what US financial services firms are doing to prepare for any potential problems from Europe.

What we found is that the exposure to the EU has actually decreased 16 percent. And a lot of that exposure reduction is being driven by exposure to the periphery. So when you look at the countries where thats actually focused, is theres been massive reduction in exposure to Greece, to Spain, to Ireland, to Portugal. We even have reduction in risk exposure to Germany. The two most notable where theres exposure to debt by US institutions is the increase in the UK and in Switzerland; notably, neither of which are actually part of the Monetary Union, which is, I think, where a lot of the concern is focused around.

So, broadly, what we see is a financial services industry that continues to repair itself beyond where we saw it in the crisis that is acting to deal with challenges that are outstanding, including the EU. And for policymakers, I think the question is that as the economy returns to growth, when that happens, is the financial services sector and are the regulators and policymakers going to be positioned best to support that growth going forward? And thats the question that people have to have their eye on as they think about the future.

And now to Steve McMillin.

Steve McMillin: Thank you.

The basic points of the fiscal cliff section of this report are first of all, the fiscal cliff, if it does occur, would be the largest fiscal contraction in four decades, which would put significant stress on an already weak economic recovery. The magnitude of the fiscal cliff, just to remind everyone, put it all

in front of you there, would be $607 billion in one year, equivalent to 5 percent of GDP.

And an important thing to understand here is the fiscal cliff is not a policy outcome that anyone in political life is advocating or favoring. The policy choices are in fact much narrower between the two parties. But because of the way fiscal policy decisions have been put off or time-limited in recent years, you have all of these policies coming due in one fell swoop.

So this deadline was meant to have such catastrophic consequences that it would force politicians to act. The risk here, of course, is that they do not act. And we have that significant fiscal contraction which will then do substantial damage to our economy especially in the first half of next year. Second point, for the long-term strength of our economy, while its important to avoid the immediate impact of the fiscal cliff, this needs to be accompanied by action to reduce our current historically large deficit. If you look at the US Government debt held by the public, by the end of the decade, thats going to be approaching 100 percent, which is a level that economist (unintelligible) was posing a significant danger to our economy. Our debt load is already higher than the European Zone as a whole, higher than some of the countries in Europe that are already experiencing economic crises. And that debt load is getting worse and more burdensome every day.

Thirdly, in addition to the direct effects of this fiscal policy, we have additional detrimental effects that come from uncertainty about government fiscal policy. The debt ceiling crisis last summer was perhaps the most celebrated example of this, where even though at the end of the day, the debt ceiling was increased, the federal government never defaulted on a single dime of debt or interest payments or any other obligation, the uncertainty

about where the government will go caused a reaction in the real economy. And that had real and negative economic consequences.

The magnitude of the policies expiring at the end of this year is even greater. You have another debt ceiling expiration, which will come at probably late calendar year or early in 2013. And you have the potential for a one-year $400-billion tax increase and a cut of $100 billion in spending again in a very compressed time-saving.

Just the risk of that shock is naturally going to have an impact on people who are trying to plan their investment, to plan their hiring, plan what their tax burden is going to be next year, and when people in the private economy are shrinking back, hedging their bets, holding onto things, waiting on Washington, that has a drag on the potential for our economy to grow.

Steve Bartlett:

So with that, this is Steve Bartlett again. We are prepared for questions for any of the three of us or all three.

First question please?

Coordinator:

Thank you.

And our first question will come from Tamara Keith of NPR.

Your line is open. Hi there. This is a question about the fiscal cliff. And I dont know if youve looked at this. But you talked about just the concern about the fiscal cliff having an impact on decision-making and investment and hiring. Has that already started to have an effect? I mean is there a point beyond which

Tamara Keith:

avoiding the fiscal cliff doesnt matter in a way that avoiding the debt ceiling didnt really resolve the economic impacts? Steve McMillin: Well, theres always going to be a benefit to avoiding the fiscal cliff. What we saw in looking at how uncertainty around last years debt crisis had feedback effects in the economy, it was something that grew as public attention began to focus on those very contentious negotiations and the potential negative consequences if the deal werent reached. So I dont think weve seen anything quantitative at this point. We certainly see anecdotal evidence of layoffs and hiring freezes. Thats starting in particular -- you see reports about defense contractor worried about cutbacks in military spending. But as we get closer and closer to the December 31st deadline, we expect well see that show up in a variety of both anecdotal evidence and in statistical trends.

Tamara Keith:

Thank you.

Coordinator:

Once again, if you would like to ask a question, please press star 1.

Steve Bartlett:

This is Steve Bartlett. To put another way is therere really two requirements here I think in the near term. Remember that it was in July of 2011 that the markets in the economy and in private businesses and consumers began to notice that the debt limit was uncertain as to whether they would be extended. And thats, as everyone recalls, when the economy hit a major bump in the road, a major dip. That was a year ago.

So that was one major dip, bump in the road. This is five major bumps in the road. We have no hard evidence of this. It seems to me though that the business decisions and consumer decisions are essentially beginning to hold their breath at this point to wait to see if the Congress and the Administration are going to agree. Therere two challenges for the policymakers. One is for both bodies, the House and the Senate and the President to agree. But they dont have to agree on the terms of what to do about the fiscal cliff until the end of the year. But the second one, I think, the near term and just as important is to agree to agree, is to agree with each other that at the end of the day, they will reach agreement to avoid this financial catastrophe because it would be an economic catastrophe of epic proportions.

Other questions?

Coordinator:

We show no further questions.

Steve Bartlett:

Matt, do you have anything to add to it?

Matt McDonald: On the fiscal cliff itself, I mean I think that anyone who pays attention to Washington, to the fiscal cliff, to the political environment so far, sees a great deal of uncertainty. And on a practical level is that if you are sitting as the leader of a company or a small business or making decisions and looking at whats happening, is that now is not the time that, if I were in that position, I would be placing big bets on actions for my business. I think that theres enough outstanding out there from Washington, from Europe, et cetera, that the uncertainty is weighing heavily on business decisions.

Steve Bartlett:

Okay.

Do we have another question?

Coordinator:

And our next question comes from Kent Hoover of American City Business Journals.

Your line is open.

Kent Hoover:

Yes. Back on the fiscal cliff, I understand that Senator Patty Murray is making a speech today at the Brookings Institution, basically saying that its so important to not continue the higher income tax cuts, that Democrats are saying theyre willing to let all of the income tax cuts expire, if necessary, and then start over. What do you think about that strategy? Do you think thats just more of a negotiating ploy or do you think that, you know, when talking about that its important to agree to agree, that you think thats a sign that maybe theres not an agreement to agree?

Steve Bartlett:

Steve?

Steve McMillin: This is Steve McMillin.

Just a quick reaction there; I think both parties recognize at this stage that the prospect for near-term agreement is low and that its important for them to set up a negotiation in December in a way thats most likely for their position to prevail.

Two years ago in December of 2010, there was a lot of discussion that that was going to be the time that those upper-income Bush tax cuts would be allowed to expire. But at the end of the day, there was agreement to allow everything to go forward.

Similarly, last year, we had a lot of concern on one side of the aisle about extension of the payroll tax holiday. At the end of the day, when confronted with a soft economy that really cant handle too many more hits like that, the parties came together and avoided that near-term hit to the economy. So its probably important to, you know, to certainly take those statements seriously, but to recognize that everyone is involved in what they plan to be a month-long negotiation. And they would like to prevail (unintelligible).

Steve Bartlett:

And this is Steve Bartlett.

Without saying anything about an individual Senator, but I will say that brinksmanship in this case is not only not the best strategy; its highly risky for the American people. Were faced with failure to reach an agreement that results in the -- Ill choose my words carefully, but this was right out of the Hamilton report -- results in the largest contraction of the American economy in 40 years. Those are very significant.

And further, failure to even appear to reach an agreement, that is failure to let the American public know that theyre going to reach an agreement, will also begin that large contraction. So I think that for any party or any policymaker in Washington, a my way or the highway approach, is dangerous for the American people and will not necessarily end up with a better deal. There are half a dozen issues that have

to be resolved. Everyone in Washington has a different opinion about how to resolve each one of them from alternative minimum tax to the state taxes, to individual tax rates, to long-term debt, to the debt limit, to capital gains and dividends, to sequestration, and to a long-term fiscal agreement for reduction of the debt.

So each of those has to be resolved and have different opinions on how to resolve them. But theyre not resolved until Congress passes a piece of legislation, sends it to the President and the President signs it. So I dont think any one individual or party or caucus is going to get their way on everything. And I think the brinksmanship is not a way of securing that; it just merely tanks the economy.

Matt McDonald: To augment what Steve said, the fiscal contraction -- meaning the impact of government spending on the economy -- would be the largest decrease in 40 years. Practically, what would happen is that it would almost certainly drive the economy into recession in the first half of next year.

And so the idea that, you know, wherever the politics lay is that if we drive up the fiscal cliff, it will be Washington hurting the economy at a time when it desperately needs help.

Steve Bartlett:

Thank you all very much. My name is Steve Bartlett, President of the Financial Services Roundtable. If anyone has any additional questions you want to ask me directly or our two authors, you can contact me directly or you can contact me through Richard Fawal at the Roundtable. And thats richard@fsround.org.

With no further questions, thank you very much.

Coordinator:

Thank you for participating in the conference today. You may now disconnect.

END