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VOLUME IV: ISSUE IV

NOVEMBER 2013

on THe Way To a BeTTer fuTure

does a separation of banks increase the stability of Financial systems?


by jensKeicher
the lehman brothers bankruptcy on september 15,
2008 shook the global financial markets and was one of
the factors that drove the world economy to the brink of
collapse. many who had invested in certificates issued by
lehman brothers lost their retirement savings, and the interbank market stopped functioning due to a massive loss
of trust between banks. the resulting credit crunch blocked
companies from funding their liquidity needs, which endangered thousands of jobs. in order to prevent further financial shocks, the bush administration enacted the
troubled asset relief Program (tarP), which authorized
the government to spend up to $700 billion to stabilize the
financial markets by recapitalizing too-big-to-Fail
(tbtF) banks whose bankruptcies would wipe off all economic growth for the next few years in case of a bankruptcy.
during the past five years since the downfall of
lehman brothers, governments all over the world have assigned commissions to develop programs to stabilize the
financial systems. the conclusions found by these groups
are clear: separating investment banking and commercial
banking will solve all the problems we are facing at the
moment. For instance, in the united Kingdom the independent commission on banking, familiarly known as the
vickers commission, is in favor of a ring-fencing of commercial banking from investment banking - i.e. the commercial banking branch can be part of the banking group
but must be governed independently and be legally separate. in the united states the volcker-rule, a part of the
dodd-Frank act, forbids banks that have access to deposits
to operate a proprietary trading unit or invest in a pension
or private equity fund. even in the european union a high-

level expert group on reforming the structure of the eu


banking sector proposed among other reforms a mandatory separation of proprietary trading and other high-risk
trading activities from traditional banking. according to
erkki liikanen, governor of the bank of Finland and
chairman of this group, these reforms ensure that de-

posits, and the explicit and implicit guarantee they carry,


would no longer directly support risky trading activities.
it is evident that due to the devastating effects a break
down of huge financial conglomerates would have on the
world economy, governments would be forced to absorb
the losses and recapitalize banks if they wanted to avoid
lehman-like scenarios. this implicit government guarantee has triggered moral hazard and enabled huge banks
such as citigroup, deutsche bank and j.P. morgan chase
Story continued on page 7, see Separation

changes in the analyzing abe- real estate re- detroits danthe chinese
janet yellens
energy industry
nomics
covery
gerous decision
economy
rise
Vincent Criscuolo
Graham Jordan
Kunal Kochar
William Helmold Kartik Bharnidipati
Brendan Tsai
Page 2
Pages 3
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INSIDE THIS ISSUE

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CHanGes in THe enerGy indusTry


What they mean for Pipeline mlPs and oil tankers
by vincent criscuolo
China overtakes u.s. in oil imports
according to the u.s. energy information administration, china has overtaken america as the worlds largest petroleum importer. chinese demand has increased due to
economic growth and the resultant increase in the standard of
living, which has put more cars on chinese roads. concurrently, american demand for petroleum products has decreased to about 18.7m barrels/day (b/d), lower than the
demand in 1978 and down 10% from 2005.
the decrease in american oil demand has been accompanied by lower imports of oil due to more domestic shale oil
production in north dakota and texas. in addition, since
2007, american biofuel production has almost doubled and
natural gas production has increased by 25%. in the past
decade, corn ethanol production has quadrupled to 850,000
b/d, allowing substitutes for traditional petroleum. in terms
of crude oil production, the u.s. has an expected average of
7.5m b/d this year in comparison to the 5m b/d average in
2008, reflecting an anticipated 50% increase due primarily to
hydraulic fracturing. Finally, fuel efficient technologies and
regulations have decreased oil use in light-, medium-, and
heavy-duty vehicles.

pipeline mlP to originate in 1981, similar companies have


been expanding their production. now, with shale oil and
other reserves being utilized, mlPs have been given the opportunity to fully implemen t their pipelines within the u.s.
this has led to significant increases in returns. to name a
couple, eagle rock energy Partners lP and mid-con energy
Partners lP have seen considerable growth in the past couple
years.
eagle rock has installed around 8,000 miles of pipeline
that connect individual wells to processing facilities in the
southern u.s. despite the recent weak natural gas prices,
eagle rock has been able to achieve a 10.8% yield. among
other indicators, this shows that the company has solid
prospects for long-term growth because it is capitalizing on
the shifting u.s. demand and increased domestic production.
mid-con has experienced considerable volatility, but has
generated a yield of 9.8%. establishing their drills to ensure
little risk or change in foreseeable production dates, mid-con
ensures low vulnerability to oil price shocks. long-term
growth is supported by mid-cons abundant capital assets,
established pipeline infrastructure, and their rapidly increasing production (up 10% in the third quarter).

effects of decreased u.s. oil importation and increased


domestic Production
lower u.s. oil imports reap many benefits, including reduced international energy dependence, reduced susceptibility to fuel price shocks, increased jobs related to domestic oil
extraction, increased productivity due to fuel innovation,
higher standard of living due to economic growth, and a more
balanced trade deficit. however, more specifically, pipeline
mlP s and oil tankers face interesting situations as a result
of this decreased american demand and increased production.

impact on oil Tankers


conversely, oil tankers have suffered due to this decrease
in demand for foreign oil. specifically, intertanko estimates
that since 2009, mid and large tanker fleets have lost $26 billion. naturally, it is important to note that this loss also stems
from the fact that operating costs in the industry exceed time
charter equivalent (tce) day-rates by as much as 69%. but
perhaps more importantly for the future, the decrease in
american demand for foreign oil has damaged the oil tanker
industry. as american production increases, oil tankers are
less necessary, as americans can consume the oil produced
in the united states. in addition, global demand for u.s. oil
has decreased from 820,000 b/d to 795,000 b/d, decreasing
the need for oil tankers.
to highlight a couple of suffering oil tanker companies,
consider Frontline ltd. and new york's overseas shipholding
group. Frontline has reported net losses for the past two
years, with last years loss totaling $83.8 million. the company has deferred its fourth quarter dividend and has warned
that it may default on a $225 million bond. likewise, overseas shipholding group has experienced considerable difficulties. due to worsening economic conditions, lowering
shipping rates, and the fact that less than 13 million deadweight tons were ordered for shipment last year, a great decrease compared to past years, the company has filed for
bankruptcy.
Story continued on page 4, See Energy Industry

Consequences for Pipeline MLPs


Pipeline mlPs, or master limited Partnerships, fit into a
unique role. as legal partnerships, their proprietors consist of
unit-holders that own a unit stake in the company. meanwhile, they enjoy the benefits of partnership tax law, as they
need not pay state or federal income taxes. since they do not
have these liabilities, mlPs have more disposable capital to
fund their commercial activities. specifically, pipeline mlPs
must generate at least 90% of earnings from activities related
to natural resources, and they must own infrastructure in the
united states.
intuitively, the decrease in american demand for oil and
increase in domestic production of fuel bodes well for
pipeline mlPs. as these are, due to their structure, necessarily slow-growth companies, they take time to establish infrastructure. but, since apache oil company was the first

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aBenoMiCs so far

analyzing shinzo abes policies


by graham jordan
on september 26th, 2012, shinzo abe became the prime
minister of japan after running on the promise of economic
revitalization. For the past twenty years, japan has had negligible gdP growth, and the country has been in a deflationary
slump ever since the japanese bubble burst in the early
nineties. abes promise to change that, dubbed abenomics,
has since then been implemented throughout japan and is
starting to have wide effects.
there are three policy goals in abenomics named the
three arrows after a story in japanese mythology. the first
arrow is much looser monetary policy than had previously
been employed by the bank of japan. the second arrow is
massive government spending programs. the third and final
arrow is large structural reforms of japans relatively rigid
labor laws.
although the bank of japan was actually one of the first
central banks to implement quantitative easing (Qe), the bank
of japan, led by masaaki shirakawa, has been relatively prudent with monetary policy. however, after abe appointed
haruhiko Kuroda as governor of the bank of japan, this
changed rapidly. on april 4th, 2013, the bank of japan massively ramped up its Qe program. in an effort to generate inflation in japans aging population governor Kuroda
announced that the bank of japan would purchase $1.4 trillion
worth of assets over two years in effect doubling japans
monetary base.
this surprisingly large increase in japans Qe program
had many repercussions. although this was not a stated goal
of implementing looser monetary policy, quickly after the announcement the value of the yen plummeted, and in the following few months it slid between 20 and 30 percent against
the dollar. this is causing some friction between other countries and japan as japan is seen to be purposefully devaluing
its currency in order to increase its exports. another effect of
the Qe policy has been a massive increase in the japanese
stock market, the nikkei. since the expanded Qe program was
announced, the nikkei has risen nearly 20%. however, this
rise has also come with incredible volatility. For example, the
nikkei rose 3,000 points between april and may and subsequently lost 3,000 points between may and june. however,
overall the japanese stock market has gained from the policy
of Qe. this is in part due to greater investor liquidity and
more money flowing into the stock market, but it is also due in
a small part to japanese exporters having more favorable earnings to report because of foreign exchange considerations.
lastly, there has been incredible volatility in the japanese government bond market. one reason for the volatility in bond
markets has been the bank of japans problems executing
their massive orders for bonds and the resulting malfunctions.
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however, there are also worries that the policy by the bank of
japan could be seen as a form of debt monetization. this is
scaring investors away from japanese bonds.
the second arrow, government stimulus measures, is currently in play. What makes government spending difficult in
japan is that japan is currently the most indebted country in
the world with, according to the imF, a public debt to gdP
ratio of 238% at the end of 2012. to put that into perspective,
at the end of 2012 the us had debt to gdP ratio of around
106.5% and greece one of 158%. Fortunately for japan, the
ultra-low interest rates provided by an aging population which
primarily invests in government bonds have allowed the country to maintain payments on this debt. however, japan is toeing a very fine line and the repercussions would be huge if this
line were crossed. Fortunately, the government is currently experiencing higher than expected tax revenues. abe plans to use
this windfall to finance his stimulus plan. however, it will be
difficult to make a meaningfully-sized stimulus plan without
issuing more debt.
abe has also been proactive in pursuing an olympics bid
and is looking to the 2022 games as potentially being a source
of stimulus for the economy. at the same time, olympic
games are often associated with high government debt levels
in the construction of a venue for the games. Furthermore,
there is a question as to how impactful securing the olympic
games will be on the current situation, given that they arent
for another nine years.
the third arrow of abes plan, addressing structural reforms in the labor market, has only been partially addressed so
far. japan has some of the most restrictive labor laws in the
world. there are various laws in place that lead to the labor
market being incredibly rigid in that it is both difficult for people to find new jobs and it is also difficult for employers to
fire people.
although the december 2012 elections to the upper house
in japan considerably consolidated abes power, there is still
stiff resistance to changing the labor laws. as such, many of
the proposed reforms have been put on hold. these original
labor reforms, which were seen as not very ambitious, are now
having trouble being enacted. this questions the extent to
which abe will be able to push larger reforms later.
so far, these three arrows have only started to be felt by
japans economy. on the one hand, inflation is at its highest
level in five years at 0.3%. While this may seem small, it is
substantial for a country that has been facing deflation consistently for decades. this success is primarily due to the fact
that abe has had the most success in being able to implement
radically new monetary policy. similarly, exports have begun
Story continued on page 5, See Japan

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reaL esTaTe reCoVery

is the recovery real, or are there signs of another bubble?


by Kunal Kochar
over the last 6 months, the housing market has seen
major improvements. many believe that the recovery is permanent and indicative of economic advancements. however,
results from september have caused much skepticism regarding how long-lived the housing recovery will actually be. according to Forbes, in september, home prices fell by 1.9% on
average and rose at the lowest month-over-month rate since
april. many attribute the most recent decrease in growth to
mortgage rate spikes: mortgage rates have been rising, and in
september rates exhibited a 2-year high. Furthermore, based
on data from Freddie mac, from june through september
mortgage rates rose by roughly 100 basis points. a large part
of this increase has been attributed to the Federal reserves
discussion of tapering, which caused a spike in mortgage
rates in july that seems to have sustained itself thus far. many
consider this rise to be too aggressive and a factor pushing a
drop in demand.
the recent housing improvement has caused some to
question whether the possibility exists for another housing
bubble to occur. housing bubbles involve a rapid rise in home
prices to unsustainable levels, followed by declines when the
bubble bursts. many attribute the financial crisis in the
united states from 2007 to 2009 to the housing bubble. the
Federal reserve kept interest rates low in the early 2000s following the dot-com bubble, and increasing global investment
from developing nations caused large surges in equity prices.
With increasing returns in the stock market and low interest
rates, many consumers engaged in excess spending, particularly by purchasing real estate. banks were willing to provide
loans with very few requirements, borrowing became rampant, and high demand caused surges in real estate prices.
With prices continually rising, mortgage payments became
harder for many to make, and the rate of default increased.
When prices began to fall, noticeable plunges occurred in the
market of mortgage-backed securities, which many consider
a catalyst for the financial meltdown.
based on past experiences, many economists and investors believe elements of another housing bubble are prevalent. the case-shiller 20 city index, produced by recent
nobel Prize-winning economist robert shiller, is up 12.4%
over the last 12 months based on the most recent reporting
period in july 2013. the index is highly regarded as one of
the leading indices to assess changes in real estate prices
within the united states, and particularly in a basket of 20
metropolitan cities in the cases of the above statistic. in some
cities such as las vegas, home prices are reportedly reaching
prices that were previously seen in 2004, a few years before
the large financial crisis. Part of the concern lies in the fact
that many of the current buyers of homes are not residential

consumers, but investors, making plays on speculation and


looking for quick returns. the risk of bubbles typically occurs
not when natural demand simply outweighs supply, which results in organic and real price appreciation, but when artificial
appreciation occurs based on speculative activities that only
appear to create high demand.
many contend that the risk for a future housing bubble
lies in select cities and is a more isolated threat than the last
one. others question whether the bubble is domestic, or more
of a global phenomenon. germanys housing market has traditionally been very stagnant in past year. recently, many international investors have taken a likening to the market.
bundesbank, the central bank of germany, noted that in the
popular and larger cities of the nation such as berlin, hamburg, and munich, real estate values could potentially be as
much as 20% overvalued in comparison to what the fundamental drivers suggest properties in these areas are worth.
this trend can be seen in other european cities as well, such
as london. real estate prices surged by approximately 10.2%
in the month of october alone due to high pressure from foreign investors and limited supply. the recent trend of rising
prices in concentrated areas is a large potential concern and
beckons the question as to the true nature of the economic recovery more broadly. overall, recent happenings would suggest that a possible housing bubble in the future would occur
in isolated urban areas as opposed to on a national scale, as
was seen in the beginning of 2007.
Energy Industry, story continued from page 2
implications of u.s. energy industry evolution
there are many implications of the rise of pipeline mlPs
and diminution of oil tankers due to decreased american demand for foreign oil and increased domestic production.
china has just recently taken americas place as the top importer of oil, so it is quite likely that we will see more extreme
changes in the valuation of pipeline mlPs, oil tankers, and
related industries. the rise in the prominence of pipeline
mlPs has implications for pipeline manufacturers such as
tenaris and northwest Pipe company. these changes will impact investors portfolios, the american fuel consumers pocketbooks, corporate fuel executives, and countless others. as
the energy market continues to evolve in this period of increasing fuel efficiency and innovation, we shall observe
novel impacts on various industries not only in the united
states, but around the world.

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deTroiTs danGerous deCision


how general is the general obligation Pledge?
by William helmold
on july 18th, 2013, the city of detroit filed for chapter 9
bankruptcy. chapter 9 bankruptcy is a form of bankruptcy reorganization unique to municipalities. it shares many characteristics with chapter 11, but since municipalities are government
entities, they enjoy greater abilities to rewrite debt and collective
bargaining obligations. this bankruptcy is historically significant for u.s. municipal debt markets because detroit is the
largest city by population and outstanding liabilities to ever seek
bankruptcy protection. this past october 1, the city had its first
default on its unlimited and limited tax general obligation (go)
bond payments. Previously, detroit had only defaulted on a june
payment of $39.7 million for its pension certificates. the city
is currently in bankruptcy court defending its eligibility to qualify for chapter 9 and its rights to restructure its debt obligations.
the citys employee union, the american Federation of state,
county, and municipal employees (aFscme), is fighting the
citys chapter 9 filings on the grounds that detroit did not make
good faith efforts to avoid bankruptcy. eligibility hearings
began on the 23rd and could last until early november. if detroit
is successful, it will have the authority to restructure its debts;
however, if it fails to prove legality, it will be forced to reconcile
its debts in private settlements. With such debts over $18 billion,
it is clear that detroit will have to restructure its debt significantly.
While detroit will undoubtedly recover with enough time,
the citys bankruptcy proceedings have the potential to set a
game-changing precedent for the u.s. municipal bond market.
currently, detroit has both general obligation bonds and revenue
bonds outstanding. though general obligation bonds are supposed to be more creditworthy than revenue bonds, paradoxically, for detroit the reverse situation is true.
currently, detroits Water and sewer bonds are expected to
be mostly un-phased by the citys bankruptcy because both these
revenue streams are secure and largely unthreatened by the other
operations of the city. in contrast, since the general obligation
bonds are funded by the citys general Fund account, these
bonds are at a high risk for default since the citys other general
fund obligations are becoming untenable. now that detroit has
entered bankruptcy, the city will need to prioritize which of its
liabilities will be paid first and how much they will be paid. it is
through this prioritization that a precedent for the market may
be set.
unlimited tax general obligation bonds are supposed to be
backed by the full faith and credit of a municipality. the implication is that these bonds should never receive haircuts to their
principal or interest payments, as long as taxes can be raised.
despite this, in his restricting proposal for detroit, emergency
manager Kevyn orr has proposed treating general obligation
bonds as unsecured liabilities of the city and putting them pari
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passu with all other liabilities with regards to the citys priority
of claims. under orrs plan, the city may only pay bondholders
pennies on the dollar. if this plan is adopted and ruled legal by
bankruptcy court, a very disturbing precedent would be set. the
underlying notion of security, and safety regarding unlimited tax
general obligation bonds would be fundamentally challenged,
ultimately causing yields for future municipal issuances to rise
significantly. this would cause significant fallout not only for
michigan, but potentially for the rest of the country. credit rating
agency Fitch noted that should a bankruptcy court approve detroit's treatment of these bonds as unsecured debt, Fitch will reassess its ratings of tax-supported debt ratings within michigan
and perhaps the rest of the country. a large scale credit rating
recalibration, as threatened by Fitch, could significantly drive
up borrowing costs for municipalities across the country, thus
stalling needed capital improvement projects, and could potentially force other municipalities into financial distress.
though detroits handling of its bankruptcy may challenge
fundamental market beliefs regarding general obligation security
pledges, current holders of detroits debt are unlikely to see
much of an effect. of the citys outstanding debt, approximately
80% is insured; this means investors should get significant (if
not perfect) recovery rates, assuming the insurers stay out of
bankruptcy themselves. in the coming months, detroits proceedings will answer the question about the sanctity of the general obligation pledge. as investors watch the actions of detroit,
the city would be wise to remember that the capital markets generally have a good memory welching on bonds today may
make securing future funding at reasonable yields all but impossible.
Japan, story continued from page 3
rise too; this is also a consequence of the weaker yen.
on the other hand, many less financial metrics dont
paint as rosy a picture. For the most part, income and unemployment have remained unchanged throughout the implementation of abenomics. While surveys such as business
confidence have started to rise to very positive levels, this confidence has not yet translated into effects for the population as
a whole.
in conclusion, while a lot has been done by abe in pursuing his goal of fighting inflation and revitalizing growth,
there is still a lot left to do. While significant progress has been
made combatting deflation, there are still a host of structural
issues in japan that need to be addressed before the effects of
growth can be felt. at the same time, japan needs to implement all of these policies while bearing in mind the fact that it
is near bursting with debt as a country. a lot has been done, but
the jury is still out on whether abenomics will be successful.

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THe CHinese eConoMy


a tale of never-ending growth
by Kartik bhamidipati
china has been the growth story of the decade with a continuous stream of double-digit gdP growth figures over the
last several years. but, growth is tough to maintain - all good
things must come to an end. even if china hits its gdP
growth target of 7.5% for the year, it will be the lowest level
of economic growth china has seen in the past 23 years. in
the short run, we are seeing a rebound; the economy grew
7.8% in the third quarter after 7.5% growth during the second
quarter. yet economists are beginning to question whether the
data means anything at all. First, the chinese could easily be
lying about their numbers. a study showed that while each of
the provinces reported gdP growth of greater than 10%, the
national average was only 7.5%. this does not make mathematical sense. simply put, the provinces are not audited and
are incentivized to lie based on a compensation scheme tied
to economic performance. even beyond this likely scenario,
it is clear that chinese growth is being fueled by investment
expenditure rather than organic growth in consumption.
throughout the entire chinese economic paradigm is the hidden force of shadow banking. this phenomenon holds together the entire chinese economy and a single fissure could
have devastating consequences on chinese economic growth.
if we look at the breakdown between investment expenditure and consumption expenditure in the chinese economy,
it is clear where the growth is coming from. 35% of the gdP
comes from consumption expenditure - that is half of the 70%
consumption that defined the us gdP. the role that consumption plays in america and other developed economies,
investment plays in china in order to prop up economic
growth. but what is the issue? it stems from a fundamental
difference in the macroeconomic policy ideals. increasing investment in fixed assets leads to diminishing marginal economic returns because at some point the investment does not
become economically productive. For example, china is investing in bridges and roads that will add no economic value,
such as the jiaozhou bay bridge. it may hold the world record
for the longest bridge over water, but this multibillion-dollar
bridge has very few users and is effectively a bridge to
nowhere. this example typifies how many of the investment
expenditures in china are nothing but short term growth
pumps. in contrast, consumption expenditure is sustainable
and expands the productivity frontier increased demand
leads to organic growth. While fixed asset investment was up
20% for the first half of the year as a result of a government
stimulus, retail sales were up only 13%. one aspect that has
fueled chinese investment is the low interest rate environment due to the post-recession deleveraging of the rest of the
world that freed up a lot of capital for developing markets.
the central government has stated in its most recent five-

year plan that it plans to lower investment expenditure in


favor of consumption expenditure. it is a plan that has not
been followed and will probably fail due to the external pressure to maintain high growth rates. under constant pressure
to live up to unrealistic growth expectations, the chinese will
likely be forced to maintain its policy of fixed asset investments. it is a cycle that is hard to break one that starts with
the chinese government lying about their numbers. the actual gdP growth is predicted to be about 2-3% lower than
what is reported. the issue starts on the local level with
provincial leaders who inflate their numbers to be promoted
more by the central government. given this flawed, unaudited
information, the chinese government generally cannot calculate accurate statistics.
the inaccuracy in these numbers, however, pales in comparison to the massive shadow banking industry in china that
is predicted to be equivalent to a full 40% of chinese gdP .
shadow banking refers to unregulated or loosely regulated
banking institutions that, in the case of china, are the
lifeblood of property developers and factories. it has come to
be represented by the wealth management products from chinese banks that issue sub-investment grade paper that pays
exceedingly high interest rates for a term usually between 1
and 12 months. as with any unregulated and large financial
entity, a single trip up can send the economy in a death spiral.
an example of this is seen in the default of a wealth management product issued by huaxia bank co. that caused great
uncertainty in the crucial shadow banking sector. if the chinese government decides to crackdown on any such activities
it could spell a catastrophic collapse for china.
the chinese economy faces serious challenges going forward. their end goal is to have a consumption based economy
like the rest of the developed world. yet they have been faltering due to unreliable economic data and continued external
pressures forcing the central government to continued fixed
asset investments to prevent social unrest. yet at some point,
the returns will have diminished too much. the solutions lies
in becoming an economy focused on domestic consumption
rather than exports. it needs to position its investments away
from factories and urbanization and towards sectors that help
sustain household income such as agriculture and services.
the issue is that the chinese people are traditionally savers,
so they feel unease when spending a lot of money. this means
that there will be a lot of social unrest associated with the
transition to a more consumption-based economy. With the
right strategies in mind, however, a chinese shift to a sustainable model of growth is possible but distant in light of corruption and expectations that will plague china going
forward.
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Separation, story continued from page 1
to raise very inexpensive funds from investors that view
these banks as a comparably safe harbor for their investments. moreover, these banks run considerable retail banking operations so that they can acquire vast amounts of
deposits insured by the Federal deposit insurance corporation. this advantage in terms of funding can lead to severe
moral hazard issues as banks are not reluctant to use these
cheap funds to make risky bets on the capital markets. this
became apparent when citigroup had to be supported by the
us government with $25 billion emergency aid during the
crisis.
From this point of view, a separation of retail and commercial banking from investment banking would increase the
safety of deposits and reduce the liabilities states have to
incur for tbtF financial institutions. given this scenario,
investment banks would be forced to entirely absorb the
losses they generate, which could provide incentives to decrease the riskiness of their transactions and therefore stabilize the financial sector.
however, reality has proved the contrary. lehman brothers was a pure investment bank that nevertheless encouraged
risky transactions. the absence of deposits caused the bankruptcy as so-called broker-dealers like goldman sachs,
morgan stanley and at that time lehman brothers entirely
relied on the capital markets to raise liquidity issuing commercial papers. the danger of such a financing structure was
also shown by lehman brothers: if the bank had had access
to liquidity, e.g. in form of deposits, it would not have been
forced to file for bankruptcy because it was struggling initially with illiquidity problems instead of insolvency.
the refinancing costs of banks and therefore the riskiness of its operations can be estimated by means of credit
default swap spread. the higher the risk investors evaluate
the higher is the cds spread - i.e. the price investors have
to pay in order to hedge the credit line they offer banks.
the market data reveal that the more diversified a financial institution is, the lower the cds spread, which means
that investors consider pure investment banks like morgan
stanley as much more unstable than financial supermarkets
like ubs that operate profitable Private Wealth management
and other divisions in addition to their investment banks.
the fact that large, well-diversified banks have access to
deposits and provide various financial services (including investment banking) contributes to their apparently high level
of stability because they are much more likely to be able to
absorb losses in one division in comparison to focused
banks. For instance, j.P. morgan chase was able to cover gigantic trading losses of about $7 billion incurred by the london-based chief investment office division in 2012 with
profits from other operations, which would not have been
possible for specialized banks. the us government even
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promoted mergers of diversified financial institutions and
specialized banks during the crisis for these reasons. j.P.
morgan chase acquired bear stearns in june 2008 and bank
of america bought merrill lynch in september 2008.
obviously, the wide range of operations of so-called financial supermarkets provide a natural hedge as well as
cross-subsidies between different divisions because profits
generated in investment banking can lower the prices for retail clients while stable revenues in retail banking can compensate for losses in investment banking during financial
crises
the thesis that a separation of banks does not increase
the stability of the financial system is supported by marc
lackritz, adjunct Professor at mcdonough school of business at georgetown university. in his opinion, the risky activities at the root of our recent financial meltdown were
elsewhere. they were about too much lending, too much
leverage, too much opacity and too little oversight. the
restoration of glass-steagall would not address any of
these. and a study published by the centre for european
economic research in germany states that, the various separate banking systems only play a minor role in reducing and
limiting systemic risk. they only marginally contribute to
solving conflicts of interest and can even be detrimental to
banking business diversification.
separating investment banking and commercial banking
is even harmful for corporations that are currently provided
by universal banks with all services they need. a separation
of these divisions would result in a considerable increase of
costs because corporations have to consult with different
banks for different financial operations. Furthermore, large
and well-diversified banks can provide high quality financial
services at decent prices as they benefit from economies of
scale and economies of scope. since universal banks have
lower refinancing costs than specialized banks they can provide their corporate clients with low-cost funding, which fosters economic growth in the aftermath of the crisis.
in order to promote a quick recovery of the economy and
ensure stability in the financial system, it is barely recommendable to split up banks. of course, a separation of investment banking and commercial banking protects deposits
from being used for risky bets. but this benefit would clearly
be outweighed by the increased threat of liquidity crises and
raised costs of financial services for corporate clients. it is
therefore rather necessary to increase capital requirements
or to ring-fence deposits from trading activities as proposed
by the british vickers commission. the reestablishment of
the glass-steagall-act would provide a seemingly simple solution that could easily be explained to the broader public
but would not address the complexity of the financial industry appropriately. the old adage whispered among couples
can also be applied to banks: getting divorced is not always
the best solution, even after a severe crisis.

WHarTon underGraduaTe finanCe CLuB

noVeMBer 2013

eLeCTinG a neW federaL reserVe CHairMan


economic impacts of janet yellens Potential rise to Fed chair
by brendan tsai

[CREDITS]

if janet yellen receives her expected confirmation from the


senate to be the next chair of the Federal reserve, she will be
the first woman to lead the 100-year-old central bank and arguably the most powerful woman in the world. While this event
would mark a truly historical precedent, she finds herself in a position much like previous Federal reserve chairmen, forced to
tackle an economy facing significant challenges from the onset
of her term. Paul volcker, appointed Federal reserve chairman
in 1979, faced an economy riddled with double-digit inflation,
and resultantly used a series of tightening monetary policies to
purge inflation. alan greenspan in 1987 heavily expanded the
money supply to tackle the declining stock market. ben bernanke
was confronted with the 2008 financial crisis, and implemented
rounds of quantitative easing to stimulate job growth and promote
spending. now, faced with the task of improving an economy that
has its lowest job participation rate in 35 years, janet yellen will
similarly struggle to uphold the two mandates of the Federal reserve: price stability and maintaining long-run potential growth.
in terms of the dual mandate, janet yellen has historically
shown a stronger concern for maintaining strong output by lowering unemployment. however, now that the nation is confronting its lowest labor force participation rate since 1978,
numerous critics have taken issue with the usage of the unemployment as a proxy of economic growth. that being said, yellen
has vocally made her intentions clear to maintain expansionary
monetary policy efforts until unemployment rates drop further,
gradually shifting back to pre-recession economic levels of activity. While her interpretation of a sufficiently low level of unemployment remains to be seen, several economists believe that
the Fed will not cease its monthly economic stimulus until as

Kevin Goldfarb
Editor-in-Chief
Vice President of Financial Analysis

early as next year. as a result, yellens strong faith in the Feds


ability to stimulate job creation will likely mean a sustained push
for economic stimulus through the governments monthly bondpurchasing initiative, even at the cost of higher inflation. however, it would be drastically oversimplifying janet yellens views
as an economist to claim that her beliefs solely rest upon lower
levels of unemployment. in january of 2012, the Federal open
market committee announced a target inflation level of 2% per
year, and yellen was an instrumental part in establishing this standard. currently, price increases in the united states dipped
slightly to a 1.2% annualized rate in august of 2013, more than
a half a percentage point below the Feds 2% goal. similarly, the
Fed has vocally announced its intentions to continue to decrease
the unemployment rate, which was 7.3% in august. therefore,
if expectations for janet yellens nomination for the Federal reserve chair hold, the Federal reserve will likely maintain its
monthly economic stimulus efforts until unemployment drops
below a certain level, at which point the Fed will gradually withdraw in its $85 billion monthly bond purchasing to control inflation.
overall, according to several of her peers on the Federal reserve, yellens leadership style suggests that she will push for
monetary reform policies more stringently than her predecessor,
which will likely be welcomed by the market driven by the fear
of sudden changes in the Federal reserves intentions. if her
nomination is passed through the majority of the senate as is
widely expected, it will be interesting to note how she straddles
the two mandates of the Federal reserve and its wider implications for the countrys balance sheet and future economic growth.

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& alejandro Villero
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Senior Financial Analyst

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