The Certainty of Uncertainty in the New Year
The only certainty in 2012 is the uncertainty stemming from the financial challenges in the European Union, which are very likely to impact the U.S. banking system.
Expect 2012 to be a gray swan year, a year in which we know a certain risk is plausible, but we don’t know how it will impact the financial and banking industries. Unlike a black swan event, which is defined as a highly improbable and unknown risk, the gray swan of the banking industry is the financial uncertainty of the European Union, which is made up of 27 member countries, and most particularly the survival of the euro currency, which is used by 17 of those countries.
Continued turmoil in the euro zone in 2012 is very likely to impact the financial and banking markets in the U.S. because of the interdependence of the global banking system and its reliance on Libor, the world’s most widely used benchmark for short-term interest rates. Libor is the rate that the world’s banks borrow money and is fixed on a daily basis by the British Bankers’ Association based on an average of interbank deposit rates for larger loans at the world’s most creditworthy banks.
One possibility is that money supply in the EU will tighten, causing Libor to go up. Higher Libor is very likely to impact borrowing interest rates in the U.S. because when banks borrow at a higher rate, they pass the increase.
Another possibility is that Libor will decrease as the European Central Bank increases the money supply in order to stimulate the EU economy. Such a scenario is likely to put even greater pressure on net interest margins in the U.S., causing deposit rates to fall all the way to near zero.
Current indications are that Libor is trending up as a result of the economic and financial status of the EU. The average Libor rate, which consists of the average of the one-month, three-month, six-month and 12-month rates, rose to 0.60% this November compared to 0.43% in April–an increase of 40% in seven months. Historically, Libor rates and U.S. deposit rates have been highly correlated.
The instability of the EU financial system is a result of two main factors, one systematic and one cyclical. The systematic factor is the European sovereign debt crisis that was caused by runaway government spending in some European countries. For example, Greece, Portugal and Italy all have elevated debt-to-GDP ratios that, when coupled with the second factor, the burst of the housing bubble in Europe, made it even harder for these countries to grow their economies.
Economic growth is a must in order to reduce and stabilize debt-to-GDP ratios, especially for countries like Italy, which has nearly 2 trillion euros in outstanding government debt. Moreover, Italy has slim growth prospects in the near term because it first needs to reform its labor market. A similar, yet less drastic, situation exists in Spain, Greece, Portugal and Ireland.
Since organic economic growth is not very likely in the short term at these members of the EU, the only two options left are default on their government-issued bonds or receive financial assistance from the European Central Bank to support the Italian government bond market until stronger economic growth begins to take place. Just to put things in prospective, Italy is the eighth largest economy in the world.
In addition to, or because of, the uncertainty caused by the events in the EU, we have another unknown in 2012: the direction of deposits’ APY and balance. Generally speaking, APY has been on the decline in the past four years, and deposit balances on the rise. But a look at the rate of increase and decrease indicates that the year-over-year variance has wide fluctuations, which makes projections challenging.
For example, the decrease in APY in 2011 was 36% less than in 2010, and conversely, the balance increase in 2011 was 300% greater than in 2010. Hence, not just that we don’t know which way balances and APY are headed in 2012 due to the uncertainty of the financial crisis in the EU, we don’t even know the extent of the change once it occurs.
The best advice I have to offer is borrowed from Nassim Nicholas Taleb, the author of The Black Swan: The Impact of the Highly Improbable.When you can’t predict, be prepared. In other words, at this point we don’t know if the financial crisis in the EU will trigger a rate hike or push rates farther down. But, we can be prepared for both scenarios. The best way to be prepared is to keep a close eye on deposit rates and to develop two pricing scenarios, one for rate increase and the other for rate decrease.
Dan Geller is the executive vice president of Market Rates Insight.
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