Downsize or doze off

Banks are being chastised from all and sundry for their misdeeds and blunders. Now even Sandy Weill, the person credited for creating the Citigroup behemoth, has been calling for banks to split their commercial arm from their investment trading arm. The common justification put forward for the split is the different cultural attributes of a bank's investment and commercial arms.

Actually, the split or the sizing down of banks should not be precipitated by the huge trading losses or the Libor rigging scandal. Warren Buffett has observed that, "Only when the tide goes do you discover who's been swimming naked." Indeed an op-ed piece in the Financial Times confirms that the banks have been rigging the Libor for more than 20 years. Bob Diamond and his ilk, the regulators and the central bankers have known this all along. The parliamentary committee hearing was a sham to provide cover for everybody's ass. The reason this scandal wasn't exposed earlier is because the tide was still up. As the tide recedes, all the skeletons will start walking out of the closet

As for the differing cultures, they can be easily managed by having separate organisational setups that don't mix the two. The only reason that compels a bank to downsize is much deeper than these specious arguments. To understand why, we must delve into the bank's ecophysiology, not philosophy since there's nothing philosophical about overly paid bankers making money from borrowing cheap and lending dear, or betting on market movements.

Like any living things, a bank grows big if its food is aplenty. Similarly, if food is scarce, it must start scaling itself down. Sizing down entails shrinking a bank's loan asset base by recalling loan assets that pose great risks. Income will fall but in these depressing times, growth and income are the least of a bank's priorities; survival is the most pressing.

It's been observed in evolution that mammals above the size of rabbits living on islands would diminish in size (see The Island Rule). To remain big and active in times of scarcity is an invitation for disaster. A bank's food is the money supply, the best measure of which is total credit. If you look at the total credit picture for the US, the picture appears bleak, more so with the recent second quarter 2012 GDP growth turning south.

Obama's deficit spending only manages to slow down the slide and the resulting bank failures (see right table). But as its impact will soon start to wear off with the declining deficits, the descent will resume its previously steep decline. The eurozone total credit has crumbled in Italy, Spain and Greece with more states joining in. Whenever total credit crashes, banks will be the first to be hit because of their gearing.

We also should be aware by now that Bernanke's QE won't work. If only someone would sock it to Bernanke that his QE actually means quantitative exchange, that is, a swapping of debts on the scale of trillions of dollars, maybe he'll wise up to the fact that QE doesn't print money. QE works only to stem a panic, that is, when a bank is in imminent danger of collapse. The bank can swap its less liquid assets for liquid money from the central bank. But if the bank has assets that have hugely lost their value, there's nothing to prevent its collapse except by a takeover by the state. And if the state itself is in a wreck, the mess multiplies severalfold. Now, this latter scenario is going to haunt the banks as round two of the economic depression starts to unfold.

The other alternative to sizing down for a bank is powering down its thermal engine through hibernation. A bank can power down by switching its loan assets to low-return Treasury bonds and bills and aggressively paring its operating costs through salary and bonus cuts. After all you don't require smart people in banking; banking is best served by staid and conservative characters. No matter how pristine the quality of a bank's loan assets is now, it will be tarnished once total credit resumes its downward slide. By then it'll be too late to unload the assets at good prices as all banks will be rushing for the exit. The sight of panic, naked bankers is not something you'd want to behold.