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Banking on Recovery with Looser Rules in Place

Central banks pursue prosperity as more relaxed Basel III regulations approved

The New Year seems to have brought a trend toward optimism in global banking, beginning with the European Central Bank. ECB President Mario Draghi boldly announced in January that “we are now back in a normal situation” and no longer in a financial crisis. He did concede, however, that “we are not seeing an early and strong recovery.” Still, he predicted that later in the year that recovery would be well underway.

Only days before, central bankers had granted a late Christmas present to banks across the world. In the first week of January they announced a relaxation of Basel III rules that institutions will find it far easier to heed. Longer deadlines and lower bars eased the way for banks that had protested for some time that the new round of rules was too strict. Among the changes was the granting of an additional four years for institutions to bring their balance sheets into compliance; also included was a modification to the liquidity coverage ratio (LCR) so that it now offers a broader menu of acceptable assets, including securitized mortgages and equities.

The ECB is definitely taking a positive view. Draghi talked up “positive contagion” after the central bank held off at its latest meeting on any further cuts on interest rates. He pointed out that investors have responded positively to the ECB’s resolve to “do whatever it takes” to keep the euro intact, and ticked off a number of achievements.

Sovereign bond yields are dropping: indeed, after Draghi’s declaration, yields on Spanish bonds fell substantially at auction, with 10-year bonds falling from a July high of 7.62% to as low as 4.84% on Jan. 11. Italian 10-year bonds saw yields drop too on the same day, reaching their lowest level in over two years. Not only that, but Standard & Poor’s, apparently in the same optimistic spirit, said thatPortugalandIrelandcould return to the markets later in 2013 once their bailouts have expired.

Market volatility has slowed, Draghi said, and there’s less demand for insurance against default; ECB balance sheet and loan redemptions are also falling. At the same time, he said, equities are up and capital is flowing in instead of out. Banks in peripheral countries are seeing higher deposits. Adding that there are positive indications in private equity and leveraged buyouts, he pushed individual governments to actively foster recovery via budgetary changes and economic stimulus—something the ECB cannot do itself.

Market optimism may have more to do with the relaxation of Basel III rules than with Draghi’s assertion in 2012 that the ECB would buy Spanish and Italian bonds, although both are good news, according to John Blank, Chief Equity Strategist at Zacks. The fact that bank supervision has been postponed till 2014 a good thing, since “another year of institutional building of the supervisory framework in Europe is good news,” he said.

If Draghi actually does buy bonds, “that will be the biggest news, in terms of the central bank,” Blank said. The potential for a central bank bond purchase, “another tool” for Draghi to use, is driving down interest rates, something Spain and Italy sorely need. Should the ECB buy a large quantity of Spanish and Italian debt, said Blank, that could create a concentration risk, which “creates the need to supervise and monitor that risk. That’s the real issue for next year, and maybe the biggest in the whole year.”

China’s influence on the world economy, of course, remains to be seen as well. Outgoing governor of the People’s Bank of China Zhou Xiaochuan said in a New Year’s address that the country intended to stick to a prudent monetary policy and work to keep consumer prices stable. The long-term government objective of allowing market forces to exert greater influence on the Chinese economy would also be continued, Zhou said. He added that financial sector reforms would bear down harder in 2013. Along with this is a push for economic growth, though, like outgoing President Hu Jintao, he offered no specifics on how the central bank would bring this about.

Zhou, who has been governor of the PBoC since 2003, will be succeeded on March 5 by Xi Jinping. The new governor is expected to maintain continuity with the passing regime during the once-in-10-years changeover, and continue the actions the central bank has already begun. Previously, the bank had taken steps to cool what it saw as an overheated real estate market. It raised interest rates and also tightened credit requirements, managing to put a lid on it without experiencing a burst bubble, as theU.S.did.

According toBlank,Chinais “the only part of the world where central banking actually works in the traditional sense.” With its benchmark interest rate cut to 6% last summer, Blank said that it’s “actually bullish” that they haven’t made further cuts to stimulate growth. “[T]hey’ve got another 70 basis points to go to get back to where they were in 2010,” when the PBoC cut interest rates all the way down to 5.3%. At present it’s not perceived as a necessary step to take.

Still, Blank warned, “Look out, and watch for that change from the 6% level down to 5.3%. If that happens,” he cautioned, “it might not be so good—but it depends on the context and what’s going on” during the year.

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