Building competitiveness

Insider aiding
Europes labour markets have favoured older workers at the expense of younger ones. The
latest in an occasional series on structural reform
Feb 25th 2!2 " from the print edition
#F $%% the euro &ones many problems'
youth unemployment is perhaps the most
distressing. (oblessness among young
workers is around )* in +ortugal and
nearly 5* in ,pain. $bove-average
unemployment is the norm for young
people' even in more liberal markets like
$mericas. .ut ,pains youth
unemployment rate /umped by nearly 2
percentage points between 20 and
21' compared with a rise of seven
points in $merica. %abour-market
regulations take much of the blame2 while
hard-to-fire older workers luxuriate on
permanent contracts' the young are
typically hired temporarily and are easier
to sack.
,uch 3dual4 labour markets are
themselves products of reform. $lthough
$merican unemployment 5uickly dropped
following the troubles of the !10s and
early !16s' European /oblessness
remained stuck at high levels. %eaders
recognised the need to in/ect more
flexibility into the labour market but
powerful trade unions headed off a full-
frontal assault on workers rights. The
answer was to create a less-protected
class of employees.
,pains experience is instructive. $s the
unemployment rate approached 2* in
the mid-!16s' the government
introduced fixed-term contracts of
between six months and three years'
which were sub/ect to lower dismissal
costs than those for workers on open-
ended contracts. $t the end of a three-
year contract firms could either convert a
worker to permanent employment or send
him packing. The reforms got results.
7nemployment fell from nearly !6* when
they began in !168 to around !8* six
years later.
.ut the reforms had unintended
conse5uences too. Temporary contracts
surged' soon accounting for close to a
third of ,panish employment. 9orkers
churned from /ob to /ob2 /ust :* of
temporary contracts were converted to
permanent employment during the mid-
2s. 9hen the economy turned down
employees were shed in larger numbers
and the unemployment rate rose faster
than before. Those more likely to be
employed on temporary contracts' such as
the young' bore the brunt of the pain. The
euro &ones long expansion from the mid-
!11s until the crisis of 26 disguised
many of these problems. $ construction
boom helped ,panish unemployment back
below !*' even as immigration soared.
.ut the crisis has exposed old weaknesses
again.
;olatility is but one cost of dual labour
markets. Fre5uent /ob turnover makes
households finances less certain' making
it harder' for example' to save regularly
for old age. <ore importantly' temporary
employment discourages firms from
investing in their workers. The cost to an
employer of converting an expiring
temporary contract into a permanent one
is 5uite high because of a discontinuous
/ump in the cost of sacking the worker. ,o
there is an incentive to get rid of him
when his contract ends and to invest little
in training him.
This systematic underinvestment drags
productivity inexorably downward. $ 2!!
study by (uan =olado of 7niversidad
>arlos ??? de <adrid' ,alvador #rtigueira
of the European 7niversity ?nstitute and
@odolfo ,tucchi of the ?nter-$merican
=evelopment .ank pins 2* of the
productivity slowdown in ,panish
manufacturing between !112 and 25 on
temporary work. The young are especially
harmed. .etween 25 and 20 roughly
6* of ,panish workers aged !: to !1
were on temporary contracts' compared
with )2* of )-year-olds and 28* of 8-
year-olds. $ lack of training may weigh on
them throughout their working lives.
$ single' open-ended labour contract' in
which severance pay rises continuously
with tenure' should increase the incentive
for firms to retain more employees for
longer and to invest more in the human
capital of new workers. ?ncremental
protections should also moderate swings
in employment. $ study of French and
,panish labour markets found that the
recent rise in ,pains unemployment rate
might have been cut by a third had ,pain
followed the French example of a
shallower gradient between labour-market
tiers.
$t this point' supporters of the model
might well point to Aermany' where the
youth unemployment rate is a mere 0.6*
and overall /oblessness is at its lowest
level for decades. ?n many respect
Aermanys labour market mirrors that of
its peers. ?t' too' responded to
eurosclerosis with flexible' second-tier
contracts. +ermanent positions protected
by strong employment rules still dominate
its labour market.
.ut Aermany also sought greater
flexibility in other areas. +art-time work
became increasingly common2 Aermanys
Bur&arbeit programme' in which firms
reacted to recession by cutting hours
rather than employees' is /ust the latest
example of this approach. Aermanys
better performance also relied on ever-
stingier unemployment benefits' which
increased labour supply and reduced
upward wage pressure. >lauses in
collective-bargaining agreements allowed
individual firms to stray from wage deals
when competitive pressures demanded it.
=ual purpose
Aermany may have pursued wage
restraint' but that is no easy route to
prosperity. ?ndeed' dual labour markets
are more likely to have the opposite
effect. +ermanent workers fearlessly seek
higher wages' confident that /ob losses
will fall first on temporary workers.
,oaring ,panish unemployment has
produced little wage moderation. =uring
21 the pay of permanent workers rose
by 8* in real terms.
$nd attractive as the Aerman model is
now' across decades $merican /obless
rates are tough to match. The $nglo-
,axon preference for little or no
employment protection may be the most
effective at herding workers from declining
industries to growing ones' driving /ob
creation and innovation. =yspeptic bond
markets are now pushing ,pain and
others towards reforms that make it
easier and cheaper to lay off workers
again. Cot before time.
The euro crisis
Europes Achilles heel
Amid growing risk of a Greek exit, the euro zone has et to face up to the task of
saving the single currenc itself
<ay !2th 2!2 " from the print edition

TDE respite in the euro crisis lasted a few

short months. Cow' despite a E!) billion
FG!:1 billionH second bail-out for Areece'
a fiscal compact agreed on by the euro-
&one leaders in =ecember' and E! trillion
of cheap long-term loans from the
European >entral .ank' the night terrors
are back. Dow dispiriting that Europe is
still so ill-prepared for the ordeal to come.
Time is short. ?n France voters have given
their new president' FranIois Dollande' a
mandate to alter the 3austere4 course set
by his ousted predecessor' Cicolas
,arko&y' and $ngela <erkel' Aermanys
chancellor' and to focus on growth. <rs
<erkel says she will not change the fiscal
compact' but <r Dollande needs
something to show voters in legislative
polls next month. <ore threatening is the
second election looming in Areece' where
parties are struggling to form a
government. ?f a ma/ority of Areeks again
vote to re/ect the spending cuts and
reforms that go with their countrys bail-
out' then euro-&one governmentsJin
particular' AermanysJwill face a drastic
choice. <rs <erkel will either
accommodate Areece and swallow the
moral ha&ard of rewarding defiance or'
more likely' stand firm and cut the Areeks
adrift Fsee articleH.
The idea of a chaotic Areek departure
from the euro at a time of Franco-Aerman
disunion should terrify everyone it touches
Fthe damage it would do the world
economy may well be the biggest risk to
.arack #bamas chances of re-election'
for instanceH. 9ith so much at stake' the
rest of the euro &one urgently needs to
lower the risk that contagion from a Areek
exit would infect +ortugal' ?reland and
even ,pain and ?taly. The worry is that'
/ust at the moment when hardheaded
realpolitik is needed' politics has fallen
prey to self-delusion' with leaders in all
the main countries peddling seductive
half-truths that promise Europes citi&ens
an easier way out.
!tories that people tell"
The euro &one needs to do a lot of hard
things. #ur list would include at the very
least2 in the short term' slower fiscal
ad/ustment' more investment' looser
monetary policy to promote growth and a
thicker financial firewall to protect the
weaklings on the periphery from contagion
Fall of which the Aermans dislikeHK in the
medium term' structural reforms to
Europes rigid markets and outsi&e welfare
states Fnot popular in southern EuropeH'
coupled with a plan to mutualise at least
some of the outstanding debt and to set
up a Europe-wide bank-resolution
mechanism Fa tricky idea for everyoneH. ?t
is an ambitious agenda' but earlier this
year' with the ?talians' ,panish and
Areeks all making some hard choices and
E>. money flushing through' the politics
seemed possible.
Cow they have lurched into dreamland.
France is the most obvious example. <r
Dollande is right that growth would
transform Europes prospects' by making
debt more manageable' restoring banks
and curtailing unemployment. .ut that
truth is undone by two falsehoods.
$lthough he pays lip-service to fiscal
consolidation' he has' above all' promised
to spend and tax his way out of the crisis'
leaving French voters with the fantasy
that the rich can pay and that their own
hardship will be limited. $nd he has told
them that liberalism' privatisation and
deregulation are to blame for Europes
crisis2 France is now committed to the
idea of sheltering behind the very barriers
to enterprise that have made its economy
uncompetitive.
?n the short term <r Dollande should be
able to find a compromise with <rs
<erkel2 a growth pact could be added to
the fiscal one. There is also indeed a good
case for Aermany doing more to boost
demand. .ut <r Dollande will have to
countenance reform all the same' because
he needs a credible medium-term plan to
pay for welfare spending without resorting
to borrowing. <oreover' as its neighbours
embrace reform' France will have to /oin
them or see unemployment grow and
wages stagnate. Dow wonderful it would
be if a cut in interest rates' :' extra
teachers and some new roads could spare
the French from all this. .ut that growth
fairy does not exist.
"and the stories the #elieve
$cross Europe the pattern repeats itself.
?n ?taly the half-truth is that the country
can escape its dysfunctional politics by
entrusting hard choices to a technocrat.
?ts prime minister' <ario <onti' is indeed a
gifted man' but the strong protest vote in
this weeks local elections suggests that
unpopular policies which touch so many
?talian lives are ultimately best
determined by elected politicians. The
Aerman half-truth is that the euro &ones
problems can be solved merely by the
indebted countries slashing their way to
prosperity. ?n fact' Aermans need to live
with higher inflation' consume a bit more
and prop up the weaker members of the
currency union. ?ndeed' the euro will
survive only if every country confronts the
choice it shies away from. %ike some
dreadful /oke' the euro needs French
reform' Aerman extravagance and ?talian
political maturity.
?t is worst of all in Areece. The half-truth
in $thens is that bigoted northern
Europeans give Areeks no credit for the
hardship they have borne. Areece really
has suffered2 between 20 and 2!2 its
economy is expected to have shrunk by
almost a fifth. The economy is being
strangled by a severe credit and li5uidity
crunch' with more budget cuts and tax
rises to come. Even if all goes well'
Areeces debt will be !:!* of A=+ next
year. 9hatever the make-up of its next
government' the idea that Areece can
repay this is the biggest fantasy of all.
=oes that mean Areece is still better off in
the euroL +robably' though the /udgment
gets ever finer. $n exit' and the ensuing
default' would lighten its debt' re-
establish competitiveness and challenge
its politicians to grasp their own destiny.
Met leaving the euro would also create
chaos and destroy savings and' as often in
the past' its advantages might rapidly
inflate away. The rest of the euro &one is
also better off with Areece 3in4' if only
because of the risk of contagion Fand the
inade5uate preparations for thatH. .ut
again' not at any price.
?f Areece re/ects the second bail-out or
falls drastically behind in its programme'
its exit could become inevitable. <rs
<erkel and <r Dollande may have as little
as a month to prepare for that. They have
a lot of work to do.
$aluing %ace#ook
&ucker#ergs rocket, read for lift'off
=espite the hype as it prepares to launch its ?+#' the giant social network still has plenty to
prove
<ay !2th 2!2 " ,$C F@$C>?,># " from the print edition
#7T,?=E Facebooks vast new head5uarters in ,ilicon ;alley is a huge sign with an image of
a hand on it giving a thumbs-up sign. $ tiny digital version of the same hand sits on millions
of websites and invites Facebooks 1m or so users to click on it to share content they
have found with their pals. Cow Facebook is hoping to get another big thumbs-up when it
stages its eagerly awaited initial public offering F?+#H of !2* of its e5uity on $mericas
C$,=$N stockmarket on <ay !6th. $ssuming all goes according to plan' the flotation will be
the largest yet undertaken by an internet company.
#n a roadshow across $merica to promote the listing this week' <ark Ouckerberg'
Facebooks 20-year-old boss' and other executives were treated like rock stars. %ong 5ueues
snaked out of hotels where they were holding meetings' as investors lined up to hang on
their every word. Dordes of photographers rushed to take pictures of <r Ouckerberg' in his
trademark hoodie' as he and his colleagues were whisked off to waiting limousines.
This fren&y is further proof' if any were
needed' that Facebook has become a global
internet idol. Facebulls reckon the flotation'
which could raise almost G!2 billion Fwith
about half going to shareholders selling upH'
will help transform the social network into a
web powerhouse in the same way that
Aoogle used the riches from its 28 ?+# to
spread its tentacles across the web. $nd
they confidently predict that Facebooks
shares will start trading well above the
range of G26-)5 that the firm has set for
themJa range that would value Facebook
at G00 billion-1: billion. FEditors 7pdate
F:255 A<T on <ay !5thH2 $ccording to
press reports' Facebook has increased the
price range to G)8 to G)6 a share. $t the upper end of that range the company would be
worth G!8 billion.H
,ome financiers think it could command an even bigger price. ?f Facebooks valuation were
to hit G! billion' it would put the company roughly on a par with' say' $ma&on and give it
a market capitalisation greater than those of =ell and Dewlett-+ackard combined. #ne
analyst even dismissed Facebooks suggested pricing as 3pretty silly4' pointing out that its
shares were changing hands at G88 on at least one secondary market before trading in
them was suspended ahead of the ?+#.
Dowever' there are good reasons for caution. ,everal high-profile internet firms that went
public last year' including Oynga' a social-gaming company' and Aroupon' a coupon-peddler'
have seen their shares fall below their ?+# prices and stay there Fsee chart !H. Even
seasoned investors find it hard to resist a lemming-like rush to grab stakes in high-profile
web firms. 39hen it comes to consumer-internet companies' enthusiasm often overwhelms
pragmatism on offering day'4 notes %ise .uyer of >lass ; Aroup' an ?+# advisory firm.
Facebook is admittedly in a different league to the likes of Oynga and Aroupon. ?ts si&e gives
it access to mountains of data and to economies of scale that others cannot match. ?t can
also tap into a wide range of moneymaking opportunities. %ast year the company made
most of its G).0 billion of revenue from online display advertising. .ut it also takes a slice of
the sales of digital tractors' swords and other virtual goods in games run by Oynga and
others that use Facebooks platform to reach customers. This business generated G550m for
the social network last year.
,uch sums of money are impressive given that
Facebook was only launched in the same year
that Aoogle went public. .ut the networks rise
also raises several important 5uestions that
investors would do well to ponder. The first of
these is whether Facebook can become a part
of the fabric of a more social web' rather than
simply a destination on it. 9ithin five years' <r
Ouckerberg sees all kinds of applications being
linked to Facebook in one way or another. .ut
to achieve this goal' the network must
convince users to stick with it. The brief history
of social networking is littered with examples of
former high-flyers' such as Friendster and
<y,pace' whose fortunes faded after users
dumped them in droves when they were no
longer considered coolJeven though this meant abandoning the content they had built up
there.
$lert to this risk' Facebook has been rolling out new features such as Timeline' which
encourages users to load their life histories onto the social network' to bind them in more
tightly. ,o far' this approach appears to be working. Facebook trumpets that it had 1!m
average monthly users in the first 5uarter of 2!2. $nd 52:m' or 56* of them' used the
service daily in <arch' up from 55* last year. This matters not least because fre5uent users
are the most likely to click on ads and to splash out on virtual crops and other gaming
paraphernalia.
Cext there is the 5uestion of whether Facebook can adapt fast enough to the brave new
world of mobile computing. The /ury is still out on this. The firm has almost 5m mobile
users' but its mobile apps are clunky and reflect the fact that its roots lie in the personal-
computer era. To help cure this weakness' Facebook recently splashed out G! billion on
?nstagram' a fast-growing mobile photo-sharing service' and it may use some of its post-
?+# riches to snap up other mobile outfits. .ut until it can develop a more robust mobile
platform of its own' it is likely to remain vulnerable to a disruptive challenger.
Facebook has little advertising on its mobile site' so its revenues could be hit if many more
people access it on their phones. ?nvestors will thus need to ponder whether its mainly
computer-based ad business /ustifies such a lofty valuation.
#n targeting
Facebook fans among admen rave about the networks ability to deliver a vast audience and
to aim ads at specific groups of people using its mountain of data on them. 3Facebook is
probably the single most powerful platform out there right now for targeting consumers'4
says =ick @eed of (ust <edia' a media-planning agency.
+erhaps' but the company has yet to demonstrate it can translate this power into a bold
new social-advertising model. ?n recent months' Facebook has expanded one of its
innovative ad formats' 3sponsored stories4' which allows brands to pump puff-pieces into the
3news feeds4 of the brands Facebook fans and their friends. Met when it surveyed 2!
executives in $merica who were running ads on Facebook' ?TA ?nvestment @esearch found
that almost half had no intention of increasing their spending on it this year.
,teve 9einstein of ?TA says that many advertisers still prefer to place traditional direct-
response ads on the network' even though Facebookers generally are too busy chatting to
their friends to click on these. +erhaps Facebook needs to work harder to educate
advertisers about how best to use its platform. ?t will also need to find ways to aim its ads
even more effectively without irritating or creeping-out its users' who have grown wary of
its intentions after various privacy debacles.
Facebooks recent figures raise other red flags. ?ts ad revenues were lower in the first
5uarter of this year than in the final one of 2!!. Facebook has blamed this dip on
seasonality' which is an excuse one expects to hear from a gri&&led industry stalwart' not a
young web revolutionary. 9orryingly' the company has also seen a slowing of growth in
average revenue per user' though this is still above :* a year Fsee chart 2H. To boost it the
firm will need to find more creative ways of making money from its expanding user base
without driving up its costs' which have soared as it pumps money into new data centres
and other infrastructure to support its growth.
The obvious way for Facebook to boost revenue is to keep inventing clever ways to advertise
on its network. .ut it also intends to explore a host of other areas' from payments to 3social
commerce4 Feg' online stores to turn Facebookers 3likes4 into purchasesH' either by itself or
through applications run on Facebooks platform by other firms which pay to reach its
audience. ,uch initiatives may in theory bring in billions of dollars of extra revenue. .ut
until there are clearer signs that they will' a valuation towards the lower end of Facebooks
own pricing range seems reasonable.
?nvestors who buy shares in the ?+# will also have to accept that <r Ouckerberg will
continue to control more than 5* of the voting rights. 3#ne person owning so much of a
potential blue-chip company is more or less unheard of'4 says =ebarshi Candy' a professor
at .randeis ?nternational .usiness ,chool. #ther tech firms' such as Aoogle' have flourished
under the tight control of small groups of founders' and <r Ouckerberg shows every sign of
maturing into an exceptional technology leader. .ut if something were to go badly wrong at
Facebook in future' its shareholders will be able to do little more than give him a big thumbs
down.
Income ine(ualit
)ho exactl are the *+,
The ver rich in America increasingl work in finance, marr each other and care
passionatel a#out politics
(an 2!st 2!2 " from the print edition

<?TT @#<CEM is not the first multi-millionaire to seek the presidency' nor the richest. @oss
+erot' the record-holder' spent some of his billions earned from computer data on losing
bids in !112 and !11:. ,ince then men who owe their or their familys fortunes to oil' sport'
publishing' trial law' ketchup' beer and bestselling autobiographies have followed.
.ut <r @omney' who earned his G2m or so as a private-e5uity executive buying and
selling companies' is the first candidate from the world of high-octane finance. $s such' he
illustrates the changing complexion of $mericas rich. The wealthiest !* of $mericans not
only get more of the pie Fsee chartHK they are increasingly creatures of finance.
The average household income of the !* was G!.2m in 26' according to federal tax data.
The ultra-rich skew that average upwards2 admission to the !* began at G)6' in 26.
The >ongressional .udget #ffice puts the cut-off lower' at G)80' in 20' or G252'
after subtracting federal taxes and adding back transfers. <easured by net worth' rather
than income' the top !* started at G:.1m in 21' according to the Federal @eserve' down
2)* from 20.
The richest !* earn roughly half their income from wages and salaries' a 5uarter from self-
employment and business income' and the remainder from interest' dividends' capital gains
and rent. $ccording to an analysis of tax returns by (on .aki/a of 9illiams >ollege and two
others' !:* of the top !* were in medical professions and 6* were lawyers2 shares that
have changed little between !101 and 25' the latest year the authors examined Fsee
chartH. The most striking shift has been the growth of financial occupations' from /ust under
6* of the wealthy in !101 to !).1* in 25. Their representation within the top .!* is
even more pronounced2 !6*' up from !!* in !101.
,teve Baplan of the 7niversity of >hicago thinks finance explains much of the rise in
ine5uality. 7pdating a series developed by Thomas +iketty and Emmanuel ,ae&' <r Baplan
notes that the share of income going to the !* reached an 6-year high of 2).5* in 20'
only to sink to !0.:* in 21 as the financial markets deflated Fsee chartH. The trend is
even more pronounced for the top .!*' whose share of total income rose to !2.)* in
20 but sank to a still disproportionate 6.!* in 21.
<r Baplan and (oshua @auh of Corthwestern 7niversity note that investment bankers'
corporate lawyers' hedge-fund and private-e5uity managers have displaced corporate
executives at the top of the income ladder. ?n 21 the richest 25 hedge-fund investors
earned more than G25 billion' roughly six times as much as all the chief executives of
companies in the ,P+ 5 stock index combined.
$lthough the !* have been gaining share in most countries' a recent #E>= report shows
that the trend began sooner' and has gone further' in $merica. ,ome scholars' noting that
ine5uality has risen more in English-speaking countries' think social and political values may
play a role2 in mainland Europe and (apan' corporate governance' tax laws and unionisation
have tended to lessen income disparities. .ut the relatively large role of the financial sector
in English-speaking countries could also be a factor2 even more of the top !* work in
finance in .ritain than in $merica.
<embership in $mericas !* is relatively stableK three-5uarters of the households in the
percentile one year will still be there the next. $lthough the proportion shrinks over time'
one study found that the vast ma/ority of the top !* were still in the richest !* a decade
later. Binship plays a big part2 rich parents tend to produce rich kids. Digh levels of
educational attainment and stable families help in this. $ccording to Aallup' 02* of the !*
have a college degree' and half have a postgraduate degreeK those are two to three times
the proportion of the other 11*. The !* are more likely to be married and to have
children.
The rich also increasingly marry people like themselves. <r .aki/a and his co-authors found
that between !101 and 25' the share of spouses of the !* who had blue-collar or
3miscellaneous4 service-sector backgrounds declined slightly' from 0.1* to :.8*. The share
of spouses who worked in finance' property and law rose from ).5* to 6.6*.
+olitically' Aallup polls find that the !* are more likely than the 11* to identify themselves
as @epublicans F))* to 26*H and less likely to be =emocrats F2:* to ))*H. $ survey of
!8 wealthy families in the >hicago area' led by .en/amin +age of Corthwestern 7niversity'
found the budget deficit was their leading worry' followed by unemploymentK for the
broader population' the reverse is true. ,till the rich' like most voters' have eclectic views'
often supporting liberal and conservative positions simultaneously. For example' Beith
9hitaker' who advises wealthy families on behalf of 9ells Fargo' says many of them
sympathise with the #ccupy 9all ,treet movement. $ lot of them became rich by building
businesses and consider 9all ,treet 3the place where businesses are taken apart and run by
someone else4.
.ob +erkowit& embodies these contradictions. $ rich entrepreneur' he now devotes much of
his time to a non-profit environmental outfit. De is a lifelong @epublican who ob/ects to
Aeorge .ush /uniors tax cuts for the wealthy' and backed .arack #bama in 26. Daving
restructured companies himself' he has no trouble with <r @omneys private-e5uity work but
agrees with #ccupy 9all ,treet that corporations have too much power.
7ntil recently he split his time between conservative >harlotte' Corth >arolina' and liberal
9ashington' =>. Dis wife' %isa @enstrom' used to manage hotels inherited from her father' a
prosperous @epublican businessman. Cow she campaigns on climate change and backs
9ealth for the >ommon Aood' a group of rich people who back #ccupy 9all ,treet. Der
father used to give his occupation as 3capitalist4. 3? grew up believing that QcapitalistsR were
making the world a better place'4 she says. 3The capitalism we have has left us with
degraded infrastructure' threats to our health' and global warming.4
<ost of the !* prefer not to talk about their good fortune. $s the New York Timesrecently
observed in an article on the !*' 3,ome envisioned waking up to protesters on the lawnK
others feared audits by the ?@, or other punitive government action.4
.ut <r +erkowit& and <s @enstrom are utterly typical of the !* in that they are far more
politically engaged than the average 11-percenters. Cearly all the rich people surveyed by
Corthwestern vote' :6* make campaign contributions' nearly half had contacted a member
of >ongress and a fifth had solicited contributions on behalf of a candidate. $ good chunk of
those calls were meant to help their businesses. .ut many were motivated by the common
good' defined in as many different ways as the sources of their wealth.
Investing in #anks
The not'for'profit sector
$re regulators striking the right balance between safety and profitabilityL
<ay 5th 2!2 " from the print edition
C$@M a cucumber sandwich was thrown and the heckling was rather subdued. .ut the
genteel rebellion over executive pay at the .arclays shareholders meeting in %ondon last
month' an echo of similar dis5uiet at annual meetings in $merica Fsee articleH' shows how
fed up bank investors have become with
their returns.
Co wonder. .etween 20 and the end of
last year shareholders in banks globally have
lost almost !* of their investment each
year' according to the .oston >onsulting
Aroup Fsee chart !H. .ehind this
international average lie some truly horrible
losses. ?nvestors who stuck it out in =utch
banks saw the value of their holdings fall by
almost 26* a year. Dolders of French'
Aerman and ,wiss banks suffered average
annual losses of close to 2*. Those in
$merican and .ritish banks lost !8* and
!:* a year respectively. 3The little secret to
doing wellShas been T/ust dont hold banks'4 says (acob de Tusch-%ec' a fund manager at
$rtemis.
$ fall in the price of an asset is usually a good signal to consider buying it. .ut those
investors who thought that they had timed the bottom of the market have been proved
wrong again and again. 3?ve been dipping in and out of ?talian banks but am keeping very
5uiet about it'4 says one fund manager. 3%ast year when ? told an investor Qin my fundR that
? was holding some he got up and left the room.4
,uch sharp falls in shareholder value are not /ust distressing for investors. They should also
worry the businesses and households that need a healthy banking system to keep credit
flowing. ?f the shares and debt issued by banks are uninvestible' then over time the banking
system will have to shrink or be nationalised.
There are three reasons why the banks have been such a bad bet. The first is weakness in
9estern economies' which has led to elevated losses' subdued demand for credit and
deleveraging by the banks themselves. 9ith returns on assets remaining largely unchanged
Fthis is a tough time to charge customers moreH' the industrys total profits are likely to
keep falling.
$ second reason is worries about sovereign
defaults. ?n the second half of last year
European banks sold virtually none of the long-
term bonds that they use' alongside deposits'
to finance loans. These markets have thawed
slightly since the European >entral .ank FE>.H
provided more than E! trillion FG!.) trillionH in
three-year loans to European banks. .ut they
are still fragile' partly because banks have
pledged collateral to the E>.' leaving less to
repay bondholders if a bank were to go bust.
,imon ,amuels' an analyst at .arclays' points
out that almost five years since the start of the
financial crisis' European banks are more
dependent on state support than ever. 39hat
we have' in effect' is nationalisation via the
debt markets'4 he says. 3?f you cant get a private-sector debt model to work then there is
no real investible e5uity.4
The weak economy and worries over the euro area are' with some luck' transient problems.
Met weighing on investors minds is a third concern2 the impact that regulation will have on
banks long-term profitability and the safety of their debt. @eturns on e5uity have fallen
precipitously' from about !5* before the crisis to below !* now. .ritish banks returns
have slipped from almost 2* to about 5* last year Fsee chart 2H.
$ big reason is that banks have to hold much more e5uity as a buffer against losses. ,imple
arithmetics dictates that returns must fall. #ther regulations to make banks safer also have
a cost. .anks will have to hold many more li5uid assets' which can be 5uickly sold. They are
also being forced to stop profitable Fif riskyH activities such as proprietary trading.
@ules aimed at ring-fencing retail banks' 3bailing in4 bondholders and making banks easier
to wind up if they fail are also pushing up banks funding costs and depressing returns. They
are doing little to encourage investors to buy bank bonds. 3?f regulators told European
banks to raise bail-in debt there would be a resounding clatter of pennies at the bottom of
the tin but no folding money at all'4 says the chairman of a large bank.
For all the gloom' most big banks are still forecasting For at least aiming forH returns on
e5uity of !2-!5*' which would handily cover the cost of their capital. That would also be
respectable by historical standards2 $utonomous @esearch reckons that over the long term
banks returns have averaged !* in .ritain and 1* in $merica. .ut it invites two
5uestions.
The first is whether banks can attract investors with a combination of utility-like returns and
bank-like volatility. @egulators hope better-capitalised banks will be less volatile and more
attractive. <ore pragmatically' index-tracking investors may have little choice but to hold
them.
The second is whether banks can /uice their returns by managing costs better. There is
plenty of room to do so' particularly in wholesale banking. The .oston >onsulting Aroup
reckons that investment banks can 5uickly cut !-!5* of fat in areas such as market data
and exchange fees. =eeper savings can be made by reducing layers of management and
title creep2 it found that almost half of the staff in second-tier investment banks had the
title of director or managing director compared with 2-)* among the better firms.
.ut banks do not have a great record as beancounters. European lenders have managed to
reduce their overall cost-to-income ratio only to about :2* from :1* since the mid-!11s'
an average improvement of .)* a year. Their current targets assume an average
improvement of 2.0* a year over the next three years' a figure <r ,amuels thinks looks
3far too ambitious4. To keep shareholders and creditors interested' they may have little
choice.