Friday, 14 November 2008

Systemic Risk, Contagion and Trade Finance - Back to the Bad Old Days

Back in the old days (pre-1980s), the term systemic risk did not refer to contagion of illiquidity within the financial sector alone. Back then, when the real economy was much more important than low margin, unglamorous banking, it was understood that the really scary systemic risk was the risk of contagion of illiquidity from the financial sector to the real economy of trade in real goods and real services.

If you think of it, every single non-cash commercial transaction requires the intermediation of banks on behalf of – at the very least – the buyer and the seller. If you lengthen the supply chain to producers, exporters and importers and allow for agents along the way, the chain of banks involved becomes quite long and complex.

When central bankers back in the old days argued that banks were “special” – and therefore demanded higher capital, strict limits on leverage, tight constraints on business activity, and superior integrity of management – it was because they appreciated the harm that a bank failure would have in undermining the supply chain for business in the real economy for real people causing real joblessness and real hunger if any bank along the chain should be unable to perform.

As the “specialness” of banks eroded with the decline of the real economy (and the migration globally of many of those real jobs making real goods and providing real added-value services to real people), the nature of systemic risk was adjusted to become self-referencing to the financial elite. Central bankers of the current generation only understand systemic risk as referring to contagion of illiquidity among financial institutions.

They and we all are about to learn the lessons of the past anew.

We are now starting to see the contagion effects of the current liquidity crisis feed through to the real economy. We are about to go back to the bad old days. Whether the zombie banks are kept on life support by the central banks and taxpayers of the world is highly relevant to whether the zombie bank executives pay themselves outsize bonuses and their zombie shareholders outsize dividends with taxpayer money. It appears sadly irrelevant to whether the banks perform their function of intermediating credit and commercial transactions in the real economy along the supply chain. The bailout cash and executive and shareholder priorities do not seem to reach so far.

The recent 93 percent collapse of the obscure Baltic Dry Index – an index of the cost of chartering bulk cargo vessels for goods like ore, cotton, grain or similar dry tonnage – has caused a bit of a stir among the financial cognoscenti. What is less discussed amidst the alarm is the reason for the collapse of the index – the collapse of trade credit based on the venerable letter of credit.

Letters of credit have financed trade for over 400 years. They are considered one of the more stable and secure means of finance as the cargo is secures the credit extended to import it. The letter of credit irrevocably advises an exporter and his bank that payment will be made by the importer's issuing bank if the proper documentation confirming a shipment is presented. This was seen as low risk as the issuing bank could seize and sell the cargo if its client defaulted after payment was made. Like so much else in this topsy turvy financial crisis, however, the verities of the ages have been discarded in favour of new and unpleasant realities.

The combination of the global interbank lending freeze with the collapse of the speculative, leveraged commodity price bubble have undermined both the confidence of banks in the ability of a far-flung peer bank to pay an obligation when due and confidence in the value of the dry cargo as security for the credit if liquidated on default. The result is that those with goods to export and those with goods to import, no matter how worthy and well capitalised, are left standing quayside without bank finance for trade.

Adding to the difficulties, letters of credit are so short term that they become an easy target for scaling back credit as liquidity tightens around bank operations globally. Longer term “assets” – like mortgage-back securities, CDOs and CDSs – can’t be easily renegotiated, and banks are loathe to default to one another on them because of cross-default provisions. Short term credit like trade finance can be cut with the flick of an executive wrist.

Further adding to the difficulties, many bulk cargoes are financed in dollars. Non-US banks have been progressively starved of dollar credit because US banks hoarded it as the funding crisis intensified. Recent currency swaps between central banks should be seen in this light, noting the allocation of Federal Reserve dollar liquidity to key trading partners Brazil, Mexico, South Korea and Singapore in particular.

Fixing this problem shouldn't be left to the Fed. They aren't going to make it a priority. Indeed, their determination to accelerate the payment of interest on reserves and then to raise that rate to match the Fed Funds target rate indicates that the Fed are more likely to constrain trade finance liquidity rather than improve it. Furthermore, the Fed may be highly selective in its allocation of dollar liquidity abroad, prejudicing the economic prospects of a large part of the world that is either indifferent or hostile to the continuation of American dollar hegemony.

If cargo trade stops, a whole lot of supply chain disruption starts. If the ore doesn’t go to the refinery, there is no plate steel. If the plate steel doesn’t get shipped, there is nothing to fabricate into components. If there are no components, there is nothing to assemble in the factory. If the factory closes the assembly line, there are no finished goods. If there are no finished goods, there is nothing to restock the shelves of the shops. If there is nothing in the shops, the consumers don’t buy. If the consumers don’t buy, there is no Christmas.

Everyone along the supply chain should worry about their jobs. Many will lose their jobs sooner rather than later.

If cargo trade stops, the wheat doesn’t get exported. If the wheat doesn’t get exported, the mill has nothing to grind into flour. If there is no flour, the bakeries and food processors can’t produce bread and pasta and other foods. If there are no foods shipped from the bakeries and factories, there are no foods in the shops. If there are no foods in the shops, people go hungry. If people go hungry their children go hungry. When children go hungry, people riot and governments fall.

Everyone along the supply chain should worry about their children going hungry.

When that happens, everyone in governments should worry about the riots.

Controlling access to trade finance determines who loses their jobs, whose children go hungry, who riots, which governments fall. Without dedicated focus on the issue of trade finance and liquidity from those in the emerging world most interested in sustaining the growth of recent years, little progress can be expected.Trade finance is rapidly communicating the stress on bank liquidity to the real economy. It presents a systemic risk much more frightening than the collapsing value of bits of paper traded electronically in London and New York. It could collapse the employment, the well being and the political stability of most of the world’s population.

The World Trade Organisation hosted a meeting on trade credit in Washington Wednesday to highlight the rapid and accelerating deterioration in trade finance as an urgent priority for public policy.

I look at the precipitous collapse of the Baltic Dry Index and I wish them Godspeed.

Further reading:

WTP warns of trade finance ‘deteriorating’ amid financial crisis

Cost of some trade finance deals up sixfold – WTO

Shipping holed beneath the water line

Shipowners idle 20 percent of bulk vessels as rates collapse


r0tiNeK said...

Fantastic Post LB. I see these "convulsions" transpiring throught the world economy & they are quite violent - people still haven't REALLY felt them YET... when there is a complete disintegration of the credit markets and as a result confidence in Trade collapses, this is really serious stuff. As you've noted (and the other intellectuals too) this most recent collapse in the Baltic Dry index will be felt in the real economy within next 4months. The thing is I'm also seeing so many businesses go Bankrupt that I can't see the Demand in Trade going forward. It's honestly collpasing.

yoyomo said...

These currency and credit manipulations may be the opening salvos in an economic war that may turn violent as a crippled US, unable to heal itself, tries to make sure that its competitors are similarly handicapped. If you can't soar with the eagles, tie lead weights around the ankles of those who can; if that doesn't work, break their wings. said...

This is what I started worrying about in September. I was having trouble sleeping at night, as all I could imagine was the global logistics chain seizing up, as supply destruction shook hands with demand destruction. Thus muddying the waters between the two. As my area is oil, I have tried to explain to people that supply is already chasing demand down the price ladder. As for dry bulk shipping, it's really just an example of how the world works. Modernity is equivalent to highly developed credit systems. Without those, you don't have efficiency--or modernity. You are immediately cast backwards into a primitive system, where wages have to be paid, and received daily.

Nice post, L.B. For two months now, I have hope the worst will not come to pass.

Joseph j7uy5 said...

To add insult to injury, or, perhaps, injury to injury, the USA in the 1990's decided that they no longer needed to keep reserves of grain or other foods. Enormous stockpiles of foodstuffs were allowed to dwindle. Just this year, they reached zero.

DiverCity said...

I routinely watch CNBC World from here in the USA. An anchor/reporter from Singapore, Adam Bakhtiar, has for a number of weeks been trying to sound the alarm regarding the ongoing deterioration of the Baltic Dry Index. The other anchors don't seem to share his concern or even know what he's talking about. It appears that we all better understand the seriousness of the matter and what it entails and portends.

Jesse said...

Brilliant and insightful post. Thanks for the perspective.

Drake said...

Likewise, a brilliant post.

You should just write these kind of mails on Monday, it is nicer to ruin the work week than the weekend...

Seriously, I have been following the collapse of the Baltic Dry Index without totally thinking it through. I have also been following what is happening in Island, which does not have functioning banks any more, and wondering when do the people there realize the true depth of the problems in which they now are - tradingwise and such. I did not realize that we are all going to be Islanders.

This was a truly scary post, thanks for the wakeup. Bonds and equities, they worry me so much less now...

@ Yoyomo
Totally agree, we are going towards trading wars, tariffs and revenge tariffs, beggar thy neighbour world.

Anonymous said...

Thanks LB!

I read your posts on RGE monitor, and I can definitely say this one scares the s*** out of me. A lot of food for thought and very sobering. Makes me wonder what 2009 will bring if this is not resolved - and that can't be good!

Anonymous said...

Aren't "letters of credit" pretty much why international banking was set up in the first place - to facilitate international trade? Its like the international money exchanges where only something like 1% of the money traded actually has to do with trade, and rest is wild speculation. And now they're throwing away the bit which actually has human value and usefulness to defend the dross.

Galbraith in his book on the Crash of '29 notes a similar phenomenon. As the huge Investment Trusts crashed as all their bad leveraged stock went belly up, they were forced to sell all their real stock in real things like steel and automobiles to try and save the bad. Just as Hedge Funds are causing all the instability in the market now by having to sell off their good stock - at rock bottom prices - in order to shore up their bad. (And thus causing all this turbulence and artificial ramps and dips in the market).

Galbraith noted dryly about this phenomenon that he'd seen swindlers swindling innocent people often enough, but this was the first time he'd noted swindlers swindling themselves.


José Luis said...

Antal Fekete, an heterodox economist of the austrian school, has deeply studied the importance of the Letter of Credit in commerce. He has stated the fall of the clearing system of letters of credit as one of the main reasons of the 1929 depression.

See "Monetary reform: Gold and Bills of Exchange"

Wisdom-Seeker said...

A less gloomy thought:

In the absence of Letters of Credit, there will be a tremendous opportunity for cash-rich shipping companies, no?

The shippers have an opportunity to increase profits by taking on the financial risks, rather than dumping those upon the letter-of-credit bankers.

Shipper with cash in hand (literally or in a local bank account) purchases a cargo in Port X. Shipper delivers cargo to Port Y, sells it, and drops cash into bank at Port Y.

Therefore, if banks won't lend to shippers, there's an opportunity for investors to do so in order to give the shippers the cash to cut out the banking middleman.

Anonymous said...

Wonderful post, LB. Mish has been talking about the Baltic Dry Index for months, but this post does the best job I've seen of making it relevant.

I just read an article about Hartford Insurance picking up a Florida bank for 10 million and thus becoming eligible for billions in TARP money. I suspect you would say this is the problem with TARP. It pulls working credit out of the 'letters of credit' system.

Are you recommending the US reinstate the Glass-Steagall Act?

RGEreader of LB said...

A most interesting perspective.

In recent months the Baltic Dry Index along with LIBOR, TED, etc. have made there way into the vocabulary of the pundits. In many cases the interpretation of these indices has been butchered, twisted and otherwise badly abused.

Popular sentiment for the decline in the Baltic Dry Index relates almost exclusively to slowing demand. The perspective you (and a few others) are offering, suggests a different and far more serious dynamic.

I wonder what portion of the decline in the index would be attributed directly to the credit issues you describe versus slowing demand. To that end if a solution were to be found to those specific credit issues it would stand to reason that the index would benefit proportionally.

Related to that I wonder to what degree the depth of the economic slowdown would be reduced if such a solution were to be found.

Finally to what degree are current economic forecasts factoring in what you have described?

Anonymous said...

Why worry about hungry children?
When the supply line fails, we can just eat them!
After all haven't we been doing so figuratively and financially for decades? What of the imposed immiseration on our posterity as we spend in every conceivable way in deficit? Born to bondage, these yummy and tender lieblings are saved a worse fate as wage slaves and dust heap scavengers were they not trussed, singed, and rotisseried (with apple in mouth no less) for our consumption.
We really would just be doing them a favour.
Yes, spendthrifts whose credit has collapsed can indulge the ultimate self-destruction--literal consumption of our young. My mouth is watering in the contemplation. Irish, Asian, melting pot infants...any will do with the right marinade.

Anonymous said...

I have a similar view...

Knute Rife said...


In reality there is no difference between demand and LOCs, because the demand that matters is payable demand, not wishful demand.

For example, there is lots of demand for my legal services. Most of that demand is wishful demand; they can't pay me, so they wish for me to help them gratis. That isn't real demand, it's Neverland.

On the other hand, there are people who use my services and pay for them, but if their cash flow and credit lines seize up, their demand goes down. That's real demand decline, and it's inextricably linked to ability to pay.

We're seeing the same thing in shipping. Shipping isn't a charity gig, and the cargo owners know it. They aren't going to approach a shipper without a LOC in hand, and so demand declines lock-step with ability to pay.

Anonymous said...

I come here for sanity. Once more, LB, you have provided a clear reflection of how the world really is. Armed with that information we can make sensible decisions. If we are armed only with the politicians' glib "well placed to weather the storm", "economy will grow again in 2009" and other such dross, then mistakes are inevitable.

Interesting comment by a medic on a financial post at New York Times. (Sorry I can't remember who or which article, it only sunk in later). He was proposing that there be the Financial Services equivalent of the US Food and Drugs Administration. It would have to licence new products, undertake the appropriate evaluation of safety testing etc, before they could be placed on the market. For retail customers that might have some benefit.

Anonymous said...

LB, I said a year ago that the Supply Chain was in jeopardy. Many laughed at the RGE commentators who were stocking canned goods and paper products.Remember? My husband works in transportation and we saw this coming in spring of 07.

There are too many "intellectuals" (are you listening Ben?)trying to "fix" things and not enough people who engage in business that produce "real things". The GS alumni haven't got a clue how the real world operates.

The wisdom-seeker is right.Capital will seek the opportunities and people with cash will purchase the necessary cargo and transport it. Cash is king and fortunes made.

Mr. Paulson and his successor need to re capitalize the banks that service the farmers and other food supply participants instead of Wall Street. That link in the chain is essential to our survival. I don't worry about distribution. The US Army has one of the best logistics operations in the world. That is why I would never dream of leaving the US if TSHTF.


don said...

Here is where may get real interesting should the scenario you paint here materialize:

Distribution chain breakdowns; supply disruptions; shortages . . .

Triggering: accumulate, accumulate, accumulate. Hoard, hoard, hoard:

Resulting in more:

Distribution chain breakdowns; supply disruptions; shortages . . .

EEgineer said...

You sir, have said in a page what others would take a book to say. I must go weep now for it will likely go unheeded...

Anonymous said...

Nice post LB, I will now put my head in the oven. because I live in Australia a place with yes a debt free national Govt. but higher personal debt than the U.S and the most expensive real estate in the world. A third of taxpayers here have a negatively geared investment property (Think Ponzi Scheme). That is a second home that runs at a loss (non productive investment) with the losses picked up by the Treasury. We have also come to view our commodity boom as permanent of late. If this trade finance problems persits even in a milder form I think we may be buggered.
And as is always the case no-one down here has mentioned it because in OZ life is so easy with an array of welfare payments and income support that would make your head spin. Wealth coming from hard work and risk, is not something Craig & Karen on the street understand. Maybe they will will when Family tax benefit A & B and Childcare rebate C get taken away from them.


Tiger Coach said...

LB... I stumbled upon your blog, and have found it an excellent reflection of world markets, and to a lesser extent human nature. I would assume the only way of weathering this financial storm:

Governments: "Continue to spend... spend... and spend. The apex of spending usually happens during war... Outside of war there is also an opportunity through massive innovation. The former would finish off the U.S. dollar...the later would reinvigorate it."

Business: "Innovate or die..."

Individuals: "Live cheap, be pragmatic, and develop a personal financial protection plan... it usually starts through debt avoidance."

RPB said...

I am a global physical commodities trader. I do believe you are spot on with most everything you have written. Demand desruction is being forced by restrictive trading terms, contract "walking," counterparty failure fears and credit line restriction.

As a result, firms are beggining to make long term capital and investment decisions that will crush supply. This will whipsaw us back with inflation over the medim/long term. While I do not have the time to go beyond the anecdotal, it is certainly looming on the horizon. The relationship of supply-demand destruction is evident and it is spiraling out of control. This is classic economic theory actually coming to fruition! Its simply unbelievable.

Its funny, I covered the exact same points you have written about in a letter to my boss last week. This type of agreement is frightening.

CityUnslicker said...

some solutions:

1) use the same bank at both ends of the transaction - i.e. HSBC.

2) use international lawyers and escro accounts instead of LOC's if you have the cash to hand.

London Banker said...

Many thanks for your well informed confirmation of my fears. I could wish they were less well substantiated!

@ Citori
Yes, indeed! We saw this one coming a long way back over on Roubini's blog. As I've said before, I'm glad to live in quasi-socialist Europe where governments are expected to provide for the people in crisis.

yoyomo said...

Michael Hudson just added his voice to Paul Craig Roberts in calling for 100% reserve banking:

The banks and Wall Street are threatening to wreck the economy by “going on strike” and creating a credit squeeze forcing foreclosures and economic collapse, if Congress and the Federal Reserve don’t save them from taking a loss on their bad loans and financial derivatives.

The most reasonable response to this brazen stance may be to return the Federal Reserve’s monetary functions to the U.S. Treasury. This is where they were conducted with great success prior to 1913. Back in the 1930s the “Chicago Plan,” put forth in the wreckage of the banking system’s and Wall Street misbehavior that aggravated the Great Depression, proposed to turn commercial banking into classic-style savings banks with 100 per cent reserves.

I would be interested to hear your take on the proposal especially as there is a growing market in sharia-compliant banking; more so in London than in NY I would imagine. Could this be one of the hidden reasons for Anglo-American animosity toward Iran; the threat of a rival banking system arising.

London Banker said...

@ Yoyomo
It will be interesting to observe how well various countries in the Gulf weather the coming financial storms. Dubai has the most westernised finance, with high leveraged credit for speculative development. Other Gulf states strike different points on the scale, with Iran and Saudi being most conservative in adhering to Sharia principles of risk-sharing and joint-endeavor/benefit.

The UK Treasury will shortly be issuing its first Sharia-compliant government bonds. The take up of the issue will merit close observation. Sharia-compliant banking here is already quite popular for retail banking, with Sharia mortgages and investment funds. It has happened quietly, but it will be interesting to see whether there are differentials in default rates on the mortgages and in observed returns on the funds.

yoyomo said...

Dubai is more of a Ponzi scheme than Iceland and its collapse is just as assured (absent a bailout) but beyond sharia banks in particular I'm interested in the feasiblity of high/full reserve banking with currency/money supply controlled by the treasury and not the banks.

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Dr. Worden said...

The financial sector, which includes banks like JPMorgan and insurance companies like AIG, had the fastest earnings growth in the Standard & Poor’s 500 in 2012.[1] As of mid-2013, the sector comprised 16.8% of the S&P 500, almost double the percentage back in 2009. With the technology sector weighing in at 17.6 percent in 2013, the financial sector was poised to become the largest sector in the S&P 500. The traditional critique of the financial sector having a larger share of the economy is that the sector doesn’t “make” anything. As this argument is well-known, I want to point to two others.