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Will COVID Finally Give Big Banks Their Direction?

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Will COVID Finally Give Big Banks Their Direction? 15

By Shreya Jain

If the recently finished 2020 has taught us anything, it is that we’d do well to re-evaluate the way things usually work. And in a world, that is still struggling to its feet after a tumultuous year, one can look around and notice that some pieces of reality have played musical chairs: social activities once regarded as keystones of public life are now greeted with deep suspicion, even fear; previously stable industries are on life support; and minimum wage employees suddenly bear the mantle of “essential workers” despite few immediate benefits of this increased responsibility.

Life, in other words, is not behaving as usual. And neither are the banks.

According to FDIC data, a record $2 trillion[1] has been deposited in U.S. banks since the coronavirus first struck the U.S. in January. More than 5.2 million[2] loans were issued by banks participating in the Paycheck Protection Program (PPP) to keep several businesses afloat during the COVID-19 induced pandemic. This is the primary role of banks – to accept deposits and to grant loans.

In a direct juxtaposition to this primary role, if we look at the sources of revenue for banks to determine its role, especially during crisis, it however tells a story of banking institutions deviating from their primary role.

Consider the revenue distribution for a few top banks (Fig. 1):

Will COVID Finally Give Big Banks Their Direction? 16

Fig. 1: Composition of total revenue in 2019 H1 and 2020 H1

For all three of these banks, an increasing percentage of total revenues has been coming from the Investment Banking division, primarily driven by the Fixed Income Market.

In fact, in the most recent Dodd-Frank Stress Tests (DFAST), Goldman Sachs and Morgan Stanley are ordered to hold the most capital of all the 34 firms tested- 13.6% and 13.2%[3] respectively. Goldman Sachs and Morgan Stanley have particularly high stress buffers because of the nature of the Fed’s exams, which put extra pressure on banks that rely heavily on capital markets; Goldman Sachs also has their decision to maintain dividends.

There is an intriguing question in all this – one made easier by recent developments.

“Should Banks be in a Growth Business?”

Will COVID Finally Give Big Banks Their Direction? 17There are a number of sources to draw from for a possible answer. We have a number of lessons from the past. The Glass-Steagall Act is a 1933 law that separated investment banking from retail banking. By separating the two, retail banks were prohibited from using depositors’ funds for risky investments. Only 10% of their income could come from selling securities. They could underwrite government bonds. [4]

However, the banking industry soon objected that the act was too restrictive. They believed they could not compete with foreign financial firms offering higher returns as the U.S. banks could only invest in low-risk securities. They wanted to increase returns while lowering overall risk for their customers by diversifying their business.

The most audacious move was when Citicorp and Travelers Group — a commercial bank and financial services company, respectively – merged to create Citigroup Inc. It was an unforeseen event that took the financial world aback for a number of reasons – not least of which was that such a move was technically illegal. But Glass-Steagall had a number of exploitable loopholes. This was just one possible outcome.

On November 12, 1999, President Clinton signed the Financial Services Modernization Act that repealed Glass-Steagall. This consolidated investment and retail banks through financial holding companies.[5] , creating new entities supervised by the Federal Reserve. For that reason, only a few banks took advantage of the Glass-Steagall repeal. Most Wall Street banks did not want the additional supervision and capital requirements.

Those that did take advantage became “too big to fail”.

The Bigger They Are…

The focus today on “Growth” above and beyond what would otherwise be allowed under Glass Stegall Act has been worrisome. The thirty-four participants in the severely adverse scenario of this year’s Dodd-Frank Stress Tests (DFAST) estimated their risk-based Common Equity Tier 1 (CET1) capital ratio would trough to 9.9%, from an end-2019 amount of 12%. In the worst-case scenario –assuming a W-shaped recession where the US is hammered by a second wave of the illness– banks’ aggregate CET1 ratios are projected to plummet to 7.7% after taking $680 billion of loan losses.

While it’s true that banks with trading focus have fared better recently due to an unusual rally in the stock market, there is still some cause for concern. Should that rally turn into a correction or a crash, the FED- and ultimately the American taxpayers – could have to actually bailout these too-big-to fail banks.

 A New York Fed paper, using data for more than 200 banks in 45 countries, found that banks classified by rating agencies as “more likely to receive government support” engage in more risk-taking. Moreover, the label of “too big to fail” and passing stress tests may create a false sense of security for large banks, thus encouraging them to continue taking risks with depositors’ money. Said differently, banks engaging in riskier behaviour are also more likely to take advantage of potential government support. Figure 2 shows that Banks with a higher probability of government support (as indicated by support rating floors – NF to AA-AA indicating increasing likelihood of government support) also have more trading assets on average.[6]

Will COVID Finally Give Big Banks Their Direction? 18

Fig 2: Summary Statistics of Bank’s Balance Sheet by Support Rating Floors

The support itself is not seen as bearing great future results either. The paper shows that following an increase in government support, we see a larger volume of bank lending becoming impaired and increase in net charge-offs. Additionally, we find that the effect of government support on impaired loans is stronger for riskier banks than safer ones, as measured by their issuer default ratings.

So, should a Bank be focusing on its growth? Should Banks be limited in what they do? Is the present Stress Test sufficient? Or does passing the stress test only contribute to an inflated confidence and outsized risk tolerance given the potential consequences?

…The Harder They Fall

Will COVID Finally Give Big Banks Their Direction? 19

A number of open questions that the banking industry still has to figure out….

Let us turn once again to lessons from the past, 2008 The Financial Crisis.

The financial crisis of 2008 had its foundation in bad mortgages, but this wasn’t what ultimately brought the banks to the brink of collapse.  Volcker noted when he proposed his idea (Volcker rule, a federal regulation that prohibits banks from conducting certain investment activities with their own accounts and limits their dealings with hedge funds and private equity funds, also called covered funds[7].) that the culprit wasn’t bad loans, but the exotic trades banks had made around them.

At the time, there was discussion of reinstating The Glass-Steagall Act but the banks argued that doing so would make them too small to compete on a global scale. The Dodd-Frank Wall Street Reform Act was passed instead. This Act requires the Fed to conduct an annual stress test of bank holding companies with $50 billion in assets – otherwise known as “too big to fail.”[8]

Section 619 of the Act was The Volcker Rule aimed, once again, at separating the commercial and investment banking divisions of banks, but not with the same stringent restrictions as Glass-Steagall Act. It aimed to prohibit banks from using customer deposits for their own profit. Moreover, restricted banks from owning, investing in, or sponsoring hedge funds, private equity funds, or other trading operations for their own use. These steps were meant to protect depositors from the types of speculative investments that led to the 2008 financial crisis.

The idea became law in the Dodd-Frank reforms of 2010, but the rule-writing took another three years due to squabbles over how to separate prop trading from market-making and hedging. Instead of blanket bans, regulators sought to define each situation and carve out a string of exemptions, which is how the rule grew. The final rule also clarifies that certain activities are not prohibited, including acting as agent, broker, or custodian. As a result, the Volcker Rule has been in force since July 21, 2015

When the final version called on traders to certify the intent of each transaction, Jamie Dimon, the chief executive officer of JPMorgan Chase, complained that traders would need a psychologist and a lawyer by their side to make sure they were in compliance.[9] Fed researchers found that the rule resulted in less-liquid markets for some bonds in times of stress. But by and large, banks adapted to it, though that did not stop them from lobbying for years to win procedural changes. Under the Trump administration, regulators showed a strong interest in simplifying the rule. The revamp, known as Volcker 2.0, is a steady effort to soften Volcker regulations during Trump’s administration.

Volcker2.0 – “Volcker 2.0” went into effect on October 1, 2020.

The Proposed Rule adds four new exclusions to the definition of “covered fund” — credit funds, venture capital funds, family wealth management vehicles and customer facilitation vehicles — thereby exempting them from the scope of the Volcker Rule.[10]

Changes in proprietary trading include eliminating a requirement that banks reserve an initial margin over 15% of Tier 1 capital and may allow banks to invest in up to $40B more in credit-default swaps.[11]

More capital will be available to venture capitalists, therefore making additional capital available to start-up companies. However, many believe this may be a short-lived change following the 2020 presidential election.

Volcker 2.0 is representative of a pendulum swing in financial regulatory compliance away from the strong reaction to the financial crisis of 2008.

Banks evaluated their capital market businesses to identify opportunities to leverage newly permitted activities and the reduced operational burden of Volcker 2.0. Different banks have commenced new strategies by increasing trading volumes and holdings. As an example, the table below (Figure 4) illustrates a trend in the commercial bank sector, and how the trading assets volume increased in 2019 in anticipation of the Volcker amendments.

Will COVID Finally Give Big Banks Their Direction? 20

Fig.4 : Total Trading Assets for Commercial Banks in the US[12]

Is COVID-19 the new lesson? Is FED, via Stress Test trying to tighten regulatory burdens for Banks majorly associated with proprietary trading driven revenues such as Goldman Sachs and Morgan Stanley? As per FED Stress Test in 2020, Goldman Sachs and Morgan Stanley were the two banks that faced the highest jump in the required minimum CET1 ratio – 4.1% and 3.2% respectively. (Fig 5)[13]

Will COVID Finally Give Big Banks Their Direction? 21

Fig.5: Minimum CET1 ratio in 2019 and 2020

 On one hand, financial regulators eased the financial crisis-era Volcker Rule. Conversely, the same regulators brought about tighter requirements via Stress Test for banks that are focussed on Trading revenues.

The change in minimum CET1 ratio is inversely related to the PEG ratio (Q3 2020) right after when the minimum CET1 were to be met. Morgan Stanley and Goldman Sachs had PEG ratios of 0.97 and 1.44, the lowest amongst their peers, while they had the largest change in minimum CET1 ratio – 4.1% and 3.4% respectively.(Fig 6.)

Will COVID Finally Give Big Banks Their Direction? 22

Fig.6: PEG Ratio post change in required minimum CET1 ratio

With another administrative change (new government) will the Volcker Rule be changed again to go closer to what it was intended for. Will banks be forced to choose between proprietary trading and having a PEG ratio comparable to its peers?

Do Banks Get a New Normal Too?

Oz Shy, a professor at MIT proposes that if we were to ensure policymakers let banks fail – we need to prepare in advance for the next wave of bank failures by protecting depositors’ money, instead of just focusing on stress tests or size reductions.

Depositors should be simply allowed to have access to accounts that maintain 100 percent reserves. That is, every cent of their savings would be backed by hard currency. His research has shown that moving in this direction improves social welfare relative to the current system of purely fractional banking, in which banks only hold a fraction of their deposits. A 100 percent reserves policy would break our current system’s bundling of risk-taking with the job of keeping accounts safe and offering payment services. Only then, by ensuring depositors (and voters) aren’t at risk when there’s a crisis, would governments have the will to let banks fail – without any regard to their size – and at no cost to taxpayers.[14]

And if a few banks want to be in growth business, they should be treated very differently than the other banks with a pure focus on transmission and custodian roles. More than what current stress test does. Maybe that’s the “new normal” banks need.

[1] https://www.cnbc.com/2020/06/21/banks-have-grown-by-2-trillion-in-deposits-since-coronavirus-first-hit.html

[2] https://www.reuters.com/article/us-health-coronavirus-ppp-banks-focus-idUSKBN2761G4

[3] https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200904a.htm

[4] https://www.thebalance.com/glass-steagall-act-definition-purpose-and-repeal-3305850#:~:text=The%20Glass%2DSteagall%20Act%20is,investment%20banking%20from%20retail%20banking.&text=By%20separating%20the%20two%2C%20retail,They%20could%20underwrite%20government%20bonds.

[5]https://www.federalreservehistory.org/essays/gramm_leach_bliley_act#:~:text=This%20legislation%2C%20signed%20into%20law,was%20granted%20new%20supervisory%20powers.

[6] https://www.newyorkfed.org/medialibrary/media/research/epr/2014/1412afon.pdf

[7] https://www.investopedia.com/terms/v/volcker-rule.asp

[8] https://www.congress.gov/111/plaws/publ203/PLAW-111publ203.pdf

[9] https://www.bloombergquint.com/quicktakes/the-volcker-rule

[10] https://www.srz.com/resources/summary-of-proposed-volcker-2-0-for-fund-activities.html

[11] https://gillespiegroup.law/2020/06/introducing-volcker-2-0-changed-need-know/

[12] https://fred.stlouisfed.org/series/USTTAST

[13] https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200810a.htm

[14] https://theconversation.com/feds-focus-on-too-big-to-fail-wont-save-taxpayers-from-next-bank-bailout-61884

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ECB faces tricky balancing act after pandemic debt surge

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ECB faces tricky balancing act after pandemic debt surge 23

By Francesco Canepa, Frank Siebelt and Balazs Koranyi

FRANKFURT (Reuters) – As the euro zone begins to emerge from the depths of a pandemic-induced recession, the European Central Bank is facing a difficult balancing act between supporting indebted governments and keeping creditors onside.

Encouraged by the ECB’s massive bond purchase programme and ultra-low interest rates, national governments have taken on a mountain of new borrowing to cushion the coronavirus pandemic, pushing total public debt to 102% of the region’s output.

With a euro zone recovery seen lagging that of the United States or Asia, these countries will not grow their way out of debt or see it eroded away by rising prices any time soon.

Yet Bundesbank President Jens Weidmann has made clear he expects monetary policy to return to normal once inflation returns.

That means President Christine Lagarde and her colleagues must strike a difficult balance between the need to keep credit sufficiently easy for weaker borrowers like Italy while not losing the support of creditor countries.

“I think the ECB is trapped,” said Friedrich Heinemann, a professor at Germany’s ZEW institute.

“Certain heavily indebted countries can no longer cope on their own. The big issue here is the Italian debt,” he said of Rome’s 154% debt/GDP level.

ECB chief economist Philip Lane has rejected the idea that the bank’s policy is constrained, saying in a Reuters interview last year he was confident the bank could exit its bond-buying programmes when inflation allowed it to do so.

This is unlikely to happen any time soon.

JAPANESE WAY

The ECB has been already buying government bonds for six years, trying but largely failing to generate enough activity to achieve its near-two-percent inflation target.

Notwithstanding an expected rebound in euro area prices this year due to one-off factors and speculation of reflation in the United States, there is no sign of a stable return to higher levels of inflation on this side of the Atlantic.

This is due to both the aftermath of the pandemic, which destroyed millions of jobs, and structural factors keeping a lid on prices such as an ageing population, relentless technological progress and globally competitive product markets.

Even if inflation were to reach 2%, Lagarde could argue that it should be allowed to overshoot for some time after lagging below target for over a decade.

This argument, borrowed by the Federal Reserve, is being discussed as part of an ongoing review of the ECB’s policy strategy.

That should give Lagarde a justification to keep rates low and perhaps even continue buying bonds for a long time, like the Bank of Japan has been doing.

“It’s the Japanese way of handling the problem,” Philipp Vorndran, a strategist at fund management firm Flossbach von Storch, said. “A state can work at zero interest for eternity if people don’t lose trust in money.”

Graphic: Italy’s debt to GDP ratio

ECB faces tricky balancing act after pandemic debt surge 24

BUYING BONDS

The ECB has bought 3 trillion euros worth of government debt and it has pledged to keep at it until the coronavirus crisis is over and replace maturing bonds for even longer.

For now, Lagarde is free of some of the problems that dogged her predecessor, notably a lengthy court dispute with German sceptics about the legality of bond purchases that has been put to bed following a constitutional ruling last May.

The European Union is finally progressing on fiscal matters, issuing for the first time substantial amounts of joint debt to finance a 750-billion-euro pandemic recovery fund – giving the ECB more scope for bond purchases and alleviating pressure on some of the weaker members of the bloc.

Former Italian Economy Minister Roberto Gualtieri had already committed to bringing Italy’s debt ratio back down to 2019 levels by 2030 through growth and investment, while the appointment of ex-ECB boss Mario Draghi as prime minister is fuelling investor hopes for growth-friendly reforms.

It is too early to tell whether the euro zone’s rising debt mountain will become a theme for conservatives in Germany’s federal election this September – but for now, coalition sources say they are steering clear of any debate around ECB policy.

But she still has some convincing to do.

Beyond Weidmann and fellow hawks on the ECB’s Governing Council, low rates have infuriated savers, who have seen the returns on fixed income investments disappear and property prices skyrocket in some areas.

Ironically, inflated assets prices make it even more difficult for the ECB to tighten policy if needed as that would likely trigger an economically disruptive market rout.

This and the unspoken need to help governments roll over their debt, known in academic parlance as “fiscal dominance”, meant the ECB was seen as having little choice but to keep the money taps open for the foreseeable future.

“What constrains the ability of the ECB to intervene against inflation is not just fiscal dominance but also the dependence of financial markets on low yields,” said Luis Garicano, a Spanish member of the European Parliament and a professor of economics at IE Business School.

(Additional reporting by Giselda Vagnoni in Rome; Editing by Mark John and Toby Chopra)

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Japan cuts economic outlook in February for first time in 10 months

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Japan cuts economic outlook in February for first time in 10 months 25

TOKYO (Reuters) – Japan’s government cut its view on the overall economy in February for the first time since April last year as an extended state of emergency to curb coronavirus infections battered consumer spending.

Analysts expect the world’s third-largest economy to shrink in the current quarter as renewed COVID-19 restrictions in Tokyo and some prefectures weigh on business activity and household spending.

“The economy shows some weakness though it continued picking up amid severe conditions due to the coronavirus,” the government said in its economic report for February.

The government slashed its assessment on consumer spending for a third straight month, saying it has shown weakness recently, as people avoided eating out and travelling.

But it raised its view on capital spending for a second consecutive month, saying it has been “recovering recently”, reflecting an improvement in core machinery orders.

The government also upgraded its assessment on corporate profits for the first time in two months as they were “picking up while weakness is seen in non-manufacturers” due to the impact from the pandemic.

Manufacturers’ profits improved helped by a recovery in auto production and 5G technology related demand, the report said.

Thanks to brisk demand for communication devices, the government raised its outlook on imports for the first time in two months.

Japanese stocks rose to a 30-year high this week as progress in the distribution of coronavirus vaccines boosted expectations for a global economic recovery. [.T]

Japan’s economy grew for a second straight quarter in October-December, extending a recovery from its worst postwar recession earlier last year.

But new emergency measures cloud the outlook, underscoring the challenge policymakers face in preventing the spread of COVID-19 without choking off the fragile recovery.

Economy Minister Yasutoshi Nishimura said on Friday that Japan’s output gap in October-December was likely around 20 trillion yen ($189.79 billion), compared with over 30 trillion yen in July-September.

“Now is the time for fiscal spending and the government must commit to preventing a return of deflation,” he told a news conference.

He said the output-gap official figure will be released next week.

The government estimates the economy will expand 4.0% in the next fiscal year starting in April, after an expected 5.2% fall in the current fiscal year to March.

($1 = 105.3800 yen)

(Reporting by Kaori Kaneko; Editing by Jacqueline Wong and Kim Coghill)

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Euro zone services hit in February but factories racing along – PMIs

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Euro zone services hit in February but factories racing along - PMIs 26

By Jonathan Cable

LONDON (Reuters) – Business activity across the euro zone contracted again in February as lockdown measures to contain the coronavirus hammered the bloc’s dominant service industry, a survey showed, even as factories had their busiest month in three years.

With daily reported infections still high governments have been encouraging citizens to stay home and closed much of the continent’s hospitality industry while factories have largely remained open.

IHS Markit’s flash composite PMI, seen as a good guide to economic health, nudged closer to the 50 mark separating growth from contraction, registering 48.1 in February compared to January’s 47.8. A Reuters poll had predicted 48.0.

However, some of that activity was from completing old orders. The backlogs of work index fell to 47.9 from 49.0.

“Ongoing COVID-19 lockdown measures dealt a further blow to the euro zone’s service sector in February, adding to the likelihood of GDP falling again in the first quarter,” said Chris Williamson, chief business economist at IHS Markit.

The euro zone economy is in a double-dip recession, according to last week’s Reuters poll of economists, who said the risks to their already weak outlook was skewed more to the downside.

A PMI covering the services industry fell to 44.7 from January’s 45.4, well below the median expectation in a Reuters poll for 45.9.

But with vaccination programmes accelerating, driving hopes for a return to some form of normality, optimism about the year ahead improved sharply. The services business expectations index climbed to its highest since April 2018.

“Assuming vaccine roll-outs can boost service sector growth alongside a sustained strong manufacturing sector, the second half of the year should see a robust recovery take hold,” Williamson said.

Strong demand for manufactured goods helped the factory PMI soar to 57.7 from 54.8, the highest since February 2018 and well above all forecasts in a Reuters poll that predicted 54.3. An index measuring output, which feeds into the composite PMI, jumped to 57.5 from 54.6.

The new orders index also soared and factories hired additional staff for the first time in nearly two years. The employment index rose to 50.9 from 49.4.

(Reporting by Jonathan Cable; Editing by Hugh Lawson)

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