18 December 2019

So you think the banking crisis is over? Sorry to spoil your Christmas!

The stock market is flashing ever-stronger orange about the health of Europe’s banks. Yet the regulatory community tells us good news about its capital strength – despite unsustainably low profitability. Fingers crossed for a muddle through!

Having watched many crises brew up during my decades in the financial markets (two of them at Salomon Brothers in its hey-day of pioneering the derivatives market) there are now some eerie parallels with earlier cycles that are increasingly concerning. Policymakers say they have learnt the lessons and the new rules ensure that the previous crisis cannot be repeated.  However, there is a large light that is flashing ever-stronger orange: the stock markets are sending a strong message about the poor health of EU banks. The average bank stock has hardly risen in 30 years and they have never recovered from the effects of the Great Financial Crisis (GFC) in 2008/9 (See chart below/link). In sharp contrast, US banks have nearly tripled since the post-GFC lows.

EU politicians, central bankers and regulators keep telling us the “good news”: key measures of capital have roughly doubled since the GFC - reflecting the implementation of global rules developed by the “Basel” Committee to strengthen the financial system. Moreover, ‘bad loans’ (“non-performing loans”) have halved since the crisis.

Why is the stock market so worried? Or is just perverse? The European Central Bank(ECB) and the European Banking Authority (EBA) produce learned reports on the banking sector. These highlight the basic problem clearly: Europe’s banks are insufficiently profitable. Their return on the equity that shareholders have paid in is only about 7% - on average – and the ECB now expects it to decline in 2020 and 2021 to 5% for the big banks that it supervises. But the costof their capital is in the 8-10% range – an unsustainable gap in the long run.

My concerns stem particularly from what should be another item of “good news” from the post-GFC regulatory response. Problem: in the crisis, it was found that banks were being economical with the truth about the build-up of loan losses. Solution: change the accounting standards to require them to report quickly on “expected” loan losses, rather than waiting years to report what was actually written off.  As I have seen several times in my career, once a crisis develops, the attitude of stakeholders (shareholders, bondholders and depositors) can turn very quickly from greed to hope, and finally to fear of unknown (but potentially disastrous) loan losses.

The new accounting standard (IFRS 9) is now in force so that there should only be a fear of reality: swiftly-reported “expected losses” if there is significant deterioration in the economy. Recently, the EBA reported on risks and vulnerabilities and found an increasing share of banks are expecting a “deterioration of asset quality” – bureaucratic-speak for rising loan losses. The leading credit-rating agency – Moody’s – has just downgraded EU banks for exactly this reason. If loan impairments push a bank into loss, then it will be under pressure to raise more capital to compensate. Where will the new capital come from?

Highly profitable banks could generate the required capital quickly by retaining more of their earnings rather than paying it out as dividends. But the ECB’s forecast of low - and declining -profitability suggests that will not be possible in the EU. However, it forecast the average of all banks. Many banks are above these averages, but - by definition - many are below the average and could be a weak link.

But here comes more “good news”: the EU has enacted the BRRD (Bank Recovery and Resolution Directive) to enable failing banks to be `resolved’ (re-capitalised by someone other than the state, sold to a strong bank or liquidated if all else fails) over a week-end. You can enjoy Christmas if you believe that - in a crisis - BRRD will function as intended because, implicitly, you believe there is not a   chain to break. But it seems that not even the regulators believe that! The European Parliament recently published a report stating that “very few European banks could be described as resolvable” if they had to meet the regulator’s (currently only draft) standards.

To complete the “good news”, the third iteration of the Basel rules must soon be put into EU law. Even the EBA thinks that will require about 10% more capital in the banks. They will then be super-safe, but the same question again: where will this capital come from? Will shareholders be willing to buy new shares? The EBA has calculated that only a quarter of EU banks’ share are priced above their “book value” so a major issue of shares would dilute the value of existing shareholders. Naturally, they may not be keen to agree to such a policy.

Are there other solutions? Even today, bankers are not popular with citizens so it is difficult for politicians to advocate that banks should “double their profits” - or at least push them up by more than 70% to match US banks. But such a rise in profits would solve the problems easily.

The EBA rather lamely suggests cutting expenses is “presumably” the main route to increasing profitability. But there is another simple and quick solution for an individual bank: cut the size of its balance sheet so that the existing capital arithmetically becomes a higher proportion of its assets – as required by the regulator. However, in aggregate that would spell disaster for the already-fragile EU economy as the supply of credit to firms and individuals would be reduced. That might induce another round of “expected loan losses”; perhaps actually putting banks into losses that reduce their capital.

The dreaded vicious spiral could then be underway – ironically, triggered by the well-meaning and individually-sensible policies enacted after the GFC. Let’s keep our fingers crossed for unexpectedly good growth and hope we can “muddle through” – it may work!  Happy Christmas.

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Note:this article has been published by Euractiv as an Op-Ed

© Graham Bishop