European Banks: Please Assemble at the Muster Station
As seen in the latest issue of Master Investor Magazine.
We really do hate to interrupt your cruise. But there’s a rumour that a keen-eyed crewman on the bridge has spotted an iceberg. No, it’s worse than that, actually. Some of the crew are whispering that we’ve already hit an iceberg. But it’s just a small one, apparently. Anyway, don’t panic. Just keep that life jacket under your arm during the cabaret…
Many people first became aware that something was awry in the European banking sector when, on Monday, 08 February, shares in the German giant Deutsche Bank fell by nearly nine percent and then by a further five percent the following day, hitting a thirty-year low. Deutsche Bank perambulated its CFO who announced that bondholders should have no fear. But German Finance Minister Wolfgang Schäuble still had to go on Bloomberg to say that he had “no concerns about Deutsche Bank”. That’s unusual – particularly in Germany.
The sell-off took place after the unremarkable announcement that the bank would have to write down some loan exposures for the last quarter of 2015. It seems that some of these are related to the oil and commodity sectors. But that was not the proximate cause. It seems that the stock market was convulsed by fears that Deutsche Bank did not have sufficient funds to meet interest payments on hybrid instruments that it uses to bolster its capital base. The bank, which has been the subject of takeover speculation in the German press, of course paraded all the latest glossy statistics on the level of its Tier One Capital in attempt to allay such fears.
In fact, shares in the European banking sector are having an even worse year than the Shanghai Index overall – some banks worse than others. On 15 February the STOXX Europe 600 Banks index was down by 28.26% over 52 weeks; but down by nearly 22% in the first six weeks of 2016[i]. In contrast, the STOXX USA 900 Banks Index was down by 13.22% over 52 weeks and by 15.83% year to date. Mind you, Japanese banks have fared worst of all, losing about one third of their value this year.
Deutsche Bank hit the headlines because of its symbolic prominence as the most enduring bank of Europe’s largest economy – though its shares then bounced back by ten percent on Wednesday, 10 February when it announced plans to launch a bond buy-back programme. (Another very unusual move, by the way.) In fact, the entire sector has become jittery. Why?
If you believe that markets move for a reason there is always, at bottom, a reasoned explanation. It seems that Mr Market thinks that – sooner rather than later – in a world of bombed-out commodity and oil prices (itself a foretaste of the threatened global deflation about which I wrote last month) one of those big commodity and or oil majors is going to go pear-shaped. What’s more, sovereign default is back in the frame. This time it’s not just Greece (which is still in trouble) but oil-dependent states like Venezuela.
And when the defaults occur, lenders will take massive hits. In fact, there could be lenders which fail as a result. And when one bank fails, there is the risk of contagion, or, as economists have it, systemic crisis.
But is it really possible that after all we went through during the Credit Crunch of 2008 (not to mention its prequel (Northern Rock, Bear Stearns etc.) and sequel (sustained recession)), the bailouts, banking reforms, Basel III, pro-active prudential regulation, quantitative easing, the European Sovereign Debt Crisis, the Greek, Portuguese and Irish bailouts, debt work-outs and pious words… that we could be back to 2008 with a banking system about to go into melt-down? I can hear John McEnroe screaming: You cannot be serious…
Well, I’m afraid that it is possible, for reasons I shall explain – though not very probable. The real point that I want to make is that the banks’ best days are behind them.
It is true that those commodity outfits are bombing. On 10 February – the day that Deutsche Bank bounced back – miners listed on the FTSE-100 endured a drubbing. Anglo American was down almost 10% at 339.20p, Antofagasta was down 8.9% at 412.90p and Glencore was down more than 7.3% at 95.28p. Their one-year charts all look like a suicide leap.
Yet unlike in 2008 the household sector is robust. Consumers, especially in the US, have more savings and less debt than eight years ago. Back in 2008, the average US household saved only 2.5% of after-tax income; today it’s about 4%. Household debt as a percentage of net worth (a sort of personal sector debt to equity ratio) hit 65% during 2009, today that figure has fallen to 36.5%. The average debt service as a percentage of income has fallen to 15% today from 20% in 2009. So households are in a stronger position today than they were when the last crisis hit. That means consumer spending should remain robust for the foreseeable future, which should continue to drive the economy.
And yet the warning lights have been flashing for months on the central bankers’ dashboards. But the underlying dissonance in the European banking sector has been muted by the orchestral volume of the European Central Bank’s QE programme, conducted by Signor Draghi. Though, it is in Signor Draghi’s home country that the banking system is in the most advanced state of decay.
According to recent research from Oliver Wyman, European banks are carrying more than €580 billion in non-performing loans (NPLs)[ii]. Italy holds the largest stock of NPLs at €161 billion or eighteen percent of the total – with SME loans making up 78% of Italy’s NPLs. This compares with a level of about eight percent in Spain. And by the way, there are still issues around precisely when a loan asset is designated an NPL. This leads me to think that these numbers could be underestimates. (Indeed, researching this article, I have found that there are glaringly incompatible figures in circulation.)
Several Italian banks have already hit the crash barriers. In Q4 2015 four Italian savings banks were recapitalised, partially or wholly by means of haircuts for depositors. Prime Minister Matteo Renzi forced depositors to bear losses in bank restructurings. Remember that when taxpayers pay the price of rescuing a bank, that’s called a bail-out. But when depositors are penalised in order to rescue a bank, that’s called a bail-in. Taxpayers, mind you, don’t commit suicide as a result of bail-outs; whereas depositors who have lost their life savings due to bail-ins sometimes do. This has cost Signor Renzi popularity.
Despite government measures, there is very little by way of a secondary market for impaired debt in Italy. Hence the Banca d’Italia is calling for a bad bank – a special purpose vehicle designed to purchase and dispose of NPLs on the Irish model. Yet Prime Minister Renzi has found it politically impossible to realise this.
Under the EU Bank Recovery and Resolution Directive (BRRD, 2014) shareholders and creditors of a failing bank must be bailed-in before any state funds can be mobilised to recapitalise a bank. Shareholders and junior bondholders are hit first, followed by senior bondholders and depositors with balances of more than €100,000. The aim of the Directive was of course to move the pain of bank recapitalisation from governments to banks’ investors and savers. But because many junior bondholders in Italy tend to be retail investors – who have been encouraged to enhance yield by buying bank bonds – many depositors are also bond investors, and so are doubly penalised.
In July 2015, when a small mutual bank, the Banca Romagna Cooperative (BRC), ran into trouble, the Italian government’s first instinct was to use funds from the national Deposit Guarantee Insurance Fund to inject new equity. But this move was prevented by Brussels. Instead, the entire cost of the recapitalisation was borne by shareholders and junior bondholders.
Then, on November 22 last year, just before the EU directive came into effect, the Italian Bank Resolution Fund, (which is funded by the country’s healthy lenders but guaranteed by the state-owned Cassa Depositi e Prestiti), paid €3.6 billion to restructure another four small banks: Banca Etruria, Banca Marche, Carichieti and Carife. €1.6 billion was paid to buy up a slew of NPLs and to shove them into a hastily formed toxic bank. The remaining €1.75 billion was invested in the banks’ equity capital. Even so, 12,500 small investors who owned €430 million in junior debt had their investments wiped out. One elderly pensioner hanged himself[iii].
The government rushed through the hybrid rescue package before the new regulations took effect because it feared that a full bail-in of the four banks could have triggered a bank run throughout the country. It was forced to impose losses on some retail investors after the EU rejected an alternative scheme that would have spared them, saying it violated EU state aid rules.
Banca Etruria, based in Arezzo, Tuscany, was the only one of the four to have been listed on the Rome bourse, so should have displayed greater transparency. The four banks were put up for sale by the Banca d’ Italia in late January with Oliver Wyman as the advisor. So far, there are no takers.
In late January this year attention was focussed on Italy’s oldest bank, Banca Monte dei Paschi di Siena (BMPS), which goes back to the age of the Medici. After it failed a so-called Asset Quality Review conducted by the ECB in late 2014 it won regulatory approval to restructure. In May 2015 it raised €3 billion in new share capital. But since then it has failed to offload much of its €42 billion in bad loans (about 31% of its total loan portfolio). The bank’s share price has fallen by more than two thirds since the May 2015 share issue.
In 2012, Italian households held more than €370 billion of junior bank bonds. Hitherto, bank bonds have accounted for 40% of retail investor portfolios in Italy, but now Italian investors have woken up to the increased risks. Many investors have declared that they were not alerted to the risks involved. Prime Minister Renzi has admitted that some of the bonds might have been mis-sold, and has set up a €100 million compensation fund. Regulators are now calling for a ban on the sale of junior bank debt to retail investors.
It is fair to say that both the popularity of Signor Renzi’s government and that of the EU have been damaged. Italians are already aggrieved by the migrant crisis and by the refusal of the EU to permit the state to prop up Italy’s ailing steel industry. Euro-scepticism is clearly not a British monopoly.
Italy has long maintained a network of tiny local banks which have served not only as financiers but as wealth advisers for families around the country. Despite some consolidation of the banking industry in recent decades, Italy still has about 650 lenders – probably the highest number in Europe. Anecdotally, poor governance is common. The Italian banking sector is further undermined by the inefficacy of the judicial system, which is notoriously slow and often stymies the swift settlement of bankruptcy disputes.
In the last week of January, Italy and the EU struck a deal to approve a new government guarantee scheme that will help rid the country’s banks of their huge NPL piles. Investors were unimpressed, and bank shares fell. Italy has thus far been unable to attract the hedge and private equity funds such as Cerberus and Apollo which obliged, for example, Lloyds Bank and Royal Bank of Scotland in the UK when they wished to discard their dross (at a deep discount to book, of course).
Portuguese bank shares have also tumbled not least because the new left-of-centre coalition government spooked the market by imposing losses on senior bank bonds last December. And let’s not even think about Greece where bank shares have fallen by 60% this year.
The new EU directive owes more to what happened in Ireland during the Credit Crunch than anywhere else. In the middle of the post-Lehman Brothers market meltdown in September 2008 the Irish government offered blanket guarantees to all bank creditors. This was partly a response to the more hesitant stance of the UK government; but it had global consequences – and Ireland paid a very high price. The entire Irish banking sector had to be bailed out to the tune of €64 billion or about one third of the country’s total GDP at the time. All of this money came from the Irish government, which in turn had to be bailed out by the EU in 2010.
Another concern in the European banking sector is the rise and rise of so-called CoCo bonds which count as Additional Tier 1 Capital. These are bonds which can be converted into equity in a crisis, or contingent convertible bonds. Though they are untested, they currently offer a cheaper alternative to equity capital. The total size of the CoCo Bond market is now estimated to be close to the volume of sub-prime mortgages floating around in 2007, although in my view the comparison is not illuminating.
Then there are the ongoing fears that some European banks – Deutsche Bank included – will face more litigation and fines from regulators. This is on top of arbitrary taxes and negative interest rates (now official in countries like Switzerland and Sweden). As recently as last November Barclays was fined £72 million by the FCA for failing to minimise the risk of financial crime. That’s another reason why it is becoming more difficult for ordinary citizens to open a bank account.
Another factor is that exposure to bank stocks seems to have been increasingly skewed of late to Exchange Traded Funds (ETFs). Thus you can get exposure to the banking sectors of almost any European country, or all together, by buying into these vehicles. But, because they are leveraged, they tend to be volatile.
One narrative that has been rehearsed of late is that banks simply cannot flourish in an environment of super-low rates. The idea is that the higher rates, the higher bank margins and therefore the higher the bottom line (net interest income). But this is only true is certain cases. In times of super-low rates like now banks can reduce their cost of funds to negligible levels. Just consider what returns you receive on your savings account. You will be lucky to get a half of a percent. But your bank can lend your savings out as a residential mortgage for a house-buyer at around four percent right now. So the bank is still turning three and a half percent on the deal – and for a relatively low-risk form of secured lending. If the cost of funds was twelve percent and the interest charge on mortgages fifteen and a half percent, they would be making just the same net interest income.
Yes, European banks are under stress, but most commentators will argue that they are probably not as dangerously exposed to widespread default as back in 2008. And they have been put under pressure by regulators to strengthen their capital bases. They have achieved this by, in many cases, shrinking their loan books, or by issuing new equity, or by a combination of the two. And it is true, on paper at least, with a few exceptions, that their capital ratios look robust. Most large banks now have tier one capital ratios in the low to mid-teens. RBS’s Common Equity Tier 1, for example, is around 15% and, according to the Bank of England’s recent stress tests, would fall to a low but not critical 6% in a crisis. RBS’s core capital ratio in 2008 was just 4%.
But actually – this is still a subject of debate – the 2008 Credit Crunch was not just due to banks having inadequate capital: it was also a liquidity crisis. That was why regulators, not least the Financial Services Authority (FSA) in the UK, took steps to ensure that banks carried sufficient liquidity cushions at all times to withstand a major liquidity crisis. These measures were further elaborated in the Basel III provisions put forward by the Bank of International Settlements (BIS) based in Basel, which is a kind of club of all the major central banks. Further, the Basel III provisions were effectively made European law by the EU Capital Requirements Directive IV (CRD4, 2011) and by an attendant instrument called the Capital Requirements Regulation (CRR), otherwise known as the single rulebook.
So banks now have to keep adequate capital buffers against losses and liquidity buffers in case the credit markets seize up as they did in September 2008. The adequacy of both the capital buffers and the liquidity buffers is determined by adherence to strict ratios. In the case of liquidity, banks have to show that they have unencumbered high quality liquid assets – that is assets that can be converted into cash quickly – sufficient to cover all net cash outflows in the event of a hypothetical “stress scenario” (that is, a crisis). There is always, of course, an opportunity cost to additional liquidity.
Global stock markets have been falling throughout January and February not because of explicit concerns about the banking sector but because of the downturn in global economic growth, which began in China. (Mind you, China’s current problems originated from its government’s intervention in the banking system to crank up lending artificially). Most pro-market economists think that the stock market itself is a fairly good bellwether of where the global economy is going. And an economic downturn means an increase in corporate and personal default rates: and that means more losses for banks.
Before the Credit Crunch of 2008 the banks had enjoyed more than twenty years of faster growth than the global economy as a whole, and the share of financial services as a percentage of the total economy in both the US and the UK – and elsewhere – had risen to record levels. This crisis – if it is one – follows seven years of bank deleveraging in which the role of the financial sector has relatively declined. More rigorous prudential regulation – those capital and liquidity buffers – plus the decline of lucrative instruments (and fraudulent practices – vide the LIBOR scandal) have attenuated banks’ return on equity. It is no longer the favoured sector that it once was.
Banks are also facing new competition from alternative funding sources, not least peer-to-peer lending (P2P) and crowdfunding, though even those unicorns at Silicon Roundabout funded by private equity and P2P debt still need banking services.
And consider this. Those all-important capital cushions are made up of either retained earnings or common equity. When the banks were raking in huge profits, they were also building up their capital buffers rapidly. In the anaemic environment of Post-Credit Crunch banking, with earnings down, their capacity to top-up those capital buffers every year is reduced. That means that many banks have had to resort to rights issues – to the tune of €250 billion for European banks over 2007-14. But reduced profit combined with more shares in circulation – that’s the classic recipe for a fall in share prices.
There has been a lot of froth in the financial media in recent weeks as to whether we are back to 2008. I don’t think so – this is 2016. But in some ways, while a systemic banking collapse in Europe is, in my view, unlikely, the outlook for banks is gloomy. They have become stable state companies (about which I wrote in my blog article of 15 December last year – Investors Should Understand the Company Lifecycle). Their prospects for growth and expansion are less favourable than for the economy as a whole. Therefore, the main motive for holding their shares is the dividend income to be obtained. Woe betides banks – like Deutsche Bank – which cancel their dividend.
On a macro level you don’t have to be a pessimist or a cynic to doubt whether the new stricter bank risk management framework will make much difference in the long term. The banks are still using risk models which (without getting technical) rely on the predictive capability of past default data assuming that it is normally distributed. (In other words – the data conforms to the mathematics of the Bell Curve.) In this model, events which represent six standard deviations away from the mean simply cannot happen.
The problem is that freak losses do happen more frequently than they should. The stock market crash of October 1987 was, in risk model terms, a twenty standard deviation event. That’s an event which is only supposed to occur a couple of times in the history of the universe. (Not really much consolation if you lost your shirt.) Brilliant minds like those of Taleb and Mandelbrot have explored precisely why these risk models don’t work; but my point here is simply this: they don’t work[iv], and the experts know they don’t work. Even the most sophisticated statistical risk models cannot accommodate Black Swan Events. They deal with known unknowns; whereas most risk resides in the unknown unknowns quadrant of the risk universe matrix.
In the same way, a buffer of liquid assets may not be a buffer at all if credit markets seize up and the bid-offer spread rises to gigantic levels, as in 2008.
And, by the way, the Credit Crunch – as Taleb has written – was not a black swan. It was predictable. It was a big fat ugly pigeon which all intelligent people could see would, sooner or later, crap on our heads.
The view in the City is that the new-style banking regulatory regime in the UK is at least as good as it is in the Eurozone – where the Capital Requirements Directive has been universally adopted. As I write, Sir John Vickers, who previously served as Chief Economist at the Bank of England and chaired the Independent Commission on Banking (ICB) (though it is unclear whom he represents now) has proposed that banks’ so-called countercyclical buffers (which are held additionally to Core Tier 1 Capital) should be increased from 2.5% to 3%[v]. To the layman this probably seems like medieval theology; but the point is that no one can come up with a universally accepted definition of how large bank capital buffers should be. It’s more a matter of judgment than of mathematical calculation. So this tedious argument will never really go away.
But so long as risk aversion dominates the mind-set of nanny policymakers, the pressure on banks to bolster their capital will persist, and bank profitability will suffer accordingly.
Looking out on deck, I think we are about to be hit by a nasty wave. But there ain’t no iceberg. This is not a red alert. But please assemble at the muster station – if, that is, you wish to join a jollier cruise. This one – the banking cruise – is going nowhere through choppy waters. And if I am right about the probability of global deflation setting in over the medium-term, as I argued in last month’s Master Investor Magazine (Deflation? It’s behind you!), then you can expect a long bout of sea-sickness too.
[i] https://www.stoxx.com/index-details?symbol=SX7P
[ii] See: http://www.consultancy.uk/news/3251/oliver-wyman-to-advise-on-sale-of-rescued-italian-banks
[iii] See: http://www.reuters.com/article/italy-banks-bonds-idUSL8N1490SJ20151221
[iv] If any readers wish to investigate the theoretical background to this I would direct them to The Black Swan (Penguin, 2010 edition) by Nicholas Nassim Taleb and to The (Mis)Behaviour of Markets (Profile Books, first published 2004) by the late incredible genius Benoit B Mandelbrot. Note that Taleb dedicated The Black Swan to Mandelbrot. Mandelbrot, who developed fractal geometry, foresaw that in future better risk modelling might be achieved by the application of fractal mathematics – but we are still waiting for a breakthrough.
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