European Banks: the nightmare continues

European banks must raise more capital at a time when their share prices are depressed and the probability of a European recession in 2020 is increasing. Even if Boris wins, the UK may be unable to avoid the fallout, writes Victor Hill.

A warning from the EBF

A report issued by the European Banking Federation (EBF – a trade association which represents 32 national banking associations across the EU and EFTA) on 22 November contains a stark warning. Compiled by Copenhagen Economics, the report envisages that the regulatory structure for banks known as Basel III– which provides a comprehensive framework for bolstering bank capital adequacy – could reduce the volume of bank lending in Europe by €2.9 trillion over the next 10 years. That, in turn, could diminish economic growth to the tune of 0.5 percent of GDP every year.

I reflected last week on a research paper produced by Citi Group which observed that while quantitative easing (QE) was back and rising fast, liquidity generated from new bank lending activity is on the wane (and I implied that there is a causal connection between the two). This week I want to explore how the framework of European banking regulation, which is largely designed to sustain the European single currency, is having an effect that is inimical to Europe’s growth prospects – and therefore to the continent’s continued prosperity as a whole. And especially inimical to the prosperity of its weaker members.

Europe’s banks will have to raise up to €400 billion of new capital in order fully to comply with the Basel III rulebook. That is a big ask when their share prices have been falling. Just consider that the Euro Stoxx 600 Bank Index (SX7GT)has halved in value since 2015. It is down by nearly 14 percent on a 12 month basis.

The alternative to raising new capital if that becomes unfeasible would be to shrink their balance sheets by liquidating loan portfolios. That course of action, replicated widely, would be highly deflationary short-term and would starve businesses of investment capital medium-term.

Basel III was promulgated after the financial crisis of 2008-09 in order to avoid any possible future systemic banking crisis. Not only did it raise minimum bank capital ratios (of which the leverage ratio is just one metric), it also set forth a portfolio of risk models by which banks can evaluate the relative riskiness of their exposures. I have written elsewhere around how these statistical bank risk models are conceptually flawed. But for now, let’s just agree that they incentivise banks to avoid high-risk activities (like lending to exciting young businesses) and to stick to boring low-risk things (like buying government bonds, thus, in the case of Italy, perpetuating the doom loop for evermore). This entails a perverse race to the bottom of the growth stakes.

Total bank assets across the EU, the report estimates, will have to be reduced by as much as €4.6 trillion in order for European banks to be Basel III-compliant. Obviously, as a bank de-leverages so its return on equity declines. This is one reason why European banks’ shares have fared so poorly on the bourses. Furthermore, in a zero or negative interest rate environment, European banks have to pay the ECB for the privilege of parking funds there.

The Basel III package of regulations, already adopted by larger international European banks, will become universal in 2022 and will be progressively tightened over the subsequent five years. It provides not just for the management of credit risk (the risk that a borrower might default on its loan obligations) but also for a range of other kinds of financial risk such as operational risk (traders going berserk, fat finger syndrome and so on). Copenhagen Economics thinks that the framework will not make the banking system much safer and that it is fraught with unintended consequences.

The key criticism of Basel III is that it is a one size fits all solution which ignores the role of bank culture in prudential regulation at both the national and corporate levels. It encourages box-ticking tunnel vision driven largely by credit ratings (and related internal ratings-based risk models).

Outside Europe, things are done differently. American banks have not signed up to Basel III but are regulated by the slew of legislation that followed the financial crisis of 2008-09 in the early Obama administration – notably the Dodd-Frank Wall Street Reform and Consumer Protection Act (2010). Large US banks are very nearly at their target levels of capital and will only have to raise another 1.5 percent of new capital. Asian banks have followed the development of Basel III very closely and have adopted similar risk models but have avoided the straight-jacket favoured by the Europeans.

In the UK, the banking regulator – the Bank of England – has implemented its own iteration of Basel III which, in some respects, is even more onerous. For example London requires banks to maintain larger liquidity buffers than in Europe. These theoretically reduce liquidity risk – the risk that banks might run out of cash in adverse market conditions (as opposed to solvency risk – the risk that they will run out of capital). Copenhagen Economics thinks that British banks will have to raise up to €70 billion of new capital in order to be fully Basel III-compliant.

The European Banking Authority (EBA – the ultimate bank regulator within the eurozone) released its own estimate in August. This was that European banks would have to raise their Tier 1 capital (equity plus disclosed reserves) by an average of 24 percent. This, it calculated, would amount to €91 billion of new capital to be raised (excluding the UK), despite a modest improvement in the level of non-performing loans. This was less than a quarter of Copenhagen Economics’ estimate of €400 billion.

A decline in debt quality

There is evidence that the slowdown in traditional bank lending is leading to a rise in the so-called shadow banking sector. The EBA claims that shadow lending increased by 75 percent between 2010 and 2017. A private equity man recently told me that the main game in the private equity space these days is high-yield corporate lending at rates of 8 percent or more. This kind of lending, paradoxically, is almost entirely unregulated.

Private equity, by the way, has been one of the key drivers of de-equitisation – the process by which the number of listed entities shrinks – which is now gathering pace. The total number of listed companies in the EU has plummeted by a quarter to around 8,000 in the space of a decade. With fewer listed entities, market liquidity decreases and, potentially, price volatility increases. Companies which are not listed obviously cannot easily raise new finance by issuing new shares and are therefore more likely to seek debt finance.

The IMF warned last month that high-risk debt (defined as debt owed by companies where the interest cost is higher than corporate profits) amounts to about $19 trillion or 40 percent of all corporate debt outstanding. That is way above the level of such debt in 2008. The total volume of global debt outstanding, including government debt (which crowds out corporate debt), is expected to reach £197 trillion by the end of 2019 according to the Institute of International Finance.

And on 18 November Moody’s predicted that Europe will be struck by a tsunami of defaults in the next downturn. The proportion of bonds graded as “speculative” has doubled in Europe over the last three years.

A new European deposit insurance scheme

Earlier this month we saw further evidence that German resistance to greater eurozone integration is weakening.

Two years ago President Emmanuel Macron laid out his proposals for eurozone reform, including a eurozone ministry of finance which would be headed by a European finance minister who would preside over a European budget. Only then could the European banking union be completed, the French argued. But since then German leaders from Frau Merkel downwards have politely declined such proposals – especially any plans (including a common deposit insurance scheme) that could make Germany (and thus German taxpayers) a lender of last resort if other countries’ banks were to get into trouble.

On 04 November, however, German Finance Minister Olaf Scholz published an opinion piece in the Financial Times calling for a European deposit insurance scheme amongst a number of measures to complete the European banking union. This attracted wide attention, particularly among Herr Scholz’s conservative coalition partners in the Christian Democratic Union CDU. (Mr Scholz is from the Social Democratic Party (SDP).)

What he is proposing is a deposit reinsurance scheme as a back-up to national schemes, but this is still a significant policy shift. He also proposed that banks hold capital against sovereign debt exposures. Actually, this is already part of Basel III by terms of which capital allocated is a function of the rating of the exposures. But the Italian banks are clearly in his sights here.

He wants common insolvency laws for banks and common corporation tax rates to be applied across the EU to all banks. He proposes common accounting rules for the calculation of company profits. This could have huge implications for the eurozone if it led to a harmonisation of tax rates more generally, especially a common level of company taxation (which would have massive impact on the Republic of Ireland’s economy).

Herr Scholz’s article came just as France’s Christine Lagarde assumed the presidency of the ECB. She is expected to make the case that aggressive monetary policy without corresponding fiscal policy is futile. She has previously advocated the completion of the banking union, including a Europe-wide deposit insurance scheme. A common deposit insurance scheme would guarantee depositors up to a proposed €100,000 in the event of bank bail-ins in a future banking crisis.

For policy-makers of a federalist inclination the challenge is why the eurozone architecture was so poorly designed in the first place. But now it seems as if the political climate is changing and that resistance from Berlin based on the notion of German exceptionalism is fading. The real dynamo for European political and economic integration remains France’s President Emmanuel Macron, with Madame Lagarde acting as his mouthpiece in the corridors of Frankfurt.

The German question

Germany just avoided a recession in Q3 2019 with a +0.1 percent growth figure but is still in the slough of despond. The country’s manufacturing sector has stabilised after two years of contraction but is cutting back. Daimler AG (ETR:DAI) announced a worldwide cull of 1,100 managers warning that it will take two years or more to manage the transition to electric vehicles and to shake off the reputational damage of the diesel scandal. Daimler’s share price has fallen by 40 percent since 2015 and its market cap is now below that of Tesla (NASDAQ:TSLA).

The German Council of Economic Experts has stated that a sustained 10 percent decline in exports to China will cut German GDP by nearly 5 percent over four years. But as China climbs the technology ladder and resorts to import substitution, that prospect becomes quite probable.

Frau Merkel’s coalition government is wedded to the “black zero” regime of balanced budgets, though there will be extra spending on green projects amounting to 0.4 percent of GDP annually over the next five years. Some commentators believe that Germany’s infrastructure is greatly in need of investment and that the country is lagging behind in digital technology and AI. Net public investment has been negative almost every year since the early 2000s and some of the Länder (states) are insolvent. Hence there is growing pressure for a budgetary framework that separates current spending from investment, as in the UK.

There could be a general election in Germany in 2020 if the SPD walks out of the grand coalition with Frau Merkel’s CDU at its party conference to be held next week (06-08 December). If that happens, it is quite possible that the combined CDU and SPD will poll less than 50 percent of the vote for the first time since 1949. That could open the way for a left-of-centre coalition of the Greens, the SPD and Die Linke. Such a coalition would be much more favourably inclined towards the notion of “risk-sharing” in the eurozone, for example by debt mutualisation (where all eurozone government bonds are mutually guaranteed).

Consequences

The above survey of the European banking landscape might seem a bit dry for non-economists – so let’s try to distil three main themes that I believe will become paramount in 2020.

Firstly, even if Mr Johnson manages to secure a majority of Tory MPs on the night of 12-13 December (an if not a when) he will face an existential problem in 2020. We presume that the Tory cohort, all of whom have pledged to support the Johnson Withdrawal Agreement, will carry the UK over the line (horrible phrase, I know) by 31 January. Mr Johnson will then be negotiating the prospective UK-EU trade deal at precisely the moment when the forces of European integration are intensifying – and very possibly against a backdrop of recession.

The EU will be much less inclined, for example, to permit the UK to end freedom of movement when the drumbeat of European solidarity is at its loudest. This entails, inter alia, that the EU shares out the influx of refugees (economic migrants) in a “fair” manner. The European Court of Justice (ECJ) has already declared that Europe is a demos.

Secondly, the possibility of a recession in 2020 in Europe is increasing. Europe is looking much more fragile than either the USA or China – though I shall share my concerns about China shortly. If a recession does happen that will put a grave burden on the banking system which will retrench further, thus further restricting the flow of capital to new businesses even more.

If the Anglo-Saxon intellectual traditions of empiricism and pragmatism prevailed in Europe then the European elite might question the impact of monetary union and its deflationary consequences. They might reflect that a poor growth performance long-term – which is very much the outlook – will only relegate Europe in the international league tables.

But those traditions do not prevail: au contraire, the Europeans, who pursue an ideological outlook (derived, as I have explained in these pages before, from Rousseau-Hegel-Marx) have concluded that the only solution is more Europe – more fiscal and therefore political integration. There is nothing that Anglo-Saxons can do to argue them out of this belief-system (for such it is). The direction of travel is ineluctable as German reticence erodes. Madame Lagarde declared on Wednesday (27 November) that support for the euro is at an all time high.

Eventually, not necessarily next year, there will be a reckoning in the European banking system. Mr Johnson’s Withdrawal Agreement (and putatively any Labour variant) will ensure that the UK will not be a passive by-stander.

Third, as I touched upon last week, there appears to be an inverse correlation between the rise of QE and the provision of private credit in the economy – though, to my knowledge, no serious economist has really got to grips with this yet. QE inflates asset prices and therefore is of most benefit to the rich, thus increasing the divide between the haves and have-nots. That is the case even when QE is pursued by ideologues with a socialist mindset.

Messrs Corbyn and McDonnell dream of getting their hands on the levers of the money machine. Their National Transformation Fund could issue bonds, so they believe, which could be gobbled up by the Bank of England ad infinitum to finance all kinds of right-on madcap schemes.

This Socialist paradise might be only two weeks away as I believe the opinion polls are awry. I’ll have more to say about that next week.