Banks
Battling to Survive
By
Pater Tenebrarum
Yesterday we had the opportunity to attend a presentation by the
treasurer of a European bank, which discussed the problems the European banking
sector faces since the beginning of the crisis era in 2008.
Many of these problems are obvious, but some of them are perhaps less
so. There are on the one hand the regulatory pressure to increase capital, a
plethora of new regulations and taxation that refers to the size of a bank's
balance sheet, regardless of its profitability. While such taxation only
amounts to about 20 basis points, it has to be seen in the context of currently
available margins in the banking business, which are dismal – once on does
that, the number actually strikes one as quite large.
Regarding the regulatory regime, European bank managers these days
apparently spend more time satisfying the demands of a whole horde of regulatory
bodies (a bank with a decent pan-European presence can count on having to deal
with up to 25 different regulators), all of which continually want to play
through stress test scenarios or are demanding data on this or that. Everything
has to be done to the perfect satisfaction of the bureaucrats concerned with
these oversight activities, down to the color of the paper the presentations
are printed on. The problem is of course that this is distracting managers from
what they should actually be doing, namely focus on the business.
Given the crisis situation, one should not be surprised at this sudden
avalanche of regulatory demands. However, as we have often pointed out
here, in a free banking system with 100% reserved sight deposits, all of
this would be completely unnecessary.
The most important problem faced by banks though are their funding costs
relative to the interest rates they can charge on loans.
Exploding
Funding Costs, Shrinking Interest Rate Margins
As a side effect of the crisis and the reaction of the ECB as well as
the Brussels based eurocracy to it, banks now have to deal with a funding
situation that is markedly different from what pertained prior to 2008.
One can infer the funding costs in terms of bond issuance via the
i-Traxx (ITRX) indexes on senior and subordinated unsecured bank debt. In
pre-crisis days the 5 year ITRX on senior unsecured financial debt traded below
50 basis points. Now, even after the ECB managed to calm the markets with its
'OMT' announcement, it stand at about 300 basis points.
The impact of the crisis on funding via customer deposits has been even
more remarkable. In 'normal times', a bank could count on having to pay less
interest on sight and savings deposits than was available in the money market
in terms of 3 month EURIBOR rates. Thus it was possible to simply lend on
deposits in the money market and thereby earn a small, but fairly 'safe'
interest margin. Since EURIBOR began to plunge in late 2008, the relationship
has reversed: since then customer deposit interest rates have remained
stubbornly above 3 month EURIBOR rates. There is no longer a relatively
risk-free spread that can be earned in money markets. On the other hand, banks
are loath to do without customer deposits, as they are regarded as a 'sticky'
funding source. As an example, a hedge fund may very quickly withdraw its funds
in a developing crisis situation. Most small depositors are far slower to react
and often don't react at all. Cyprus is in fact a good example for this, as
only a small percentage of depositors actually fled the Cypriot banks, in spite
of what were rather obvious warning signs. In addition, we can probably assume
that a certain portion of those who did withdraw their deposits from Cypriot
banks in time had insider information regarding the impending depositor
'haircut'. In short, even though customer deposits have become a headache in
terms of cost, they provide banks with an invaluable liquidity buffer in the
event of worsening crisis conditions.
One major reason why the cost of funding in terms of bond issuance has
shot up – a situation that is unlikely to reverse anytime soon – is in fact the
Cyprus affair. Even though euro area politicians continually stress the
'uniqueness' of the Cyprus 'bail-in', any halfway awake investor knows that
'bail-ins' are now indeed the new template for dealing with insolvent banks in
the euro area.
The Bundesbank brief to the German constitutional court, which we've discussed in a previous article, inter alia contains the Bundesbank's
opinion on ELA (emergency liquidity assistance) financing. On this point the
BuBa remarks that the ECB should be far more circumspect about granting
ELA and that insolvent institutions should simply be wound up. Bond investors
therefore are nowadays poring rather attentively over bank balance sheets in
order to calculate what precisely their risk in the event of a bank failure is.
Equity capital is the initial buffer, then comes subordinated debt and
senior bondholders are next in line. However, many European banks have issued a
great many so-called 'covered bonds'. The cover pools that stand behind these
covered bonds have to be deducted from the assets available for distribution to
bondholders: a great number of mortgage loans as well as sub-sovereign
securities that sit on bank balance sheets can actually not be touched by
these unsecured creditors if they back covered bonds. Thus a unique feature
that has contributed to the perceived safety of credit securitizations in
Europe has now ended up putting notable pressure on bank funding costs. Indeed,
these days the financing costs of financial intermediaries are a great deal
higher than those of non-financial corporates.
As a result of the foregoing, the traditional banking business of credit
intermediation – which according to the treasurer still makes up about two
thirds of bank earnings – is threatening to become non-viable. Net interest
rate margins have roughly been cut in half since 2008 and are now so small that
they offer very little margin for error. Banks will have to adapt to this
situation by attempting to grow other income sources, but there are clearly
noteworthy macro-economic consequences flowing from this.
Going
the Way of Japan?
What follows from the above is that the era of willy-nilly credit
expansion by the commercial banking sector in Europe, which dominated the first
decade of the euro's existence, is over. This is also why the ECB has been
unable to create any notable money supply growth in the euro area, in spite of
occasionally increasing its balance sheet at an even faster pace than the Fed.
Regardless of how much central bank credit is made available – and even though
it provides temporary relief from funding stresses to some extent – it cannot
spark credit demand nor can it make banks more eager to expand credit on their
own given that they are faced with the need to keep much larger liquidity
buffers than before and are experiencing a collapse in their net interest
margins.
To be sure, the Fed is confronted with a very similar problem in the US,
but its modus operandi is different from that of the ECB, in
that it has created a great deal of deposit money directly with its 'QE'
operations. Every securities purchase from non-banks immediately increases not
only bank reserves, but creates deposit money in the system to the same extent.
Thus the broad US money measure TMS-2 (which excludes bank reserves) has grown
from roughly $5.3 trillion at the beginning of 2008 to $9.4 trillion at the
beginning of 2013. That is obviously an enormous inflation of the money supply,
which was accomplished in spite of the fact that US commercial banks have been
contracting credit up until about mid 2010.
By contrast, euro area TMS grew from €4 trillion at the beginning of
2008 to €5.1 trillion as of the beginning of 2013, a far smaller rate of
monetary expansion. It should also be pointed out that the great bulk of this
expansion occurred in the 'early days' of the post 2008 crisis phase, i.e.
between 2009-2010, before the euro area sovereign debt crisis went into
overdrive.
We strongly suspect that the increase in euro area money supply growth
that could be observed in 2012-2013 is mainly a reflection of the growth of the
carry trade in peripheral sovereign debt in this period – in other words, banks
in Spain, Italy, etc., created deposits in favor of their governments by buying
their bonds. This money has then entered the economy via government spending.
However, it should be obvious that this type of monetary expansion is highly
dependent on the state of play in the sovereign debt crisis and the continued
growth of public debt. Both are
in danger of receiving a significant damper.
Conclusion
In conclusion, the same basic conditions that pertained in post bubble
Japan nowadays appear to be a characteristic of the euro area. Bank credit
expansion is likely to stagnate or even go into reverse. This will continue to
put great pressure on all bubble activities in the euro area – many of the
capital malinvestments of the boom that haven't been liquidated yet are bound
to be liquidated as time goes on, and it will be very difficult to start fresh
bubble activities in spite of very low administered interest rates. As a
consequence, the growth rate of the supply of euros should begin to stagnate as
well. These developments should actually be welcomed, as one should certainly
not wish for a repetition of the boom-bust cycle that has laid Europe low.
Unfortunately, it all happens against the backdrop of vastly over-regulated and
over-taxed economies. If Europe were to implement a program of
far-reaching economic liberalization, cutting all the red tape, shrinking the
size of governments and lowering taxes, the foundations for a sound economic
recovery would now be in place. However, this is clearly hoping for too much.
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