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Banks – the frozen lubricant

How much exposure do banks have on their books? What is their financial strength? Can they withstand a Greek default, or worse? Have they learned the lessons from 2008?

Article also available in : English EN | français FR

With the Greek tragedy unfolding and making daily headlines, many investors and policymakers are starting to zoom in on the global banking sector. How much exposure do banks have on their books? What is their financial strength? Can they withstand a Greek default, or worse? Have they learned the lessons from 2008? These are important questions – not just to assess potential systemic risks, but also to see if the banks can act as lubricant to get the economy going again by providing cheap credit to companies and consumers. To assess the potential threat of a global banking crisis, you need to take a closer look at the bank’s balance sheets and at the potential sources for additional funding.

In short, there are two major problems facing banks: 1. Peripheral sovereign exposure and 2. availability of funding. Banks can have direct exposure to peripheral sovereign debt or indirectly through exposure to other banks with large peripheral sovereign debt positions, and risk facing significant write downs on these loans. In addition the banks face a looming recession that could lead to higher non-performing loans levels on both their corporate as well as consumer loans.

The deep and complex inter-connections within the banking system make it appear like a house of cards: if one fails, we risk the collapse of all banks. So intransparency about the sovereign debt exposures leads to a lower level of trust among banks, leading to problem nr. 2: availability of funding. Funding is a scarce resource these days with capital markets closed for raising senior debt, and is only available in the form of covered bonds (senior bonds with collateral). Interbank deposits are becoming increasing expensive, if available at all. And the cost of attracting and retaining retail deposits is going up. The ECB recognizes this funding problem and is available to provide liquidity to banks if needed, but this also comes at a cost.

The above is putting pressure on the banks’ profit and loss account, which is being eroded by the higher funding cost and the requirement to add to loan-loss reserves to cover potential losses from declining asset quality. It is also not helping the banks’ capital base. Since the bailouts of 2008 and 2009, banks are under increasing pressure to raise capital levels to reduce the risk that future government bail-outs would become necessary.

Instead, what we have witnessed this year is capital erosion from sovereign debt write-downs and lower than expected retained earnings. With capital markets closed to issue new share capital or subordinated debt, this leaves only a few options for banks to comply with the increased capital requirements from their regulators.

The best way to simulate the economy today is through government induced incentives such as tax reliefs, subsidies, expenditure programs, etc. However, governments today focus on austerity rather than spending
Hans Stoter

We expect that bank management’s least preferred option would be to apply for capital support from the government. The banks just repaid (most of) the 2008/2009 support, and are not looking forward to renewed negative headlines, public scrutiny and political influence on how to run the bank, including their compensation structures. So what we expect banks to do instead is: Reduce lending activities, raise lending margins, cut costs, de-risk the balance sheet, and push their clients to the debt capital markets.

The result of this is a “frozen lubricant”, which will impact mainly the small & medium-sized companies and consumers. Larger companies with access to the debt capital markets are much less impacted as they can issue bonds to attract funding (although current market volatility currently only allows for the strongest corporates to issue new debt).

The cost of debt capital is very low due to the continued monetary stimulus, but this is only available to the larger companies. These companies can still do well in the current challenging economic environment. But don’t look at banks to fuel economic growth by supplying cheap credit to small & medium-sized companies and consumers. It’s not in their interest to do so.

The best way to simulate the economy today is through government induced incentives such as tax reliefs, subsidies, expenditure programs, etc. However, governments today focus on austerity rather than spending. The above leads to a rather grim conclusion for the overall economy: Zero to low growth for longer, until the debt-financed economic balloon has been deflated. The investment opportunities in this ‘Japan-like’ environment are few. Corporate bonds could be one of them. As an indication: Japanese corporate credit spreads are by far the lowest in the world!

Hans Stoter November 2011

Article also available in : English EN | français FR

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