Saturday, February 13, 2016

Banks: Borrowed time


FOR those who worry that a repeat of the crisis of 2007-08 is imminent, this week brought fresh omens. Shares of big banks tumbled; despite a mid-week rally, American lenders are down by 19% this year, European ones by 24% (see article). The cost of insuring banks’ debts against default rose sharply, especially in Europe. The boss of Deutsche Bank felt obliged to declare that the institution he runs is “absolutely rock solid”; Germany’s finance minister professed to have no concerns (thereby adding to the concerns). This is not 2008: big banks are not about to topple. But there are reasons to worry, and many of them converge on one country.
Start with the better news. Banks are more strongly capitalised than they were. Even in Europe, where lenders have been slower than their American counterparts to raise capital, banks have plumped up their core equity cushions from an average of 9% in 2009 to 12.5% in 2015. Managers at European banks are making a renewed effort to adjust to the post-crisis landscape. New rules on everything from capital to liquidity are forcing them to change. John Cryan, Deutsche’s newish co-chief executive, was brought in to trim its investment bank. He is jettisoning whole divisions, and suspended the dividend this year and last. Credit Suisse is undergoing similar surgery. Just now, this is weighing on the banks’ share prices. Yet, however painful for investors, the sensible goal is ultimately to create slimmer, safer, more profitable outfits. 
    Also salutary, if painful, is how investors in bank debt are coming to understand that they bear greater risk than they did. New European rules that came fully into force at the start of this year stipulate that troubled banks must deal with capital shortfalls by “bailing in” holders of bank bonds before any call is made on the taxpayer. The chance that bondholders might lose money suddenly seems more real. The turmoil at Deutsche this week stemmed partly from fear that the bank might struggle to pay interest next year on a type of bond that is designed to act as a buffer in a crisis (see article). There are some design flaws in the bail-in regime, but the possibility that European banks are at last repairing themselves at a cost to their investors is the silver lining to this week’s spasms.
    The clouds, alas, still loom. One source of anxiety is the health of the world economy. The factors that spook markets more broadly—the slowdown in China, plunging commodity prices and indebted energy firms, political upheaval from Greece to New Hampshire—all weigh heavily on banks in particular. Banks do well when the economies they serve are growing, and miserably when they are not.
    The receding prospect of higher interest rates leaves American banks with less hope of widening the margin between the rates they pay depositors and what they charge for loans. In Japan, where bank shares have fallen by 24% this month, and Europe central banks have imposed negative rates, in effect levying a fee on some reserves—one that banks have not yet been able to pass on to depositors. With the economic outlook growing gloomier, margins being squeezed and restructuring costs still hitting profits, investors have good reason to fret.
    Worse, some countries appear to have taken so long to deal with their banks that they will now struggle to clean them up at all. The IMF reckons that the total amount of non-performing debt in Europe was around €1 trillion ($1.13 trillion) at the end of 2014. Bail-in is an especially ugly prospect in countries where bank debt is owned not only by diversified financial institutions but also by local retail investors. Under such conditions, politicians may find that they cannot force the cost of cleaning up balance-sheets on voters without causing uproar.
    Rome is where the hurt is
    No country is more impaled on this dilemma than Italy. The gross value of non-performing loans makes up a whopping 18% of their total lending; retail investors own some €200 billion of bank bonds, equivalent to 12% of GDP. A government plan to buy bad debts from the banks at close to face value would fall foul of European rules against “state aid”. But selling the loans at a significant discount would force Italian banks to recognise losses, some of which could be borne by retail investors. The prime minister, Matteo Renzi, headed down this road late last year, when the efforts to save four small banks clobbered the savings of individual Italians and seemingly resulted in a high-profile suicide. He will not want to do so again.
    The European Union and the Italian government recently agreed on a half-baked alternative to bail-in, though few think it will cleanse banks’ balance-sheets. Instead Italy seems trapped between the rock of hurting small savers and the hard place of a banking system strangled by bad debts. If Mr Renzi cannot negotiate his way round the new rules on bail-in, Italy’s banks and economy risk years of more stagnation, poisoning relations with the EU. Behind this week’s banking headlines is the threat of something very bad coming out of Italy. 

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