LA TORMENTA EN EL SECTOR BANCARIO (ALASDAIR MACLEOD, 16-06-2022)

 

A perfect storm in banking is brewing

Jun 16, 2022·Alasdair Macleod

Now that interest rates are rising with much further to go, the global banking system faces a crisis on a scale like no other in history. Central banks loaded with financial securities acquired through QE face growing losses, and their balance sheet liabilities are now significantly greater than their assets — a condition which in the private sector is termed bankruptcy. They will need to be recapitalised urgently to retain credibility.

Furthermore, banking regulators have made a prodigious error in their oversight of the commercial banking system by focusing almost solely on bank balance sheet liquidity as the principal determinant of risk exposure. And on the few occasions in the past when they have demanded banks increase their own capital, it has always been through the creation of preference shares and pseudo-equities to avoid diluting the true shareholders. The consequence is that the level of leverage for common equity shareholders in the global systemically important banks has risen to stratospheric levels.

Meanwhile, G-SIBs (GLOBAL SYSTEMYCALLY IMPORTANT BANKS) have asset to common equity ratios often more than fifty times, with some in the eurozone over seventy. It is hardly surprising that most G-SIBs are valued in the equity markets at substantial discounts to book value.

G-SIBs have accumulated excessive exposure to financial assets, both on-balance sheet and as loan collateral. With vicious bear markets now evident and further interest rate rises guaranteed by falling purchasing powers for currencies, the one thing regulators have not allowed for is now happening: like a deepening meteorological low, bank credit is contracting into a perfect storm.

Why are markets crashing?

Contracting bank credit always ends in a crisis of some sort. With a long-term average of ten years, this cycle of bank credit has been exceptionally long in the tooth. Before we even consider the specific factors behind a withdrawal of credit, we can assume that the longer the period of credit expansion that precedes it, the greater the slump in economic activity that follows.

Whenever the dollar slipped, by lowering interest rates instead of raising them the Fed could encourage foreign portfolio buying. Lower interest rates increased flows of currency and credit into financial assets instead of debasing the currency in the non-financial economy.

Thus, the creation of extra bank credit was directed increasingly into financial speculation in bond and equity markets. There were bubbles, such as the dotcoms in the late-1990s and in mortgage financing preceding the financial crisis of 2008/09. Despite these interruptions, the US authorities made sure that global investment flows primarily supported US financial interests.

As markets caught on, interest rates declined to the point where they disappeared altogether. But as Triffin observed, policies to ensure that a currency is available as the world’s reserve are economically destructive in the long run, and the whole trend set in motion from London’s big bang onwards has now concluded with rising interest rates. It amounts to a super cycle of bank credit expansion certain to end more dramatically than a single cycle. Therefore, this bear market and its systemic issues can be expected to be of a greater magnitude than those which followed the dotcoms and the Lehman failure. 

With interest rates so far beneath the rate at which prices are rising, which is mainly the consequence of earlier monetary debasement, losses are now accumulating for all those who bought into the financialisation story and have failed to bail out of it. Top of a hubristic list are the central banks themselves which augmented monetary expansion with the acquisition of substantial bond portfolios through quantitative easing. Those assets are now collapsing in value, wiping out central bank equity many times over. The central banks themselves will need recapitalising before they can tackle the problems of a widespread systemic collapse in the commercial banking network.

How to recapitalise a central bank

The Fed recently admitted that unrealised losses on the bonds on the asset side of its balance sheet stood at $330bn at end-March, which wipes out its balance sheet equity of $50bn more than six times over. Since then, bond yields have risen a further 1%, increasing the deficit to closer to $500bn. But in the Fed’s case, two differences from other central banks should be noted. First, the profile of US Treasury debt is shorter term in average maturity than in other advanced economies with high levels of government debt, confirmed by the Fed’s intention to retain debt to maturity rather than selling it. This means that price volatility is lessened. And secondly, some of the debt is agency debt (Fanny Mae, Ginny Mae, and Freddy Mac) which on early mortgage redemptions distributes payments to mortgage-backed securities holders. In effect, the maturity profile is shortened by these repayments, increasing their yield, and reducing their notional volatility

But the Bank of Japan and the ECB are in an entirely different situation. And so their ability to underwrite their commercial banking networks is extremely impaired.

The G-SIBs’ balance sheets have deteriorated significantly

To see any banks with asset to equity ratios for their ordinary shareholders of more than twenty times, let alone the two French G-SIBs which appear to be over seventy, is simply jaw-dropping.

Of particular concern is the bunching of risk, with the Eurozone’s G-SIB cohort most vulnerable to shocks, closely followed by the three Japanese banks. That banks in these two jurisdictions are the most highly leveraged groups is partly a consequence of negative interest rates. Credit margins have been tightly compressed, and so long as banking regulations are complied with, the management of these banks have been encouraged to maintain profitability by increasing credit leverage.

Furthermore, as discussed below, the European Central Bank and the Bank of Japan themselves will need to be recapitalised if they are to underwrite the losses in the commercial banking sector which are certain to quickly develop as interest rates rise and bank credit contracts.

The ECB’s impossible position

Economic reality and the ECB’s monetary policies have only occasionally had a tangential relationship, with the ECB bullying its way over markets. The falsity of its position is now being exposed.

Clearly, non-performing loans are rapidly becoming an issue. Additionally, energy, food, and escalating producer prices will make the situation far worse in the coming months. The ability of the Eurozone’s banks to survive all these headwinds will be increasingly questioned. The news here is exceedingly grim, with balance sheet common equity to asset ratios in the stratosphere for the Eurozone G-SIBs. Local banks, upon which most of the non-financial burden of Eurozone credit defaults will fall will not be so highly leveraged, being run by sensible local and regional managers in the main. But in the deteriorating conditions the Eurozone now faces, even asset to equity ratios of as little as ten times could prove fatal to a bank’s future.

With respect to their underlying shareholders, the Eurozone’s G-SIBs are the most highly leveraged banking cohort. In the face of rising interest rates and the contraction of bank credit, there can be little doubt that the first G-SIB failures are likely to be among these banks. The ability of the ECB and its network of shareholding national central banks to weather a credit storm will be challenged and almost certainly found wanting.

At the end of 2021, the ECB’s balance sheet showed assets of €8,466bn and share capital of €109bn. That’s a ratio of assets to shareholder capital of 78 times. A high ratio is tolerable for a central bank so long as it sticks to issuing bank notes. But by last December the ECB had also accumulated Eurozone government and other bonds totalling €4,886bn.

Since the year-end, by last Friday the value of these bonds has fallen sharply, as shown in Table 2, of selected 10-year Eurozone government bonds.

But just assuming an average loss of 25% on its bond holdings as of end-December, there is a loss to the ECB’s assets from this source alone of €1,222bn. That’s a valuation write-off of over eleven times the ECB’s capital account.

A recapitalisation of the ECB is due as a matter of urgency before it is called upon along with the relevant national central banks (NCBs — which are similarly insolvent) to undertake the rescue of the Eurozone’s G-SIBs. We can see from their exceptionally high gearing that they are likely to be the first victims of bank credit contraction.

There are no easy options. It is possible to conceive of a systemic failure at the central bank level threatening the existence of the euro itself. Certainly, the foreign exchanges are likely to be brutal in this matter.

Bank of Japan is in deepening trouble

The Bank of Japan has been conducting QE since 2000, and to date has accumulated 80% of the country’s ETFs amounting to 52 trillion yen ($420bn), as well as 538 trillion yen ($3.7 trillion) in bond purchases.It appears that these investments are carried at cost on the BoJ’s balance sheet. The combined losses amount to approximately 14 trillion yen ($104bn) since the year-end compared with balance sheet capital consisting of equity and reserves of 4.7 trillion yen (USD35bn). That’s a rapidly rising ratio of net liabilities to capital of 3:1. 

The Bank of Japan is trying to save itself from further financial embarrassment by ensuring bond yields rise no further. It has drawn a line in the sand for the 10-year JGB yield at 0.25% and has cleaned out the market at this maturity. The price is now in Humpty Dumpty territory: what the BoJ says is the price, is the price.

The cost has been yen weakness, which is now accelerating. Figure 1 shows the chart of the yen priced in US dollars.

However, permitting yen interest rates to rise will lead to further problems for Japan’s commercial banks, which at equity shareholder level are very highly leveraged, as the table below illustrates.

The Bank of England has dug a hole for itself as well

How will the Fed respond to global problems?

a Fed funds rate of1.5%—1.75% is still a long way behind the curve. They are bound to go considerably higher, collapsing bond and financial collateral values. It will lead to a crisis in financial markets. And given that the commercial banks in the Eurozone and Japan possess extremely high shareholder leverage, that can be expected to occur very soon.

Unless the Fed is prepared to let markets sort this mess out — a course of action we can dismiss out of hand — the Fed’s only possible response will be to inflate the dollar to compensate for the contraction of bank credit. The means by which this will be done is not the point. There will be no alternative, as the Fed’s priority will be to save the financial system and to minimise the consequences for the wider American economy and particularly for the Federal Government’s finances. The other central banks mentioned in this article will have to follow suit, where they can. Expect swap lines between them to be expanded to enable them to do so. Expect bond markets to be closed by diktat, perhaps for more than a day or two. As helpless bystanders, we will all be looking into an abyss, fearful that there is no resolution to an unsolvable crisis.

The outturn could be very different, but logic suggests the following. Interest rates will rise until bank failures materialise. Meanwhile, financial assets will have fallen in value, possibly very quickly. Then we can expect monetary policy to expand to rescue the commercial banks, supress bond yields and to finance soaring government deficits.

At this side of the crisis, which is only in its initial stages, the euro is slated as the first currency to collapse entirely, not just because it is a fiat designed by committee, but because of the depth of the structural problems in the ECB and its shareholders.

Will the authorities respond by suppressing prices like latter day Diocletians, banning gold ownership as well? These would be stupid moves, but extremely likely. Gold markets could be simply closed, denying access to those belatedly fleeing fiat.

https://www.goldmoney.com/research/a-perfect-storm-in-banking-is-brewing