You know it’s bad when the finance minister of Germany has to publicly state he has “no concerns” about his country’s biggest lender — Deutsche Bank — as Wolfgang Schauble did on Tuesday while bank shares plummeted.
It’s been brewing for a while.
The business models available to European banks, the methods by which they make money on a consistent basis, are disappearing fast and investors are taking flight.
Here’s a stunning chart from David Buik at Panmure Gordon to illustrate what that’s done to bank stocks this year:
The old-school, traditional model of making money in banking is to exploit the net interest margin — the difference between the rate at which they lend and the rate at which their interest-earning assets bring in income.
But that’s not really a viable way to make money in the post-crisis, low-interest-rate era. Central banks have held rates at or below zero since 2009, and around $6 trillion (£4 trillion) of interest-yielding assets are now in negative rate territory, making the margin game impossible.
To borrow a word of Adair Turner, former chairman of Britain’s Financial Services Authority, the global economy is in a debt-fuelled “malaise,” so central banks won’t be changing policy anytime soon and banks will struggle to make easy money.
Here’s Turner on the BBC on Wednesday:
If we are to look at the banking system itself, we are in a safer position than we were in 2008. Because of the reforms that have occurred, there’s more capital in the banking system, there’s more liquidity in the banking system and there are better ways to deal with winding down banks.
But, I think we really haven’t dealt with the even more fundamental problem that there is too much debt in the world economy and that since 2008, far from that debt going away, it’s just shifted around the economy and simply got bigger.
We’re less likely to have a financial crisis than 2008 but we are stuck in an economic malaise.
The other, sexier, forms of profit-making are also on their way out.
These were the things like originating and selling structured derivatives such as collateralised debt obligations, making a market for bonds, trading currencies, and commodities and selling payment-protection insurance (PPI).
These are methods of targeting a high return on equity — a commonly-used metric to work out how profitable a bank is. It measures the extent to which the bank earns more money than its share capital is worth on the stock market.
These methods incentivised risk-taking and taking on debt, or leverage, to juice returns. Since the financial crisis, those capital and liquidity reforms referred to by Turner have made that much more expensive for European banks to do. Maybe more so than for US banks, with whom they compete.
Back in November, Credit Suisse CEO Tidjane Thiam put his finger on the problem with a few sentences.
“We don’t really have a good measure to triangulate returns,” he said last year at the Financial Times banking summit. “In the end you get into a death spiral. Until the regulatory framework is settled, sometime in 2019, we won’t have a ROE target.”
So it looks like we’ve hit that death spiral then.
It’s particularly bad for banks like Credit Suisse, Barclays, and Deutsche Bank, who were fans of the risky, high-ROE approach before the crisis and are in the middle of restructuring.
Here’s Credit Suisse:
And here’s Barclays:
While stocks are recovering, they have been having a shocking week with near double-digit falls. Credit Suisse is down nearly 20% in the past weeks.
But investors have known they were on shaky ground. What’s changed? Why have they taken flight now?
Well, for a start, the annual results posted by Credit Suisse and Deutsche Bank in recent weeks have crystalised these fears over the future business models of the big, full-service banks.
They took big losses and investors are beginning to question how much time they have left as going concerns if they don’t find a reliable business model.
In the case of Deutsche Bank, this timescale shortened to about a year. The bank has payments due in 2016 and 2017 on so-called contingent-convertible bonds, which end up being worth very little if the bank can’t service them.
Unlike more senior bonds, CoCos are near the front of the queue when it comes to handing out losses. They cost more for banks to issue, because the people buying them assume more risk, but the banks do have to issue them to fulfil tougher capital regulations.
In the past week, the market got so worried Deutsche couldn’t meet these liabilities that the price of insurance on a credit event (ie not paying) spiked up.
Here’s the graph from Bloomberg:
This lack of confidence in the debt translates quickly into lack of confidence in the shares. Equity is the first part of a bank’s capital structure to take losses and so will be volatile when the bank itself is under threat.
So, really, the market rout for European banks comes down to the age-old problem of matching liabilities with assets.
While banks’ liabilities have increased, through the need to issue more capital instruments such as CoCos that need to be paid for periodically, their assets just aren’t yielding enough to cover the bill.
With yields falling below zero on safe assets and interest payments on banks’ own debt ballooning, it’s the gap between the two that has spooked investors.
And rightly so.
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