Where to Next for the Global Banking Crisis?

| About: Financial Select (XLF)

What does public ownership, or at least vast government shareholdings mean for the global banking sector? It would be nice to think that this is the end of the global banking crisis.

But since when does state support for a collapsing industry have a happy ending? You generally end up backing a loser and hobbling the potential winners. Say you assist a bankrupt US car maker, that supports it unfairly against its superior German rival, and if the market shrinks they both lose even more money.

Will it not be the same with the banks? Stopping systemic collapse means that a chain reaction of counter party risk is eliminated. But a literally bankrupt system is preserved with good and bad banks treated equally. The bad loans remain on the books to drag down profits for years.

Already the signs are not good. Many UK banks will not pay a dividend for five years as buying back shares from the government gets priority. But they will have to stay in business and compete against banks without their problems - keeping profits lower for banks with good loans.

Stages to come

But there are still big problems ahead from the fall-out of the current crisis that cannot be avoided.

In the 1930s banks were not bailed out and thousands failed, precipitating the Great Depression as a downward spiral developed. But there were two more stages to the banking crisis - we have only seen the credit implosion so far this time.

The next stage is partly a result of the first. In order to pay for the $3 trillion global bank bailout there will have to be a huge issuance of US dollar bonds. Now the credit markets have frozen between banks and are only thawing very slowly.

So why should investors stump up large amounts of money to invest in treasury bills at a lower rate of interest than they can get on the inter-bank market? Why indeed should they continue to hold low paying treasury bonds and not go into cash, and deposit it in a bank with a government guarantee?

Is a bank deposit paying a high rate of interest with a state guarantee not better than a bond whose capital value can, and will fall? When are capital markets going to understand this obvious reality and sell down the bond market?

Bond prices falling

In fact, 10-year T-bonds have been falling in value during the recent stock market crash, the reverse of what you would expect - so it looks as if some insiders have already got it and are cashing out while they can. What starts as a trickle could quickly become a rush to exit the bond market.

Where will the funds for the bank recapitalization come from then? Governments will have to resort to printing money - which is highly inflationary - or raise interest rates in a recession.

In the meantime, bank lending is hardly going to be a thriving business as companies hunker down for a recession and individuals rush into cash. So banking will be a low profit public utility. And in order to bail itself out, the cost will be higher interest rates paid to savers.

However, there will be a third stage of the banking crisis, if we follow the 1930s precedent. This saw a gradual withdrawal of cash and the purchase of gold. State deposit guarantees and state shareholdings should go some way to maintaining confidence in the banking system this time.

Gold and silver

But there is a very clear reason why the banking system’s nationalization still ends with a rush into precious metals, and that includes silver which will cease to be an industrial metal as soon as gold begins to take off and will likely outperform because of its more limited supply.

Meet inflation, probably a mild form of hyper inflation, that is the inevitable result of the trillions of dollars being injected into the global financial system. That might indeed be saving us from the worst effects of the 1930s banking collapse but the general pattern can still be used as a historical guide to the near future.

What I am less clear about is how long this banking crisis will take to mature from credit crisis to bond crisis to precious metals boom. Markets do move a lot faster than the 1930s and are globally integrated (although arguably globalization was stronger in 1930, it was the backlash of nationalism that destroyed it in the depression years).

But it could be that the speed and substantial size of the response by global governments is enough to freeze the impending crash for a while, or alternatively the indigestion it causes will produce an immediate systemic reaction of similar size in the opposite direction.

Everything has changed

All I am quite certain about is that the world has changed in the past two weeks, and that hoping to get back to ‘business as usual’ is totally unrealistic. The late 2000s banking crisis will now go into stages two and three, and we must be prepared for some nasty shocks along the way.

Commodity prices could slump along with share prices in anticipation of a deep recession. Hedge fund casualties could be even bigger than feared. The dollar could move from being the currency of choice to one nobody wants. Any weak business will fail. Unemployment is going up. House prices are going even lower.

That is what happens in the wake of a banking crisis, even if you nationalize the banks.