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Banks Battling to Survive

Yesterday we had the opportunity to attend a presentation by the treasurer of a European bank, who discussed the problems the European banking sector faces since the beginning of the crisis era in 2008.

Many of these problems are obvious, but some of them are perhaps less so. There are on the one hand the regulatory pressure to increase capital, a plethora of new regulations and taxation that refers to the size of a bank's balance sheet, regardless of its profitability. While such taxation only amounts to about 20 basis points, it has to be seen in the context of currently available margins in the banking business, which are dismal – once one does that, the number actually strikes one as quite large.

Regarding the regulatory regime, European bank managers these days apparently spend more time satisfying the demands of a whole horde of regulatory bodies (a bank with a decent pan-European presence can count on having to deal with up to 25 different regulators), all of which continually want to play through stress test scenarios or are demanding data on this or that. Everything has to be done to the perfect satisfaction of the bureaucrats concerned with these oversight activities, down to the color of the paper the presentations are printed on. The problem is of course that this is distracting managers from what they should actually be doing, namely focus on the business.

Given the crisis situation, one should not be surprised at this sudden avalanche of regulatory demands. However, as we have often pointed out here, in a free banking system with 100% reserved sight deposits, all of this would be completely unnecessary.

The most important problem faced by banks though are their funding costs relative to the interest rates they can charge on loans.

Exploding Funding Costs, Shrinking Interest Rate Margins

As a side effect of the crisis and the reaction of the ECB as well as the Brussels based eurocracy to it, banks now have to deal with a funding situation that is markedly different from what pertained prior to 2008.

One can infer the funding costs in terms of bond issuance via the i-Traxx [ITRX] indexes on senior and subordinated unsecured bank debt. In pre-crisis days the 5-year ITRX on senior unsecured financial debt traded below 50 basis points. Now, even after the ECB managed to calm the markets with its 'OMT' announcement, it stand at about 300 basis points.

The impact of the crisis on funding via customer deposits has been even more remarkable. In normal times, a bank could count on having to pay less interest on sight and savings deposits than was available in the money market in terms of 3-month EURIBOR rates. Thus it was possible to simply lend on deposits in the money market and thereby earn a small, but fairly 'safe' interest margin. Since EURIBOR began to plunge in late 2008, the relationship has reversed: since then customer deposit interest rates have remained stubbornly above 3-month EURIBOR rates. There is no longer a relatively risk-free spread that can be earned in money markets. On the other hand, banks are loath to do without customer deposits, as they are regarded as a 'sticky' funding source.

As an example, a hedge fund may very quickly withdraw its funds in a developing crisis situation. Most small depositors are far slower to react and often don't react at all. Cyprus is in fact a good example for this, as only a small percentage of depositors actually fled the Cypriot banks, in spite of what were rather obvious warning signs. In addition, we can probably assume that a certain portion of those who did withdraw their deposits from Cypriot banks in time had insider information regarding the impending depositor 'haircut'. In short, even though customer deposits have become a headache in terms of cost, they provide banks with an invaluable liquidity buffer in the event of worsening crisis conditions.

One major reason why the cost of funding in terms of bond issuance has shot up – a situation that is unlikely to reverse anytime soon – is in fact the Cyprus affair. Even though euro area politicians continually stress the 'uniqueness' of the Cyprus 'bail-in', any halfway awake investor knows that 'bail-ins' are now indeed the new template for dealing with insolvent banks in the euro area.

The Bundesbank brief to the German constitutional court, which we've discussed in a previous article, inter alia contains the Bundesbank's opinion on ELA (emergency liquidity assistance) financing. On this point the BuBa remarks that the ECB should be far more circumspect about granting ELA and that insolvent institutions should simply be wound up. Bond investors therefore are nowadays poring rather attentively over bank balance sheets in order to calculate what precisely their risk in the event of a bank failure is.

Equity capital is the initial buffer, then comes subordinated debt and senior bondholders are next in line. However, many European banks have issued a great many so-called 'covered bonds.' The cover pools that stand behind these covered bonds have to be deducted from the assets available for distribution to bondholders: a great number of mortgage loans as well as sub-sovereign securities that sit on bank balance sheets can actually not be touched by these unsecured creditors if they back covered bonds. Thus a unique feature that has contributed to the perceived safety of credit securitizations in Europe has now ended up putting notable pressure on bank funding costs. Indeed, these days the financing costs of financial intermediaries are a great deal higher than those of non-financial corporates.

As a result of the foregoing, the traditional banking business of credit intermediation – which according to the treasurer still makes up about two thirds of bank earnings – is threatening to become non-viable. Net interest rate margins have roughly been cut in half since 2008 and are now so small that they offer very little margin for error. Banks will have to adapt to this situation by attempting to grow other income sources, but there are clearly noteworthy macro-economic consequences flowing from this.

Going the Way of Japan?

What follows from the above is that the era of willy-nilly credit expansion by the commercial banking sector in Europe, which dominated the first decade of the euro's existence, is over. This is also why the ECB has been unable to create any notable money supply growth in the euro area, in spite of occasionally increasing its balance sheet at an even faster pace than the Fed. Regardless of how much central bank credit is made available – and even though it provides temporary relief from funding stresses to some extent – it cannot spark credit demand nor can it make banks more eager to expand credit on their own given that they are faced with the need to keep much larger liquidity buffers than before and are experiencing a collapse in their net interest margins.

To be sure, the Fed is confronted with a very similar problem in the U.S., but its modus operandi is different from that of the ECB, in that it has created a great deal of deposit money directly with its 'QE' operations. Every securities purchase from non-banks immediately increases not only bank reserves, but creates deposit money in the system to the same extent. Thus the broad U.S. money measure TMS-2 (which excludes bank reserves) has grown from roughly $5.3 trillion at the beginning of 2008 to $9.4 trillion at the beginning of 2013. That is obviously an enormous inflation of the money supply, which was accomplished in spite of the fact that U.S. commercial banks have been contracting credit up until about mid 2010.

By contrast, euro area TMS grew from €4 trillion at the beginning of 2008 to €5.1 trillion as of the beginning of 2013, a far smaller rate of monetary expansion. It should also be pointed out that the great bulk of this expansion occurred in the 'early days' of the post 2008 crisis phase, i.e. between 2009-2010, before the euro area sovereign debt crisis went into overdrive.

(Click to enlarge)

(click to enlarge)

The year-on-year rate of change of the euro area's true money supply (money TMS) and M3 via Michael Pollaro. As can be seen here, there was a huge growth spurt in 2009-2010, which has tapered off quite a bit thereafter

We strongly suspect that the increase in euro area money supply growth that could be observed in 2012-2013 is mainly a reflection of the growth of the carry trade in peripheral sovereign debt in this period – in other words, banks in Spain, Italy, etc., created deposits in favor of their governments by buying their bonds. This money has then entered the economy via government spending. However, it should be obvious that this type of monetary expansion is highly dependent on the state of play in the sovereign debt crisis and the continued growth of public debt. Both are in danger of receiving a significant damper.

Conclusion

In conclusion, the same basic conditions that pertained in post bubble Japan nowadays appear to be a characteristic of the euro area. Bank credit expansion is likely to stagnate or even go into reverse. This will continue to put great pressure on all bubble activities in the euro area – many of the capital malinvestments of the boom that haven't been liquidated yet are bound to be liquidated as time goes on, and it will be very difficult to start fresh bubble activities in spite of very low administered interest rates. As a consequence, the growth rate of the supply of euros should begin to stagnate as well. These developments should actually be welcomed, as one should certainly not wish for a repetition of the boom-bust cycle that has laid Europe low. Unfortunately, it all happens against the backdrop of vastly over-regulated and over-taxed economies. If Europe were to implement a program of far-reaching economic liberalization, cutting all the red tape, shrinking the size of governments and lowering taxes, the foundations for a sound economic recovery would now be in place. However, this is clearly hoping for too much.

Source: Credit Expansion In Europe - Going The Way Of Japan?