European Central Bankers Are Risking A Massive Failure Of Banks

by: BubbleBustInvesting

Summary

Negative interest rates in Europe are pushing banks off the cliff.

They eliminate bank profitability.

Create the risk of massive withdrawls.

Scare investors.

  • European banks have been selling off lately. And some of that sell-off is spreading over to US banks, driving major US market indices lower.

Stock

5-day performance

3-month performance

Deutsche Bank (NYSE:DB)

-7.77%

-40.10%

UBS Group (NYSE:UBS)

-7.75

-25.40

Banco Santander (NYSE:SAN)

-10.6

-29.96

Click to enlarge

Source: Finance.yahoo.com

What's going on? What's haunting European banks?

Negative interest rates.

By driving nominal interest rates below zero, European central bankers are risking a massive collapse of traditional banking. That's why investors are heading for the exits.

For decades, negative nominal interest rates weren't even mentioned in economics textbooks. They didn't make any sense.

Now, negative interest rates are a reality in the Eurozone, Denmark, and Sweden. Early in December, for instance, the ECB cut its deposit rate to -0.3%. Denmark's central bank has its deposit rates at -1.25%.

Central bankers, schooled in conventional economics, deploy negative interest rates to fight deflation. And to some extent they have achieved it while re-inflating old asset bubbles.

The trouble is that in some cases the interest rate spread -- the difference between deposit and lending rates -- has turned negative. Deposit rates are set near zero, while certain floating rates have dropped below zero.

This means that banks are losing money on the loans.

To remedy the situation, these banks should either charge depositors interest or get out of the lending business altogether.

But charging depositors interest would certainly prompt massive withdrawals, as depositors will choose to keep money in a safe -- or chase after inflated assets -- rather than keep them in the bank.

Massive withdrawals, in turn, will be followed by a credit contraction, crashing asset values. This means that banks will be squeezed on both sides of their balance sheet, and some will fail.

Alternatively, banks can borrow funds from central bankers, but they will still have hard time to find qualified borrowers.

By trying to fight deflation at all costs, central bankers have been caught in an irrational exuberance--to use Alan Greenspan's old expression.

They have been driving negative nominal rates negative, risking a total collapse of the financial system.

That's a scenario far worse than the specter of deflation, which central banks are currently fighting.

What should investors do?

Two things. First, they should resist the temptation of buying European banks, until European nominal interest rates are "normalized, i.e., they turn positive. Second, park funds with gold and US Treasuries, the safe havens in times of global uncertainty.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SAN over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.