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Jason Cawley
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I am the Director of Architecture at Wolfram Solutions, the consulting arm of the large privately held software company, Wolfram Research. I manage teams of programmers developing custom applications for business and, government, applying advanced analytic methods to practical challenges. I... More
  • Undercapitalized European Banks And Basel III 13 comments
    Nov 13, 2012 3:39 AM | about stocks: DB, BCS, ING, UBS

    I want to bring out a contrast between the capital structure and valuation of some selected major banks in Europe with similar large banks in the US. I bring this up because I believe most investors do not understand the root causes of slow broad credit growth at the present time, and because of this, miss the ongoing power of deflationary forces in the world economic system. They then see official policy both monetary and fiscal in loose positions, and expect rapid inflation to result, and are surprised when this does not materialize. To understand what is actually happening investors need to understand the private financial sector and its role in all this.

    My underlying thesis is simple. Financial capital is the scarce item in the present system. Losses stemming from the financial crisis of 2008 and sustained bad debt performance since have reduced the aggregate financial capital of the developed world's financial system. Regulators have responded to the risks that appeared in that crisis by moving to increase capital requirements for banks. Bank substitutes that boomed before the crisis but failed during it have also been collapsing. The net effect of all these forces has prevented any appreciable growth in broad credit. And macroeconomic weakness then follows from lack of credit growth, because that is equivalent to a static rather than a growing broad money supply.

    With that as some basic context, I present a few balance sheet and market cap items about 5 major European banks. I picked these as strong institutions in their respective countries, banks that are worth owning in good times. And all of them are from countries with basically sound finances and financial traditions - I will not be talking about Greece or Spain or Ireland.

    The five are Deutschbank in Germany, Barclays in Britain, BNP in France, ING in the Netherlands, and UBS in Switzerland. Yes ING also has insurance operations, etc. It is still to me a major bank as a bank. These 5 banks control between them total assets of over $10 trillion - DB being the largest at $2.55 trillion and UBS the smallest at $1.41 trillion. They are also major players in bond issuance, investment markets, etc. I am not picking out weaklings here, this is the cream of the crop.

    The first thing I want to point out about them is that you could buy all of them today, lock stock and barrel, for $223 billion. You get $45.44 in assets for every dollar of equity capital you put up, at market. Combined they are trading for about 86% of their tangible book, with only UBS trading above tangible book value. This means their assets to tangible book aka their equity leverage level is 39.25 times. Otherwise put, their equity capital is only 2.55% of assets.

    Now, under Basel I, the current international capital standard, the bare minimum level of tangible equity is 2%. Fall below that and regulators are supposed to seize the bank. That level is pretty ridiculously low. Understand, overall capital requirements under Basel I are higher, 8% of risk adjusted assets - but two major factors allow banks operating under those old Basel I rules to run at very high leverage. First, government bonds along with cash are considered riskless under those rules, and therefore do not require any capital against them. They are effectively removed from the asset total before capital requirements are assessed. And second, most of the "capital" of the bank may take the form of long term debt securities, rather than stock equity.

    And European banking practices make heavy use of both of those items.

    The long term debt position of the five banks is $3.07 trillion, or fully 30% of all assets. Along with the thin equity cushion, long term debt plus tangible equity rise to a third of their sheet size - the other two thirds being deposits and other short term liabilities. Basically this means they are run with a view to liquidity risk only - there is not the same understanding that equity capital protecting *all* the bank's debts (long or short term) is the best protection, that we have in the states.

    The next thing to understand is that the new Basel III rules adopted by international consensus after the 2008 crisis will change all of that. Under the new rules, banks need a higher capital level, cushions on top of that, and must include sovereigns in assets that carry risk, because in fact they do. And the biggie, the new rules require that most of that capital take the form of common equity - a minimum of 6% of assets, 3 times the minimum level under Basel I.

    This means all the long-term debt capitalized European banks need to shift their capital funding to common equity, and need to do so on a large scale, as Basel III goes into effect.

    Recall that they are trading below tangible book, other than UBS. This makes raising new equity capital by selling shares distinctly unattractive. Basically it is the most expensive capital there is, for the existing shareholders, and it is the worst possible time to be selling new shares.

    So instead what they are all doing is trying to increase their capital out of earnings. And that can happen - they do have earnings, and will continue to do so as long as massive sovereign defaults don't bury them. Some have other issues on a smaller scale - Barclays legal liabilities, BNP some dodgier investments in the southern European periphery, ING both legacy business issues and regulatory oversight stemming from them. DB doesn't face those issues, it just starts from the highest level of leverage to common equity - a whopping 57 times.

    Basel III does not need to be fully in effect until 2019, but it starts phasing in by next summer. It was supposed to start phasing in by January 1, 2013, but regulators are delaying that because of the trouble they fear it may cause.

    Banks can grow their capital by retaining earnings, and without question the financial system as a whole will be safer and sounder when they are all done with the transition. But here is the thing - they won't be growing broad credit in the meantime.

    See, normally a bank leveraged 40 to 1 that grows its net worth by $10 billion through earnings, can support new loans to the amount of $400 billion off that increment to its equity capital. If instead it is only leveraged 12 to 1, it can only expand $120 billion in loans, again if it is already at the desired leverage level. But a bank now at 40 to 1 that needs to retain all the earnings it can just to drop its leverage ratio, won't expand its loans at all.

    The growth rate of overall credit, plus the rate of decline in the leverage ratio as a percentage, added together, cannot exceed the rate of change in the common equity of the banks. If they are earning 10% returns on equity, for example, they can drop to 36 to 1 in one year with no loan growth, then 32.5 to 1 the next year with no loan growth, and so on - or they can stay at the same leverage level and grow loans outstanding as fast as they earn. But they can't do both.

    Since it looks like they will be using every scrap of their earnings to reduce leverage and still will be hard pressed to make even a 2019 deadline for Basel III (recall, their common equity needs to *triple* for the same size sheet, to get there), we can safely conclude they won't be growing their sheets while that is happening.

    Even without additional losses on dodgy European sovereigns.

    The US banks, in contrast, have pretty much already made the necessary adjustments. In come cases, very painfully for common shareholders, by issuing equity even at lousy (low) prices at the bottom of the smash (e.g. Citigroup) - but they have raised their equity, their liquidity, and lowered their leverage ratios already.

    How can the EU banks avoid 7 lean years of no growth, brought on by that deleveraging? The best option I see is some form of debt for equity swaps, arranged with creditors who currently own their long term bonds, to turn their solid total capital in the old sense, into sufficient (equity) capital in the new sense. The prices on those swaps will not be great, given the current level of their share prices. But it is much better that they handle it that way, than that the entire continent suffer through 7 years in which its broad money supply stagnates. EU wide unemployment is already in double digits, and it has hit catastrophic levels, 1930s levels, in places like Spain (25%), and among the younger generation Europe-wide.

    Regulators need to understand the extreme danger of the perverse incentives they have set up and that banks are currently operating under. The sharply increased capital requirements, while desirable in themselves in the long term, are acting much like the increased reserve requirements of 1937 in the US, extinguishing money growth prematurely. All involved need to work out a way to meet the new requirements with deals with bondholders, not by grinding through a lost decade, waiting for retained earnings alone to delever the European banking system.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Stocks: DB, BCS, ING, UBS
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Comments (13)
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  • daro
    , contributor
    Comments (1685) | Send Message
    good article.
    13 Nov 2012, 04:44 PM Reply Like
  • Adjusted Return
    , contributor
    Comments (386) | Send Message
    Many good thoughts. I think you should net out derivatives from balance sheets (some $1.2b for DB, etc) which brings down the leverage. But there is no doubt that European banks have committed to reducing balance sheet and increase equity - by derisking, retaining earnings and cutting dividends. In fact they have made good progress on that. All of them did raise capital a number of times in the process.


    But on credit supply, I don't see that as a negative. European banks followed others in global - not necessarily European - credit expansion and helped fuel bubbles in many capital intensive and/or speculative sectors, from real estate to insurance capital to shipping. They now sell off their international books and operations and "refocus" in Europe or traditional banking operations.


    You already talked about deflation of the non-banking finance sector and this article is in the same line. But why not? If the bubbles where fuelled by easy, engineered, credit, everyone should accept that the much-vaunted economic growth will not come so easy any more.
    14 Nov 2012, 05:36 AM Reply Like
  • Jason Cawley
    , contributor
    Comments (5485) | Send Message
    Author’s reply » Lower leverage is certainly desirable, but the process of getting there is not fun. And it is better to get there by restoring destroyed financial capital than by the entire world not growing for a decade, waiting for slow growth of financial capital to catch back up.


    Concretely, I believe an extra dollar or Euro added to financial equity capital right now can add at least $10 in macroeconomic demand in the near term. It is the highest leverage point to improve weak economies. Adding narrow money doesn't have that impact, deficit spending doesn't have that impact. It is the bottleneck, in other words.


    As for why it is a good idea to increase economic activity now, the clear reason is idle real inputs. Unemployment in the US is around 8% and labor participation is running below trend on top of that. Millions of additional workers are available, in other words. Across Europe, over 10% of the workforce is idle. In Spain, 25% of the workforce is idle. All the output they could be adding is a potential real increment to everyone's wealth, and it is a waste that they remain idle.


    Successful investment would take them up, put them to work, and pay for its financing costs. That investment is not happening in part due to lingering uncertainty about policy (e.g. what will happen to sovereigns in Europe, and the knock-on effects of that), but in my opinion is largely depressed by below trend growth in broad credit.


    I don't want to see broad credit galloping along at 15% a year. But if it remains completely flat for a decade, all those workers are going to stay on the dole instead of working, for that decade. Which will waste a huge amount of real output. They aren't being used because projects to employ them cannot be profitably financed at the moment. My diagnosis of why is that the private financial sector is rationing access to credit (cherry picking the lowest risks), rather than that market "clearing" by price. The supply side, specifically, of the credit market, specifically, is blocked by insufficient finance capital available.


    I hope that helps understand my diagnosis and prescription. Fair question.
    14 Nov 2012, 11:58 AM Reply Like
  • DigDeep
    , contributor
    Comments (3569) | Send Message
    Thanks Jason


    I had a couple of disconnects with your reasoning. Your thoughts or clarification would be appreciated.


    "Concretely, I believe an extra dollar or Euro added to financial equity capital right now can add at least $10 in macroeconomic demand in the near term"


    Unemployment in the US is around 8% and labor participation is running below trend on top of that. Millions of additional workers are available


    I read this as; Extra liquidity (higher capital ratio) can add 'fractionally' @ 10-1 for increased loans. If correct, would they not find what the Fed has found out - ZIRP environment doesn't necessarily grow outstanding credit. Demand, or lack thereof, being the key driver.


    "...Unemployment in the US is around 8% and labor participation is running below trend on top of that. Millions of additional workers are available"


    Would not this be a structural issue of skills, foreign labor competition, effects of automation. Like the ZIRP thought - more equity and hence the ability to fractionally lever - might not have an effect given the structural nature of the 'available' capacity.


    Private financials = shadow banking - that's been shrinking (~6$T since 08). I know you've covered this before - but I'm not seeing the clear pic on why the shadow industry is shrinking vs the large institutional banks. Shadow is the driver of the reduced broad credit pool - it would seem attention should be directed to prop the shadow banks....?


    With tighter leverage ratio's and the large banks constrained/stagnate - would this (possibly) mean that to meet demand, smaller regionals/locals would pick up some slack - shouldn't the shadow industry expand credit? Spreading risk - healthier at tighter ratios with a wider base.
    14 Nov 2012, 04:39 PM Reply Like
  • Jason Cawley
    , contributor
    Comments (5485) | Send Message
    Author’s reply » "Extra liquidity (higher capital ratio)"


    So that is the first issue - liquidity is not capital. Banks face 2 separate regulatory constraints on making new loans. On the *asset* side of their balance sheet, some of their assets need to be in riskless, short-term assets - vault cash or reserve deposits at their Fed branch. Then on the *liability* side of their balance sheet, some of their "total liabilities and equity" needs to be equity.


    The first, reserve requirement, is about the bank's *liqudity*. The second is about their *solvency*. The second binds much more tightly than the first right now, precisely because the central banks have already done way more than enough to make the banks *liquid*.


    But adding all the liquidity in creation doesn't move the needle on *capital*, one dime.


    Only an increased *net worth* for the banks as a group, can support additional broad credit, once it is the capital requirement that is binding the tightest.


    "what the Fed has found out - ZIRP environment doesn't necessarily grow outstanding credit."


    I am explaining *why* ZIRP has not led to faster broad credit growth. It removes only one of the two main constraints preventing the banks from growing their sheets, while leaving the other untouched. And recent large losses to the financial system as a whole, along with low prices for their stocks, has made that second, capital bind, very tight. That is the force currently keeping credit growth slow, and only actions directed at it, can get broad credit moving again.


    As for the shadow banks and their collapse, I don't think their business model was sound to begin with, as the 2008 crisis showed - they were too dependent on regular market funding of their liabilities. Basically, they needed to be able to sell their long term bonds at strong prices (near par), and also needed to be able to borrow large portions of their asset positions short term, by pledging bond market collateral. They borrowed short on Repos that the other side could refuse to renew, at any time. This made them highly susceptible to runs, to liquidity pressure. They lacked the broad diversification, stable pools of deposits on their liability side, direct access to the Fed discount window in difficult times, and other reserve practices that keep the commercial banks safe.


    They are shrinking and are not going to come back. The rest of the financial system needs to grow, net, to take up the broad credit they used to provide.


    As for smaller banks and S&Ls, despite strong regulatory push favoring them, they have shrunk by a few hundred billion dollars since the crisis, almost as much as the larger banks have grown. They basically just are not competitive with the larger banks. They were much deeper into the problem parts of the mortgage loan market, including originating poor quality loans (commercial and residential) than the financial market pundits with their naive picture of Jimmy Stewart virtues, believe.


    They might be able to hold market share from here, now that loss rates on most categories of loans have fallen, but they are still in a poor competitive position with respect to the majors. They don't have the same income streams from card issuance, capital markets, etc. Many pundits and pols think those more modern banking forms were the locus of the problem, but they were not, for the commercial banks themselves at least. Vanilla mortgage lending and commercial loans to property developers were huge generators of loss in the past recession, and those were the smaller banks' main business.
    15 Nov 2012, 08:19 AM Reply Like
  • DigDeep
    , contributor
    Comments (3569) | Send Message
    Thanks Jason - appreciate the clarification(s).


    The balance of higher cap ratios for safety vs broad credit being flat or declining seems to be a quandary.


    Your solution;
    "How can the EU banks avoid 7 lean years of no growth, brought on by that deleveraging? The best option I see is some form of debt for equity swaps, arranged with creditors who currently own their long term bonds, to turn their solid total capital in the old sense, into sufficient (equity) capital in the new sense."


    Would creditors have the incentive to swap?
    15 Nov 2012, 09:32 AM Reply Like
  • Jason Cawley
    , contributor
    Comments (5485) | Send Message
    Author’s reply » They need to be given one, that is the point. Between the banks themselves, the regulators, the goverments, the international authorities like IMF etc, instead of worrying about how much loss on bad Greek debt the ECB or private parties can bear, they all need to be focused on making such swaps happen - without then turning around and stealing the new capital to "save" the official sector on bad public debt.
    16 Nov 2012, 11:04 AM Reply Like
  • Westcoaster
    , contributor
    Comments (752) | Send Message
    Another great Instablog, Thanks JasonC.


    I think it is ironic that American banks are considering Basel III regs when on the face of it European banks are so highly leveraged and so concentrated in a market that lacks any sort of super-national bank regulator.


    Many banks failed in the US but that is the point of bank regulation. Hit-m hard, hit-m earlier, and let the winners get stronger.


    I am still confused by the American stockmarket expectation of ROI for banks currently. If you look at all of these strong banks trading under book value, sitting on way too much capital, and way too much reserves it's a bit of a puzzle to me. Ok, fine Return on Equity is below average, and NIM's have been compressed, but they can't compress too much further. When does Chase take out Key? When does Well's Fargo buy up 30 small locals? Why aren't these boards trying to take over each other at these low stock prices?


    The only reason to hold this much capital is to have the FDIC hand you your neighbor bank and give you a nice juicy loss-guarantee asset. The days of these deals are done, so why don't banks buy back stock, reduce ALLL, and get the stock market excited about bank stocks again. This human reaction is what is interesting to me.
    18 Nov 2012, 02:15 PM Reply Like
  • Jason Cawley
    , contributor
    Comments (5485) | Send Message
    Author’s reply » The major US banks stocks are undervalued, certainly. But they have been very slow to buy back stock, in part because the regulators frown on it. Even on ordinary dividends. The regulators want them building the strongest possible capital cushions.


    Understand, beyond the required capital under Basel III there is a secondary requirement for a capital "cushion" beyond the regulatory requirement, of another 2.5% of capital. Within that zone - over 8%, under 10.5% capital - they are restricted from buying back stock, paying out dividends, or paying various sorts of bonuses. Now, those rules are not yet in effect, technically. But e.g. Bank of America still hasn't received regulatory approval to raise its dividend rate, slashed during the recession.


    Recently JP Morgan Chase has announce a buyback, that will come to about 9% of the common when completed - that is the first move by any of them to buy in stock in meaningful amounts. And it is about the strongest one out there (USB is the only other in its league, really).


    As for takeovers, remember how much they have all been burned by the legal difficulties of failed firms they absorbed. Bank of America is *still* paying for Countrywide. It has paid many times more in legal bills related to Countrywide than it did for the company. It got sued over Merrill, even though Merrill proved a profitable buy in the end, by its own shareholders - or rather, lawyers with a stamp claiming to represent them, when the stock price went down.


    It is completely unsurprising that they are all gun-shy and animal spirits are nowhere in evidence. As a group, they've had the holy tar beaten out of them, by governments, the courts, Wall Street analysts, the markets, defaulting borrowers, you name it.


    Doesn't mean they are not undervalued - they are, by any objective standard. Just explaining why we won't see a lot of high wire act deals out of any of them, for the forseeable future.
    18 Nov 2012, 06:58 PM Reply Like
  • Westcoaster
    , contributor
    Comments (752) | Send Message
    Thanks Jason, this is a good explanation for the current timid market. I guess I need to watch the capital ratios build up even further before any of these bankers become brave capitalists again.
    18 Nov 2012, 07:59 PM Reply Like
  • pgace123
    , contributor
    Comments (188) | Send Message


    I've been following your comments for some time and must say that you may just be the single most knowledgeable contributor on SA re Financial's. Thank you. I've learned quite a bit from you esp on the macro-side of things.


    I've been investing heavily in U.S. Community and regional banks. There's been some nice consolidation among the community banks but not at the rate I expected, it's slower. The regionals are starting to pickup some steam but are at a very slow pace.


    It appears that the regulatory environment is not condusive to bank M&A, buy backs, etc for the time being.


    With that being said, I believe it is an opportune time to load up on these companies. I find that history usually repeats itself and the pendulum will swing back into the financial sectors favour. It just may take some time.
    The same goes for insurers.


    I've also been investing in U.S. And European insurers and European banks. I currently own DB, AEG, MET and GNW to name a few.


    Obviously free free not to respond, but I would like to get your take on a few things:


    1. Would u invest in U.S. Financial's now and if so, what type - community, regional and/or national/global;


    2. Same question as 1 above except for European Financial's; and


    3. Do u have any comment on GNW as a turnaround insurer story or split/private transaction? Not sure if u have any background on long term care insurance
    12 Nov 2015, 09:46 PM Reply Like
  • Jason Cawley
    , contributor
    Comments (5485) | Send Message
    Author’s reply » pgace123 - I do like the US financial sector right now. The regulatory environment is not favorable, but the economic fundamentals are OK, and they have done a lot to improve their practices and repair their balance sheets. I am long some larger names that those you mention. I do think there is opportunity in the better small and mid sized banks, but one needs to be selective. Many are small for good reason, and don't have the breadth of the big ones (too concentrated in commercial real estate lending e.g.).


    As for European financials, I want to like them, but many are still running at much higher leverage than I consider sound, levels around 25x for assets to common equity. They need to bring that down to meet tighter Basel III rules, and until they do, they can't grow rapidly by internal means, and have to stay in low risk assets for the sake of capital risk adjustments. That in turn limits their profitability. Most just don't have competitive return on asset measures by international or US standards.


    Banks I want to like in Europe are UBS, Barclays, and some of the Nordic country banks. But I am not sure the timing is right or that they have done enough on the capital and safety side. I think a better time to acquire them might be in the next down cycle, rather than right now. Personally I am holding off on those.


    I don't know GNW or its line of business well enough to give you a comment on that one, sorry.
    13 Nov 2015, 02:14 AM Reply Like
  • dmiller4
    , contributor
    Comments (89) | Send Message
    Very interesting and informative analysis. Thanks JasonC!
    29 Dec 2012, 07:38 AM Reply Like
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