The Brexit vote has had some fairly impressive knock-on effects in Europe. One of the main market effects has been the huge sell-off in banking stocks throughout Europe (Charts 1 and 2). It certainly seems like Warren Buffett's dictum about the tide going out and letting us see who's swimming naked is in full operation here. There have been a number of authors who have noted that the European banking crises of 2008 and 2012 were never fully resolved. For example, Mehreen Khan has written in the Financial Times that many European economies and their respective banking systems did not ever recover from the 2008 crisis. Many eurozone banks continue to have very high non-performing loans (NPLs; cf. Chart 3).
Chart 1: The Demise of the Oldest Bank in the World
Chart 2: The Shocking 2015-2016 Decline of DB Compared to Lehman Brothers
Chart 3: Very High NPLs in More Than A Dozen EU Countries
The ECB is again allowing the deferral of risk weightings on sovereign debt, according to Rupert Hargreaves of the ValueWalk blog. This means that once again, eurozone banks can load up on relatively high-yielding Spanish and Portuguese debt using cheap funding from the ECB, all the while treating these somewhat doubtful securities as risk-free, and thus using them to cut their reserve requirements. We also observe many examples of "extend and pretend" loan refinancing in many countries around the world, including the US and China. These accommodations, especially when they involve sovereign debt, are convenient in the short run, but they join governments and banks at the hip; there can be little doubt that they will eventually share the same fate.
This kind of thinking has gone so far now that even Greek debt is considered adequate collateral for ECB funding. This allows Greek lenders to pledge junk-rated sovereign debt against ECB funding, according to Jana Randow and Nikos Chrysoloras of Bloomberg. The ECB is also apparently ready to allow senior tranches of hypothetical securitized Italian NPLs to be used as collateral for ECB funding, should that be needed. This is a fairly shocking replay of the kinds of things done by Bernanke's Federal Reserve during the height of the 2008 crisis. It is fair to say that we are again in a European banking crisis, and what happens next is critical to our economic health.
What is amazing to me is the fact that despite massive evidence of poor management and widespread, systematic law-breaking, very few banks in Europe are being allowed to fail. The same thing happened in the US during and since the 2008 crisis; indeed, hundreds of small banks failed, but very few big ones. Yet trillions of dollars were required to bail out or buy out large US banks in 2007-2009. Admittedly, many of the 2008 bailouts didn't even involve real banks, as the mostly unregulated shadow banking system allowed brokers, investment banks, and insurance companies to get in so much trouble that they ended up being bailed out (just like banks) by the Fed and the Treasury. This demonstrated a critical need for reform, but in essence little has actually been done to rein in shadow banking anywhere.
As I have stated elsewhere, no central bank seems inclined to actually follow the standards of Bagehot's (1873) Rule, i.e., to lend only to solvent banks, on good collateral, at a premium interest rate. By doing the opposite of Bagehot's Rule, first the Fed in 2008, and then the ECB in 2012, and now the ECB again in 2016, have essentially abandoned capitalism. Or rather, they have simply confirmed that their long-term negligent supervision of banks, their complete ignorance of shadow banking, and the various unconstitutional measures they've undertaken to save TBTF banks in the last few years have together long since signaled the end of their support of capitalism. The fiscal authorities in every case seem not only to have backed up their respective central banks on this, they've actively promoted this undisciplined ad hoc decision-making process, at almost any cost. This is not a universal failing, as evidenced by what happened in Iceland over the last few years, but it is nearly so.
This ends up meaning that because of circumstances that tend to develop in a financial crisis, any thought of proper financial discipline or prudent action tends to be abandoned by the authorities in the name of expediency. There are no principles guiding the technocrats who make these decisions, except the support of the status quo. The principles of capitalism, on which our entire economic system is based, have thus been summarily tossed out in a series of crises for convenience alone. The result is that we are all more or less poorly led, and none of our financial problems (like failing banks) ever seem to get truly resolved in a permanent way.
If you think that this doesn't apply to America because our banks are so much stronger than European banks, I give you Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) and Ginnie Mae and Sallie Mae as counter-examples. My God, they are back to 98% LTV loans at Ginnie Mae again, and Fannie Mae is buying equally toxic mortgages! Student loan debt in the US has more than doubled since the crisis (to $1.35 trillion), and default rates on them are high and getting higher. The Fed's recent stress test, according to Rupert Hargreaves of the ValueWalk blog, allowed all 33 US banks to pass, but an alternative market crash scenario had the top six banks requiring another $376 billion of capital. This is not that much different (at the extremes) than the weakness in Europe, I'm afraid. Government is pushing the same agenda as before, not having learned anything at all.
This tendency of government to favor systemically important banks and GSEs and shadow banks (at any cost) also means, in my opinion, that without ever casting a vote, hundreds of millions of people on different continents have lost their right to a fair and equitable economic system. Such a system would have eventually (at least in crisis) weeded out poor managers and badly run companies through creative destruction, and ultimately protected the public from the asymmetric results of moral hazard in the banking/shadow banking industries. Instead, the worst managers and companies have been explicitly protected nearly everywhere.
All anyone in the central banks or government can talk about is how to save these monsters yet again, not how to eliminate the threat. Sure, there were some reforms, but they were written by big bank lobbyists for the most part. If you're a small company or bank owner, the rules apply to you, and you are at risk for your mistakes, but if you're really huge, and somehow involved in finance, they don't, and you aren't. Of course, I realize that you can't just let big banks fail left and right, but we've had years and years to institute reforms, and in this we have failed in Europe, and mostly failed in the US.
A great illustration of the modern dilemma can be seen in Chart 4, which shows a lower incidence of bank closures in the US in the Great Financial Crisis of 2007-2009 than was seen in the S&L Crisis of 1982-1990. This is in spite of the fact that the later crisis was orders of magnitude bigger than the earlier one. Of course, banks have been getting bigger for many years, so this may not be the best measure for capturing the banking problem. However, it is also the case that many non-banks were at the center of the troubles in 2008, and this may be the best explanation for the low number of bank closures: the crisis involved unregulated entities that are not captured in normal financial crisis statistics. This is the great danger that we still face around the world.
The same kinds of problems are of course very persistent in Europe, but banks are far more important in the capital markets there. The explanation for the persistence of banking problems in Europe is in part the tremendous amount of interconnectedness in the global system, as shown on Chart 5. This feature scared central banks and fiscal authorities into doing basically anything necessary to avoid presumed total systemic failure. Yet somehow this impulse didn't translate into taking action after 2008 to prevent this risk from ever happening again.
Chart 4: Asymmetric Distribution of Bank Failures Is Unrelated to Crisis Severity Since 1965
Source: FDIC; fool.com
Chart 5: Interconnectedness of Deutsche Bank (NYSE:DB)
Source: kitco.com; marketoracle.co.uk; wsj.com
In consequence, global systemic risk is still elevated seven years after the initial crisis, according to Robert Engle and Matthew Richardson of the NYU Stern School of Business (2015). Their work involves estimates of systemic risk (SRISK) that can be aggregated up to country or regional levels (Chart 6). Thus, the banking systems in France, the UK, Greece, Switzerland, and Japan are still relatively large contributors to systemic risk. Reforms since 2008 were generally written in favor of big banks and at the expense of small ones in many places, although the Dodd-Frank legislation in the US seems especially egregious in this regard (Charts 7 and 8). This, plus the failure to fully recapitalize European banks and write off losses has left many giant banks in weak condition. Zombie mega banks are the result: they are neither dead nor alive, but just undead, and they can still cause a systemic crisis.
Chart 6: Engle & Richardson (2015) SRISK/GDP Estimates
Chart 7: More Big Banks, Fewer Little Banks
Chart 8: Five Largest Banks Have 40% of Deposits
Given the absolutely appalling size of the banking crises in 2008, in 2012, and now again in 2016, and the "need" during each crisis to partially resolve it with government bailouts, the cost to the general public has been shocking in scale (Chart 9). As can be seen, if we just look at Europe and the US in 2007-2011, their combined estimated increase in debt was about 20% of GDP (about $2.76 trillion for the US and about $3.17 trillion for Europe), and direct costs were probably 4% of GDP ($552 billion for the US and about $633 billion for Europe), according to the IMF. The failure by banks, regulators and legislators to fully reform the banking system (and the shadow banking system) means that these kinds of costs are ongoing, and each new crisis (like the present one in Europe) has the potential to trigger a massive new fiscal cost that will hit the public yet again. Governments have already responded with money printing or debt monetization; it is hard to see how this can continue without markets and the public losing faith in the system at some point.
Chart 9: Huge Fiscal Costs of Financial Bailouts
We are seeing strong signs of a populist rebellion in many countries right now. This kind of sentiment started in the aftermath of the Great Financial Crisis, when banks got bailed out after the greatest fraud in history, yet essentially no one went to jail for that fraud (except in Iceland and perhaps the UK). Of course, there are many other factors involved in the rise of populism, such as immigration policy, but the lack of punishment for the financial industry has probably become an issue with legs, and the new banking crisis will likely renew populist anger, as it already has in Italy. This will be awkward because it is a referendum year in Italy and an election year in the US, and there are elections in France and Germany next year.
Chart 10 below suggests that the lack of prosecutions since 1998 has actually encouraged accounting fraud, here defined as the violation of Benford's Law (which is a forensic accounting identity that predicts the frequency of specific numbers that should occur in normal accounting data). Jo Craven McGinty of The Wall Street Journal has pointed out that the Enron fraud was readily visible on a Benford's Law diagram, and there is still popular anger about that incident many years later.
What is the real justification then for letting the greatest fraud in history go unpunished? There must be a political explanation, but it must also be a pretty weak one. Anyway, the public outrage over 2008 here in the US, and 2012-2016 in Europe, is palpable and growing larger. This is a cancer on the body politic that will not be helped by another financial crisis and bailout in Europe.
Chart 10: Accounting Fraud Encouraged By Lack of Prosecutions
The series of financial crises and bailout actions by central banks and the fiscal authorities in recent years may very well be the biggest policy mistakes that have ever occurred since the 1930s. I don't necessarily expect the end of capitalism to come from this, but I do expect a lot of trouble, and our political cohesion will continue to be tested.
What central bankers have done, with the full acquiescence of unprincipled and/or clueless politicians of all stripes, is to serially violate the rules of capitalism and the laws of their respective jurisdictions, all in order to preserve the status quo for very poorly run major banks and speculative shadow banks. Much of this is due to the deferral of problems until a crisis forces action. Now, of course, there's nothing new in who gets to pay for such a mess; it is always and has always been the public. But at least in the Great Depression (the last time such a huge crisis occurred) most bad banks were actually closed (cf. Chart 4 above). We now have allowed the unregulated speculators in the shadow banking world and the TBTF banking sector to effectively control our destiny, without ever voting to give them that power.
Indeed, our elected representatives may be in gross dereliction of their duty in not reining these bad bankers and speculators in, but the legal and financial systems in place were originally set up for actual capitalism, and have been maintained as such under a body of law that dates back to the 1930s. No one has openly proposed or voted for the mess we see now in so many countries. It has happened because the entire regulatory and political apparatus of the state, of many states in fact, has been captured by the big financial interests; it has also happened because of human error, something that will always be there. Slowly but surely, the original safeguards on the system have been repealed or set aside for convenience, financial engineering has been deemed useful rather than destructive, and the common sense and probity that used to dominate our system are mostly gone.
Our so-called reforms have done little to diminish the power of shadow bankers and TBTF banks to generate catastrophes. Even where we do have some regulatory control, such as in the case of actual banks, we have sometimes given bigger banks nearly unlimited room to profit from moral hazard. That is less a case in the US than it was, but it is still very much the case in Europe. For crying out loud, the leverage on Deutsche Bank is around 40:1, but was "only" 31:1 for Lehman Brothers, according to Chris Vermeulen at thestreet.com. How can the supposedly sane and prudent Germans have allowed this to go on? The answer must be the same as it was in the case of Lehman Brothers: no one is minding the store.
As for trades, I am not convinced that the recent equity rally means anything at all. The currency and bond markets are telling the real story here, as well as the banking indexes in equity markets. Investors should stay defensive unless a real, confirmed breakout of 3% or more above the old 2015 highs occurs, holding intermediate to long Treasuries: the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT), the iShares 7-10 Year Treasury Bond ETF (NYSEARCA:IEF), the Vanguard Intermediate-Term Bond Fund (NYSEARCA:BIV), the PIMCO Total Return ETF (NYSEARCA:BOND), and the iShares Core Total U.S. Bond Market ETF (NYSEARCA:AGG). Also, defensive sector funds like the PowerShares S&P 500 Low Volatility Portfolio ETF (NYSEARCA:SPLV), the iShares MSCI USA Minimum Volatility ETF (NYSEARCA:USMV); also some liquid alternatives like the Otter Creek Long/Short Opportunity Fund (MUTF:OTCRX), the AQR Long-Short Equity Fund N (MUTF:QLENX), or the AQR Equity Market Neutral Fund (MUTF:QMNIX); and even some sophisticated hedge-like Closed-End Fund strategies like the Nuveen S&P 500 Buy-Write Income Fund (NYSE:BXMX).
Disclosure: I am/we are long BIV, BOND, OTCRX, QLENX, QMNIX, BXMX.
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.
Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.