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.