Bad Numbers : The World Bank estimates the ratio of non-performing loans (“NPLs”) to total gross loans is comparable the 2009 levels of 4.2% in 2009.
Several loci of banking stress are identifiable.
European banks have around €1.2 trillion of problem loans. Italian banks alone have an estimated €360 billion of non-performing loans (“NPLs”), around 20% of Italy’s GDP. Italian NPLs represent around 15% of all loans, compared to around 5% in the US in the 2008 banking crisis. Italian banks do not have sufficient capital and access to new equity is now limited. The government’s established a vehicle -Atlante nicknamed Atlas- to recapitalise problem banks. Its €4-6 billion of funding was inadequate for the size of the task. It also entailed raising money from stronger banks, insurers and asset managers to support weaker entities, in effect weakening them spreading contagion.
Other European banks are not immune. Germany’s fragmented banking sector (with around 1,500 institutions) is vulnerable, not having fully reformed after the 2008 crisis. Deutsche Bank, its premier bank, faces significant challenges. Landesbanks, central institutions for savings banks and house banks for the German Laender (states) responsible for promotion of regional development, face rising bad debts and persistent low profitability. Some face potential difficulties in replacing formerly State guaranteed term funding, no longer permitted under EU competition rules.
NPL problems are also apparent in emerging markets, especially India, China and Brazil.
India stressed loans total more than US$150 billion, over 15% of bank assets. The problems are driven by over-leveraged borrowers, including state owned enterprises (“SOEs) family owned conglomerates and infrastructure concerns, and government driven trophy projects with dubious economics to which state owned banks are pressured to lend to.
China’s official bad debt are under 2% of total credit, and around 6% including ‘special mention’ loans. Independent estimates are as high as 15-16%. The IMF studies indicate US$1.3 trillion of risky loans, with potential losses equivalent to 7% of GDP, lower than other forecasts which range to over 20% of GDP. The losses are not dissimilar to previous debt cycles. However, this time around it unlikely that strong growth resulting from some liberalisation and strong external demand can resolve the NPL problem.
Brazil’s delinquency rate for loans more than 90 days overdue is approaching 3.5%. It will rise as borrowers struggle to service debt due to a brutal economic downturn, high interest rates, falling commodity prices and a weaker currency.
Banking systems in other less affected advanced economies also face increasing risks. Loans are supported by artificial collateral values, especially real estate and equity, inflated by unconventional monetary policies. Debt sustainability is also based on artificially low interest rates. Normalisation of interest rates may threaten solvency of many over-indebted borrowers.
Old and New Causes
Traditional banking crises are caused by bad lending, often to an individual sector, most frequently real estate. Lending to leveraged buy-outs and telecommunications were contributors to the 1994 and 2001 crises, while real estate lending was a factor in the 2008 problems.
The current problems have some familiar causes. There is significant exposure to the troubled resource sector, emerging markets and overvalued housing markets. Lending to the energy sector alone totals around $3 trillion, where borrowers are struggling to service debt in an environment of falling commodity prices, weak growth, overcapacity, rising borrowing costs and (in some cases) a weaker currency. Banks in the US, Canada, UK, some European countries, Asia, Australia and New Zealand are exposed to property markets, which are over-valued by historical measures.
Non-traditional factors also contribute to banking instability.
A weak recovery from the great recession is a problem. In advanced economies, such as Italy, low growth and disinflation or deflation rather than aggressive real estate lending is driving loan stresses. In many European countries, it is a by-product of a lack of global competitiveness exacerbated by the effects of the single currency.
Since 2009, official policies have targeted expansion of bank lending to increase growth and inflation. With safe assets offering low returns, risk in the financial system has risen. Seeking higher returns, banks have financed less credit worthy borrowers, especially in the shale oil sector and emerging markets. Abundant liquidity has increased asset prices. Banks have lent against this overvalued collateral. Low rates have allowed weak borrowers to survive. This has encouraged a persistent failure to address asset quality problems, by writing off bad loans.
In developing economies, strong capital inflows, seeking higher returns or fleeing depreciating currencies, has encouraged increases in leverage. State policies encouraging debt funded investment or consumption to create economic activity has also led to banking problems. In China, the principal cause is government directed social lending to SOEs for investment to meet growth targets resulting in overcapacity and project which cannot meet debt repayments.
The risk now is that banking sector problems now trigger a familiar doom loop.
Banks are highly leveraged, typically around 10 to 12 times. In contrast, hedge funds are leverage 3/5 times on average. This means a small loss can wipe out a significant portion of capital increasing the risk of insolvency e.g. a loss of 5% of its assets can reduce its capital buffer by a half.
In advanced economies, many banking systems are also large relative to the real economy. They are also vital in facilitating payments and supplying the essential credit that drives consumption, investment and government spending. Any disruption in financial intermediation quickly results in a real economic slowdown.
Banks are networked both domestically and internationally through inter-bank borrowing and lending and derivative transactions. Problems at one bank can quickly spread, infecting other firms and the financial system. International banks, primarily Europeans bank also have varying degrees of risk on Italian banks and sovereign debt as well as to other weaker European issuers. These banks have exposure to Italy of more than €500 billion, with French and German banks holding a large proportion of this.
Traditionally regarded as safe investments, bank deposits, bonds and shares act as another channel for transmission. Principal losses, deferral of interest payments or cut in dividends quickly affects investors. Loss of wealth and income affects real consumption.
Public finance problems flow as governments and central banks are forced to support banks to prevent failure of essential payment and credit flows.
Don’t Bank on A Quick Fix
A number of factor means that this time a banking crisis might be different and more difficult to resolve.
Solution of banking crises requires strong earnings, capital infusions, isolation of bad loans, and industry reforms.
But the ability of banks to earn their way out of the crisis to allow losses to be written-off is limited. Many troubled banks have low profitability, which is compounded by current monetary policy. Low and negative interest rates lower banking profitability as banks are unable to cut deposit rates to the same extent as lending rates because of the need to maintain deposits and comply with regulatory requirements for stable funding.
Traditionally, banks have built capital by earning the margin between low deposit rates and safe, longer term fixed rate assets, such as government bonds. Today, the term premium, the difference between short and longer term rates, has collapsed reducing this option.
Access to new capital may be limited. Today several structural factors have created uncertainty about the long-term future of banks and may have permanently reduce available returns reducing the attraction for potential investors. Many bank business models are fundamentally in need of major reform, entailing consolidation and cost reductions which are unlikely to be willingly embraced by governments fearing job losses and lack of competition. Many nations are also resistant to foreign ownership, capital and expertise.
Poor institutional and legal frameworks, especially inefficient bankruptcy procedures, are a barrier to new investment in banks or distressed assets. Foreclosures in Italy can take more than 4 years, compared to 18 months in the US or UK. Emerging market procedures for dealing with corporate restructurings are complex and frequently untried.
In Europe and emerging markets, there is frequently reluctance to foreclose because of politically difficult business closures and job losses. Labour laws, which have onerous requirement in relation to retrenched employees, can be problematic. In emerging markets, the pervasive influence of the state in both the lending banks and the borrower, either through ownership or other relationships, complicates enforcement of claims. Politically connected borrowers or strategically important industries can force weak loans to be rescheduled rather than recognised as unrecoverable.
Unanticipated political developments also complicate the matter. Energy prices are affected by geo-politics as much as market forces. Brexit affects the banking system through the currency devaluation and the altered prospects for individual financial institutions.
Political factors are impeding recapitalising banks. This can be seen in Italy. Resolution of insolvent banks under EU procedure requires progressively writing down equity, subordinated debt, senior debt protecting only insured deposits. However, “bailing in” creditors would result in writing down around €200 billion of securities held by retail investors in part due to a quirk of the tax code. The suicide of one retail bondholder in November 2015 after large losses when a small bank experienced difficulties highlighted the fact that the risk of such investments have been understated or misunderstood. Further write-downs would create political difficulties for the government. At the same time EU banking regulations as well as budgetary and debt limits make it hard for the government to intervene.
New Regulations, Old Problems
After 2008, new banking regulations, covering capital levels, leverage, liquidity and resolving insolvency were introduced globally to make the financial system safer and eliminate the need for a future taxpayer financed bailout. The unpalatable reality is that the regulatory measures may not ensure the stability of the banking system.
Higher levels of shareholder capital and total loss absorbing capital (“TLAC”) in combination with reduced leverage have increased the buffer against losses. However, more capital does not reduce the risk of incidence of losses. In a new crisis, the problem will be transferred to shareholders and holders of TLAC securities, such as private investors, pension funds and insurance companies. Given their systemic and political importance, governments may be forced to bail out these investors in a major crisis.
Bank are now required to hold larger amounts of liquid high quality assets, typically government bonds, to protect against a run on deposit or disruption to money markets. But in a crisis, banks may not be able to sell holdings because of the potential impact on yields. Instead, the central bank would be forced to finance the bank using the bonds as collateral, in effect transferring the risk to the public.
Resolution schemes envisage using all bank equity and liabilities other than insured retail deposits to absorb losses. This includes hybrid securities, subordinated and senior debt which may be “bailed in” to prevent the need of public funds to support a distressed bank. In practice, this may prove difficult. Bail-in securities are untried. There are complex triggers for write-offs. As Italy illustrates, it may be politically difficult to enforce the strict bail-in protocols.
Resolution schemes underestimate the challenges of an orderly unwinding of derivative and cross-border transactions. Conflicts between different legal systems, especially bankruptcy regimes, are problematic. A number of banks have not been able to satisfy regulators that their winding up plans (known as ‘living wills’) are adequate.
The success or otherwise of the new regulatory regime will not be known until the next crisis. But in a major crisis like 2008, governments and public funds are still likely to be required to guarantee the payment system and supply of essential funding for the economy. Whether governments have the financial capacity to do that and the public’s willingness to countenance another bailout is uncertain.
A new banking crisis will be significant. For example, European banks alone may need between €150 and €900 billion in new capital. Given that they are significant owners of sovereign debt and the main source of lending to the small and midsized companies which make up 70 per cent of the economy, banking problems represent a major source of continued economic instability.
Banking system problems threaten a repeat of the epidemic which in 2008 created the global economy’s most serious crisis in the post WW2 era.