European financial system: next crash just around the corner?

By Dick Nichols November 1, 2016 — Links International Journal of Socialist Renewal — The trials of major European banks, starting with “venerable institutions” like the Monte dei Paschi di Siena (the world’s oldest bank) and Deutsche Bank (Germany’s largest), have raised the spectre of another 2008 — a “Lehman Brothers times five” in the words of one finance market analyst. Deutsche Bank has been found to be seriously undercapitalised, both according to the international bank regulation standards set by the Basel Committee on Banking Supervision (“Basel III”), as well as in relation to its own targets. The bank, whose US division failed Federal Reserve stress tests earlier this year, has been described by the International Monetary Fund as probably “the most important net contributor to systemic risks." The immediate cause of Deutsche Bank’s plight was the insistence of the US Justice Department in early September that it pay $14 billion in compensation for peddling worthless mortgage-backed securities to US housing finance providers Fannie Mae and Freddie Mac before the 2008 crash. However, according to Financial Times commentator Martin Wolf, Deutsche Bank, a specialist in financial derivatives, is also “structurally weak … [and] highly leveraged by the standards of its peers. Roughly half of its €1.8 trillion in assets are linked to its trading activities … [It] is a highly-leveraged bank with a doubtful business and opaque assets.” According to an analysis by German bank Berenberg, in June Deutsche Bank held 96% (€32 billion) of its assets in the lowest grade (“Tier Three”) asset class established under Basel III — financial derivatives whose nominal value is established by the best guesses of risk managers. These financial instruments contributed a lot of the dynamite that made the 2008 finance markets implosion so globally devastating. Monte dei Paschi is a simpler case. The only bank to fail the European Banking Authority’s (EBA) most recent stress test (made public on July 27), Monte dei Paschi has lost €15 billion over the last five years because it has nearly €30 billion in non-performing loans on its books. Non-performing loans for the entire Italian bank sector total €360 billion (18% of all loans), and, according to Euromoney magazine, are causing great anguish for European banking regulators. A typical restructuring plan has been developed to try to save Monte dei Paschi. It involves slashing 2500 jobs, closing 500 of its 2000 branches, selling-off its non-performing loans and its payment processing system, and raising capital through a debt-to-equity swap and a €5 billion share issue. By October 27, Deutsche Bank shares were trading at €14.60, one-tenth of their April 2007 high point. On the same day, trading in Monte dei Paschi shares was suspended after they fell to €0.27 on the announcement of the restructuring plan. In May 2007, they had reached a high of €108.52. These enormous collapses in share value would seem to confirm the predictions of impending disaster that have been around since January, when economists for the Royal Bank of Scotland (RBS) infamously told clients to “sell everything except high quality bonds”. This apocalyptic response has not just been pushed by bearish financial commentators in search of a scary headline. Two-thirds of finance industry respondents to a recent special Euromoney poll believe that Europe will experience a major banking crisis, even though they disagree as to whether it can be contained to Italy or will have Europe-wide or even global fallout. Former Bank of International Settlements (BIS) chief economist William White told the US National Association of Business Economists on September 11 that “the situation we face in late 2016 ... is arguably more fraught with danger than was the case when the crisis first began. By encouraging still more credit and debt expansion, monetary policy has dug the hole still deeper.” White, one of the few mainstream economists to predict the 2008 crash (“an accident waiting to happen”), concluded that “the fundamental problem is one of excessive debt and possible insolvency. Such problems must be solved by governments, not central banks.” Now employed by the Organisation for Economic Cooperation and Development (OECD), White proposed that “debt restructuring and outright forgiveness must be used much more aggressively ... major increases are required in public investment in infrastructure ... governments should use what measures they still have at their disposal to increase aggregate demand.” ‘Under siege’ The troubles of Deutsche Bank and Monte dei Paschi are only the most extreme expressions of a debt-induced “zombification” of the European banking sector, described by European Central Bank (ECB) vice-president Vitor Constâncio in a July 7 address at the University of Navarra as being “under siege”. Other banks generating concern include the RBS, which was bailed out by the UK government in 2008 and has since posted eight straight annual losses, Irish banks Allied Irish Bank and Bank of Ireland, British bank Barclays, Spanish bank Banco Popular, Switzerland’s Credit Suisse and Austrian bank Raiffeisen. In the July EBA stress test all experienced deterioration in their key ratio of core capital (shareholders’ equity plus retained profits) to total assets (as measured with risk weightings). In addition British bank Lloyds, which has met its 13% target for this capital ratio (known as Tier One), is suspected of getting across the line by the use of creative accounting involving asset reclassification, an operation described by one finance industry analyst as “reaching down the back of the sofa”. EBA chair Andrea Enria outlined the overall situation for European banks in an October 5 speech in Vienna. While noting that across the EU only 5.5% of loans were “non-performing” (down from 7% three years ago), this figure was three times as high as for the US. This average figure also concealed serious problem areas. For big banks the non-performing loan ratio was under 4% while for small banks it was almost 25%: for ten EU countries it was over 12% (with Cyprus and Greece leading the way at 44.8% and 34.4%). Enria emphasised: “The problem is European in scale: we have more than €1 trillion of gross non-performing loans in the system [around 9% of EU GDP]; even considering provisions [against loan default], the stock of uncovered non-performing loans is at almost €600 billion — more than all the capital banks raised since 2011, more than six times the annual profits of the EU banking sector, more than twice the flow of new loans... “For supervisors, this casts serious doubts on the long term viability of significant segments of the banking system. The same concern is shared by investors and is reflected in the low valuations registered in stock markets.” (emphasis added) EBA vice-president Constâncio said in his Navarra address that “the European banking sector is bound to continue to shrink in the future. This raises the important question of how to achieve a reduction in excess capacity without triggering bank distress and negatively affecting economic activity.” That concern has only increased since Brexit added an extra destabilising factor to the mix and further depressed the share prices of banks with big operations in London — supposedly Europe’s natural financial hub in the high-risk, high-return business unleashed by financial deregulation. Shrinking profit openings The state of siege in the European banking system comes after it has received €1.6 trillion in taxpayer support since 2008 and when the European Central Bank (ECB) makes €80 billion a month available in life-support financing. So why are major European banks still in such dire straits? What has happened to the vast pool of largesse that was supposed to save them? The source of the mess lies not only in banks’ non-performing loans and the fines paid for their pre-2008 scams and misdemeanours (₤17 billion for UK banks alone), but also in the generally stagnant economic environment in which they have had to operate since 2008. This was shaped in Europe by the 2009-10 and 2012-13 double-dip recession. In addition, measures forced on banking regulatory authorities by the financial crisis — mainly the increase in capital and liquidity requirements and leverage limits introduced under the Basel III —have made the system more stable at the cost of curtailing opportunities for profit-making. Bankers can no longer run their operations on as little as one or two per cent of Tier One capital (as they did before 2008): some now complain that the price of greater systemic safety in terms of lost profit opportunities is too high — the “gains” of the 1980-1990s wave of financial market deregulation are supposedly under threat. Inevitably, tighter regulations have also increased the incentive for banks to shift increasing transactions into the realm of “shadow banking”. This universe continues to expand and the regulators have only just begun to address how to police it. The post-crisis interventions of central banks — releasing trillions in cash into the system and accepting government and corporate bonds and even shares as collateral — contribute to an excess demand for these financial assets above and beyond that created by their value as claims on corporate profit and the tax income of governments. The result, according to former Bundesbank head Axel Weber, now chairman of the Swiss banking giant UBS, is that: “I don’t think a single trader can tell you what the appropriate price of an asset he buys is, if you take out all this central bank intervention.” In addition, the negative deposit rate of -0.4% now charged by the ECB to commercial banks for holding their excess cash also hurts them by potentially narrowing the gap between what they pay for funding and what they can charge for lending. The purpose of the measure is to create an incentive for banks to lend funds rather than have them idle and losing income in their ECB account. However, it confronts banks with the unpleasant choice of either passing on the cost (that is, providing lower or even negative interest rates to their own clients) or absorbing the cost and squeezing profits. This ECB policy has created an outcry within the German banking system in particular, with its many smaller banks claiming that the only choice it gives them is how to lose money: either through the ECB’s negative interest rate slug or though increasing lending to risky customers. The German Commerzbank has threatened to store its cash in safes rather than send it to the ECB, while the Bundesbank has calculated that ECB interest rate policies cost the German banking sector €248 million in 2015. However, the chief pressure squeezing bank profitability has come directly from real economic conditions, from the subdued demand for loans, still the main asset class on most bank balance sheets. This stagnation in credit demand is due to big business being more reluctant to invest since 2008 and, in any case, very often able to fund any investment undertaken out of its own retained profits. At the same time, given their experience of non-performing loans, banks have raised interest rates and tightened borrowing conditions for non-prime borrowers, typically small and medium business. Because of low, even negative interest rates, they have also had to accept narrower margins on loans to their more reliable customers. Matters are worst on the “periphery” (Spain, Portugal, Greece, Ireland, Italy and Cyprus), where between 2007 and 2015 investment as measured by gross fixed capital formation crashed from an average of 25.9% to 20.9% of Gross Domestic Product. As a result, while bank credit to non-financial business for the whole of the Eurozone was negative from the beginning of the crisis in 2008 until the end of 2013, for the distressed economies of this “periphery” it crashed by five per cent annually. Since 2014, it has picked up for the Eurozone as a whole, but has continued to fall in Spain and Greece (see Figure 1). 
ECB financing operations The situation would have been even worse had it not been for the European Central Bank’s longer-term refinancing operations (LTRO), begun in late 2011. The LTRO handed banks hundreds of billions at one per cent interest, which they often invested in government bonds at higher interest rates. This was money for jam that helped banks reduce their own indebtedness, at the expense of government budgets in which debt servicing payments became an ever larger line item. Next, in mid-2012, came the ECB’s decision to undertake Outright Monetary Transactions (OMT) — the purchasing of government debt in secondary markets — in order to help drive down interest rate on public debt in the “periphery”, in fulfilment of ECB governor Mario Draghi’s undertaking to do “whatever it takes” to save the euro. Finally, by the beginning of 2014, there was a mild pick-up in bank lending to business that was reinforced by the ECB’s next initiative — targeted longer-term refinancing operations (TLTRO). This was a program to effectively give banks money on condition that these funds were used to finance credit to small and medium business and not to speculate on the bond market or real estate (a major destination of LTRO funds). However, by the end of 2015 the TLTRO was also running out of steam, with banks increasingly not taking up the ECB’s very generous offer because demand for credit was simply not there. A second phase of TLTRO began in June. It is doubtful how much take-up there will be of TLTRO II. In the words of one anonymous finance commentator cited on the Zero Hedge web site: “The lack of positive real expected returns dampens new investments in hiring plans, plant and machinery, and related borrowing and credit formation with it. Thus, [ECB president Mario] Draghi’s move was just another artefact of financial leverage, not a game changer.” The result of the ECB’s expansionary monetary operations, conventional and unconventional, has been to underpin what very mild growth there has been in the Eurozone since 2013, but at the very high cost of producing overvalued and increasingly volatile financial markets (especially share and bond markets), as the beneficiaries of ECB largesse hunt for some return in the world of low and negative interest rates driven by stagnating rates of investment and growth. For the banking sector the end result of the operation of all these tendencies is chronically low profitability (see Figure 2). In the euro area average bank return on equity (income after costs as a ratio of shareholder equity) was at 5.8% in early 2016. This is not only less than the 10% generally accepted in the industry as a “good performance number”, it was less than the cost of capital (cost of raising funds via equity and/or loans and estimated at around 9%).
Chronic instability The low profitability of banking is set to continue because it is driven by three very intractable factors: the huge stock of non-performing loans; the low, even negative, interest rate environment caused by the low demand for credit; and the ongoing overcapacity in an industry that it also being challenged by developments in new financial technology (“fintech”) such as crowd-funding, peer-to-peer lending and private money systems like Bitcoin. In this context even national banking sectors that have carried out “successful” reconstructions (such as Spain, where bank branches have been reduced from 45,000 to 30,000 and staff by one-third), safety is fleeting, as the fragile situation of Banco Popular reveals. Bad news about a troubled financial institution can readily send it on the road to ruin if twitchy investors and depositors fear that their bank is in danger of failing and start to pull their money out, producing the very annihilating bank run they fear. This is the brink on which both Deutsche Bank and Monte dei Paschi di Siena are now perched: they are at the point where paper thin confidence in their future could give way before any more bad news, producing the “rush for the exits” that finished off Lehman Brothers in 2008. If Monte dei Paschi failed it could probably be incorporated into some other Italian bank, just as Bear Stearns and other failing banks were snapped for a song by J. P. Morgan Chase in 2008. However, a Deutsche Bank failure would be qualitatively more destructive because of the sheer size of the banks obligations to other major banks, including central banks, and the range of its trading activities (especially in derivatives). The latest news from Deutsche Bank is that it lost 5% of its total deposits and 13% of its demand deposits in the July-September quarter — suggesting the possible start of a bank run. If this is the case, intervention from the German government of Angela Merkel must loom on the horizon. The German chancellor has said that the government has no intention of intervening to help the bank, but this is an institution that really is too big—and too connected with the rest of the European and global financial system — to be allowed to go under. On October 27, Deutsche Bank reported its third quarter result, revealing its biggest profit in more than a year at €278 million (compared to a €6 billion loss in the same quarter last year). Did this mean that, after all the panic, Deutsche Bank had turned the corner? The share market did not think so: the bank’s shares continued to slide because it still needs to carry out a massive restructuring to regain profitability. The present profit figure represented a miserable two per cent return on equity, and this in a quarter that was good for banks worldwide. Moreover, although revenues rose three per cent to €7.5b billion, the bank’s asset management fund shrank by €8 billion and its liquidity reserves fell by 10 % to €200 billion. And the politics? It is not excluded that Monte dei Paschi, Deutsche Bank (and others) will survive in some shape or other. But whatever the result, the political price for the financial and political establishment will be very big. In the case of outright bank failures, who will pay for cleaning up the mess? If it is the taxpayer (via bail-out) — as with the €53 billion restructuring of the Spanish financial system — some version of the indignado response of “rescue people, not banks” is certain. If it is the depositors (via “bail-in”), protest might be contained in the exceptional case that the operation is like that of Cyprus’s March 2013 bank restructuring: there the majority of those forced to take a “hair-cut” on their deposits were Russian émigrés and other overseas investors. More likely, the reaction will be like that in Italy in late 2015, when the government forced the bondholders of four small banks to take losses. There were extensive protests, one pensioner who lost his investment of €100,000 committed suicide, and the populist Five Star movement got a big boost that contributed to its later winning important mayoralties, including that of Rome, in June this year. And if bank restructuring, by some miracle, gets carried out by the “natural” processes of takeover, branch closures and job destruction? In Spain, even though the protests of the tens of thousands of finance sector workers threatened with job loss in the banks that survived the crisis have not stopped restructuring, their anger has had real political impact: it has both deepened popular rejection of the financial elite and the politicians at their beck and call and made the need for a different banking system a matter of broad public debate. All of which is already having increasingly strong feedback effects on the stability of the financial world itself — even on those institution apparently far from Deutsche Bank’s and Monte dei Paschi’s predicament. In the October 14 Financial Times, correspondent Gillian Tett wrote: “[T]he real danger in finance is not one that tends to be discussed: that banks will topple over (as they did in 2008). It is, rather, the threat that investors and investment groups will be wiped out by wild price swings from an unexpected political shock, be that central bank policy swings, trade bans, election results or Brexit.” If the present state of siege in the European banking sector has emerged at the peak of a phase of anaemic growth, what will a future of slowing growth and even recession hold for it? Dick Nichols is the European correspondent of Green Left Weekly. An initial version of this article has already appeared on its web site.
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Submitted by Jurriaan Bendien (not verified) on Wed, 11/02/2016 - 09:31


According to Dick Nichols, "the chief pressure squeezing bank profitability has come directly from real economic conditions, from the subdued demand for loans."
I doubt very much is that is true.

It is not really that there is a "subdued demand for loans", but that banks have been "under pressure to curb their lending". The "chief pressure" is simply that interest rates are low.

At low interest rates, the bank profit margin on bank loans is rather small, and it would take only a relatively small percentage of non-performing loans, to ensure that the bank makes no money from the loan business at all. That being the case, the risk criteria which banks use for the issuing of loans to consumers and business have been tightened up a lot.

Furthermore, most governments have imposed higher capital adequacy requirements and bank charge ceilings on banks, plus much stricter statutory loan qualifications on borrowers, which mostly have to do with the borrowers' ability to repay. For every credit operation, banks now have higher administration costs and more legal requirements as well.

All of that has the effect that it becomes much more difficult to get a loan, if you want one. The business sector which is most affected by this predicament is that of small and medium-sized business, since large corporations can usually issue their own debt. Yet it it the small and medium-sized business sector which proportionally provides most of the paid jobs.

In response to the lacklustre lending-business, banks themselves typically seek to buy assets up and businesses which they think will appreciate greatly in value. As regards securities, however, the margins are hardly spectacular in most cases, and the state typically restricts the ability of banks to make speculative investments. Ultimately therefore, it is still the real profitability of ordinary business establishments which strongly determines the overall, longterm outcomes for aggregate economic activity.

What Gillian Tett is really alluding to, is that even well-protected and secure investors have become very conservative, in a situation where relatively small fluctuations in key economic indicators can have huge financial consequences and destabilize whole countries. Trillions of dollars are now invested at a negative return in real terms, even.

For that very reason though, it becomes more likely that extra-economic (socio-political) events could touch off the kind of financial panic that causes a new slump. Even if there is no disturbance or panic though, the incremental effect of debt growth which is much faster than GDP growth is to increase socio-economic inequality and social tensions, and increase the financial vulnerability of societies.