Symptoms of dysfunction
If bank shares are the canary in the global economic coalmine, they are currently singing a very alarming tune. In Japan bank shares have cratered -10% since last Friday’s decision by the central bank to move to negative interest rates, even though the new negative -0.1% rate will only apply on the margin to additional deposits at the Bank of Japan.
Elsewhere, in Europe, the banking component of the Euro Stoxx index has slumped -16.8% year-to-date, while the broader index is down a “mere” -6.8%. Similarly, in the US, bank shares are down -11.9% YTD, compared with the S&P 500, which is down some -5%.
In part, this underperformance reflects market fears about what may be lurking on bank balance sheets; Japan’s megabanks, for example, have significant exposure to oil producers. But in a broader sense, the slump in bank shares is symptomatic of persistent dysfunction in the sector. Seven and a half years after the global financial crisis (and quarter of a century after the bursting of Japan’s bubble economy), efforts to clean up and strengthen bank balance sheets have fallen far short of what is needed to create healthy and resilient banking sectors. Worse, the sense is growing that when it comes to banking sector stability, the tools adopted by central banks to pump up inflation and revitalise economic growth — ultra-low and even negative interest rates across much of the curve — are doing more harm than good.
For a picture of banking dysfunction, investors need look no further than Europe. Despite much-vaunted plans for “a fully-fledged banking union”, problems abound. The biggest is arguably the weakness of Italy’s banking sector. Last week, the Italian government agreed a plan to help Italy’s banks dispose of the EUR 350 bln in non-performing loans — equivalent to 22% of gross domestic product — they are carrying on their balance sheets. We doubt it will work.
Under new EU rules which prohibit direct state aid to the banking sector, Rome cannot copy the formula adopted by Spain and Ireland, and move non-performing assets off bank balance sheets and into a state-backed “bad bank”. The government’s solution, agreed after months of negotiation, is to offer a guarantee mechanism it hopes will encourage private investors to buy securitised NPLs.
Under the new scheme, banks will bundle their bad loans into securities so that the senior tranche of each issue — the first to be repaid out of proceeds recovered from the underlying assets — is of sufficiently high quality to achieve an investment grade credit rating. The government will then guarantee this senior tranche (and only this tranche). To circumvent the rules against state aid, issuing banks will have to pay a regular fee to the government for its guarantee. The fee will be priced off benchmark credit default swaps for reference credits of similar quality, and will be reset upwards over time to encourage a speedy recovery process.
By offering a guarantee, the government hopes to bump up the market value of the underlying loans more closely into line with the value at which they are carried on the banks’ books, minimising bank losses, while simultaneously encouraging investors to buy the bonds, so creating a new market for distressed debt. However, because of the EU’s new restrictions on state aid, the Italian deal falls far short of the Spanish and Irish resolution schemes, under which large tranches of NPLs were transferred into “bad banks”, freeing up the “good banks” to restructure and resume lending. In both Spain and Ireland, banks were forced to participate in the restructuring programmes. Under Italy’s plan each individual bank will decide whether to pay for the government guarantee and accept a writedown in asset values, or alternatively to leave the bad assets on its balance sheet.
Even in Spain and Irelan,d NPLs remain painfully elevated at 10% and 20%, respectively, suppressing new credit creation. So, it looks unlikely that Italy’s new plan will cut NPL levels by anything like enough to make an appreciable difference to banks’ willingness to extend new loans. As a result, banking sector profits will continue to underperform, while Italy’s economy will remain handicapped by weak credit creation and investment. Worse, companies with unresolved debt problems will be unable to hampering the process of creative destruction.
The government is promising to publish further details of its guarantee mechanism soon, which may assuage some of our doubts. However, as things stand now, much of the Italian banking system remains dysfunctional, calling into question the ability of the EU’s proposed banking union to deliver a strong, healthy and integrated banking system for the European continent. Judging by the recent price action in global markets, things are scarcely any better elsewhere.