Next time there’s a crisis, banks be allowed to fail
IS something up at Europe's banks? The markets certainly seem to think so. Deutsche Bank shares have been hammered, while its convertible bonds have been in freefall. A series of smaller Italian banks have had to be rescued, and the whole sector is under pressure. The key index of European bank stocks has lost almost a third of its value in only a few weeks. It has been a torrid opening to the year for the financial sector, and right now does not show any sign of coming to an end.
Of course, that might just be the markets getting into a panic, and in the next few weeks bank stocks might start to perk up again. It would hardly be the first time a sector has been sold off too far and too fast. Then again, it might be a sign that one or more financial institutions are about to run into big trouble, hit by a toxic combination of near-zero interest rates wiping out their profits and huge potential losses from the collapse in commodity prices. If so, we need to be prepared for that, and let one or more banks go bust. Another round of bail-outs in unacceptable. The public finances won't stand the strain, the public would be outraged, and the moral hazard would be too great. If we do see some banks collapse, we should be ready and willing to let them go under.
There are certainly plenty of worrying signs of trouble brewing in the banking sector. The Stoxx Europe 600 Banks Index, which includes all the major banks across the continent, has now declined for six straight weeks. The last time that happened? Well, that was back in 2008, as the global financial system went into meltdown.
Overall, the index is down by 24pc since the start of the year, compared to 11pc for the wider index. More worryingly, the cost of insuring European bank debt has been rising sharply for the past week - anyone trading in that asset is essentially making a bet that the banks are about to run into trouble and may be insolvent. Deutsche Bank is down 37pc so far this year. Credit Suisse is down by 34pc. In Italy, the carnage in financial stocks has been so severe that government ministers have had to be wheeled out to re-assure everyone that the banks are solid - which is about as comforting as the Manchester United board saying they have no plans to replace Louis Van Gaal.
You don't exactly need to be Hercule Poirot to work out why there is so much nervousness. The culprits are obvious enough. Collapsing oil and commodity prices are starting to seep into the financial system, much as collapsing house prices did in 2008. The big oil and mining conglomerates have massive debts, and so do the smaller oil explorers. Hedging contracts on commodity prices are scattered throughout the financial system, and enormous losses may start to crystallise in the next few months.
Even worse, we may soon see a re-emergence of the sovereign debt crisis, except this time it will be the commodity exporters that are hit, not the peripheral euro area nations. Azerbaijan is already discussing a rescue with the IMF. Venezuela and Ecuador look bust, and it can't be long before Saudi Arabia and Russia, two major economies, are in big trouble. If so, it will be the banks that take the hit - loans to oil exporting nations look a lot more fragile now than when they were made two or three years ago with the black stuff trading at $100 a barrelIn the background, central bank policies may be making the problems worse. Near zero interest rates have made it very hard for banks to earn any kind of profit margin on the difference between deposits and lending - everyone thinks record low rates are there to help banks, but actually they have been hurt most of all. On top of that, there are now negative rates across much of Europe, so the cash on their balance sheets is actually costing them money. Over time, that weakens banks a lot.
True, no one really knows whether we are likely to see another full-scale banking crisis. Quite possibly, the banks themselves don't know, despite the increased emphasis on stress tests over the last few years One of the lessons of the 2008 collapse was that the financial system had become so complex, and so interdependent, that losses in one market could easily pop up somewhere else.