Next time there’s a cri­sis, banks be al­lowed to fail

The Pak Banker - - OPINION - Matthew Lynn

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.

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