The trou­ble with banks is con­tained, for now

The Pak Banker - - OPINION - Mo­hamed A. El-Erian

THREE as­set classes -en­ergy, high-yield cor­po­rate bonds and emerg­ing-mar­ket cur­ren­cies -- be­came un­hinged last year amid ab­nor­mal as­set price volatil­ity. Now the bank­ing seg­ment seems to be get­ting a lot closer to fol­low­ing the same route. Should this oc­cur -- thank­fully, that's still a big if at this stage -the con­se­quences for the real econ­omy and global fi­nan­cial mar­kets would be much more con­se­quen­tial.

An un­hinged as­set class is one that losses most of its fun­da­men­tal an­chors, caus­ing any small bit of news to pro­voke out­size move­ments in as­set prices. The longer this per­sists, the greater the dam­age to a shrink­ing in­vestor base, lead­ing to even greater volatil­ity. In the process, even the stronger names within the as­set class are con­tam­i­nated, in­creas­ing the risk of ad­di­tional rounds of spill­backs and dis­lo­ca­tions.

This is what has hap­pened last year to en­ergy (and par­tic­u­larly oil),junk bonds is­sued by com­pa­nies rated below in­vest­ment grade and for­eign ex­change mar­kets in the emerg­ing world.

Each class ex­pe­ri­enced eye-pop­ping price over­shoots and con­ta­gion. And each has yet to re­gain its foot­ing. To­day, the bank­ing sec­tor is ex­pe­ri­enc­ing un­usual price volatil­ity, both up and down. Th­ese swings have taken place around a de­clin­ing mul­ti­day trend with three self-re­in­forc­ing fac­tors ex­ert­ing an in­flu­ence:

"Lower in­ter­est rates, in­clud­ing neg­a­tive ones in Europe and Ja­pan, along with flat­ten­ing yield curves are re­duc­ing the abil­ity of banks to gen- er­ate steady earn­ings from their ba­sic fi­nan­cial in­ter­me­di­a­tion func­tion. "Per­sis­tently low eco­nomic growth, to­gether with the sharp de­cline in com­mod­ity prices, are plac­ing pres­sure on the credit qual­ity of banks' loan port­fo­lios. "Pe­ri­odic re­minders from reg­u­la­tors that, af­ter highly con­tro­ver­sial past bailouts, in­vestors no longer have the back­ing of gov­ern­ments, which is mak­ing both equity and bond hold­ers more anx­ious and their cap­i­tal more flighty.

Th­ese three con­tribut­ing fac­tors are far more in ev­i­dence in Europe, and bank­ing in­sti­tu­tions there have been hit a lot harder. In ad­di­tion, de­spite progress brought about through the de­ter­mined in­sis­tence of the Euro­pean Cen­tral Bank, Euro­pean banks have lagged their U.S. peers in bol­ster­ing their cap­i­tal cush­ions, im­prov­ing their as­sets and con­vinc­ing mar­kets of their will­ing­ness to be suf­fi­ciently trans­par­ent in con­vey­ing in­for­ma­tion.

Last week, a hand­ful of banks - - in­clud­ing in France, Ger­many and Switzer­land -- saw their stock prices fall to mul­ti­decade lows. This forced some bank ex­ec­u­tives to re­as­sure mar­kets of their in­stitu- tions' ro­bust­ness, and re­quired a govern­ment of­fi­cial to back those re­as­sur­ances. And, in at least one case, an in­sti­tu­tion in­ter­vened to sup­port bond prices via buy­backs.

Al­though banks gen­er­ally have a more ro­bust an­chor­ing than the three other as­set classes, in­creased volatil­ity should be mon­i­tored care­fully over the next few weeks (even though we are nowhere close to the type of bank­ing dis­lo­ca­tions that crip­pled the global econ­omy in 2008-09). Should the bank­ing sec­tor be­come un­hinged, the flow of funds to com­pa­nies and house­holds would slow, and in­ter­na­tional trade fi­nanc­ing would be more ex­pen­sive and less ac­ces­si­ble. It also would fur­ther re­strict the al­ready lim­ited ap­petite of bro­ker-deal­ers to al­ter their bal­ance-sheet in­ven­tory to ac­com­mo­date in­vestors seek­ing to re­po­si­tion their port­fo­lios. The trou­ble with banks, though no­table, has been con­tain­able so far. But should it evolve into a much sharper down­turn, there could be se­ri­ous con­se­quences for a slow­ing global econ­omy and for fi­nan­cial mar­kets that have gen­er­ally had a lousy start to the year.

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