Today has brought the Euro area financial sector and banks in particular into focus as the ECB ( European Central Bank ) issues its latest financial stability report. More than a decade after the credit crunch hit one might reasonably think that this should be a story of success but it is not like that. Because the ECB is rather unlikely to put it like this a major problem is that the medicine to fix the banks ( lower interest-rates) turned out to be harmful to them if you not only continued but increased the dose. Or as Britney Spears would put it, the impact of negative interest-rates on banks is.
I’m addicted to you
Don’t you know that you’re toxic?
And I love what you do
Don’t you know that you’re toxic?
Actually the FSR starts with another confession of trouble as it reviews the Euro area economy.
The euro area economic outlook has deteriorated, with growth expected to remain subdued for longer. Mirroring global growth patterns, information since the previous FSR indicates a more protracted weakness of the euro area economy, leading to a downward revision of real GDP growth forecasts for 2020-21.
There is the by traditional element of blaming Johnny Foreigner which has some credibility with the trade war issue. However if we look deeper we were reminded only yesterday about the told of the Euro area in its genesis.
In September 2019 the current account of the euro area recorded a surplus of €28 billion, compared with a surplus of €29 billion in August 2019. In the 12-month period to September 2019, the current account recorded a surplus of €321 billion (2.7% of euro area GDP), compared with a surplus of €378 billion (3.3% of euro area GDP) in the 12 months to September 2018.
It sometimes gets forgotten now that one of the factors in the build-up to the credit crunch was the Euro area ( essentially German ) trade surplus.
However the essential message here is that lower economic growth is providing a challenge to the Euro area financial sector and banks and tucked away at the bottom of this section is one of the reasons why.
At the same time, inflationary pressures in the euro area are forecast to remain muted over the next two years, translating into overall weaker nominal growth prospects.
Paying down debt can be achieved via inflation as well as real economic growth and is one of the reasons why the ECB keeps implementing policies to get inflation up towards its 2% per annum target. A sort of stealth tax.
Bond Markets
There is a warning here.
Asset valuations, reliant on low interest rates, could face future corrections.
If we start with sovereign bonds then there is am implied danger for Germany as it has the largest sector with negative yields. But if we switch to banking exposure then eyes turn to Italy because not only does it have a large relative national debt but its banks hold a relatively large proportion of it at 20%. They will have done rather well out of the ten-year yield falling by over 2% to 1.3% over the past year but is that the only way Italian banks make money these days? There is a reflection of this sort of thing below.
Very low interest rates, coupled with the large number of investors which have gradually increased the duration of their fixed income portfolios, could exacerbate potential losses if an abrupt repricing were to materialise in the medium-to-long run.
Tucked away is an arrow fired at Germany.
there is a strong case for governments with fiscal space to act in an effective and timely manner.
What about the banks?
Here we go.
Bank profitability concerns remain prominent. Bank profitability prospects have weakened against the backdrop of the deteriorating growth outlook and the low interest rate environment, especially for banks also facing structural cost and income challenges (see Special Feature A).
Nobody seems to want to back them with their money.
Reflecting these concerns, euro area banks’ market valuations remain depressed with an average price-to-book ratio of around 0.6.
Although the ECB would not put it like this if this was a rock concert the headliner would be my old employer Deutsche Bank. It has a share price of 6.5 Euros which certainly must depress long-term shareholders who have consistently lost money. There have been rallies in this example of a bear market and well played if you have taken advantage but each time they have been followed by Alicia Keys on the stereo.
Oh, baby
I, I, I, I’m fallin’
I, I, I, I’m fallin’
Fall
I keep
This bit is both true and simply breathtaking!
Banks have made slow progress in addressing structural challenges to profitability.
If you have policies which are fertiliser for zombie banks then complaining about a march of the zombies is a bit much. In this area it is Halloween every day.
If you are wondering about Special Feature A so was I.
These banks all stand out in terms of elevated cost-to-income ratios. But there also appear to be three distinct groups: (i) banks struggling with legacy asset problems; (ii) banks with weak income-generation capacity; and (iii) banks suffering from a combination of cost and revenue-side problems.
We are told this is only for a “sub set” but point (iii) is plainly a generic issue in the Euro area banking sector. The proposed solution looks not a little desperate.
But in systems with many weak-performing small banks, consolidation within their domestic system could improve performance. Finally, a combination of bank-level restructuring and cross-border M&A activity could help reduce the costs and diversify the revenues of large banks that are performing poorly.
Consolidating the cajas in Spain and some of the smaller banks in Italy did reduce the number of banks in trouble but did not change the problem.There is a bit of shuffling deckchairs on the Titanic about this which turns to laughter as I consider “cross-border M&A activity”. Like RBS in the UK? That was one of the ways we got into this mess. One of the problems with banking right now is what do they diversify into?
On aggregate, euro area banks’ return on equity is expected to remain low, limiting the sector’s ability to increase resilience through retained earnings
Er well yes.
Should this all go wrong we will be told we were warned.
A banking system operating with significant overcapacity is also vulnerable to weak competitors driving down lending standards and an underpricing of risk.
Shadow Banking?
Some of the role of banks has moved elsewhere and of course there are plenty of issues for long-term savings in a negative interest-rate world.
After a slight decline in the last quarter of 2018, the total assets of investment funds (IFs), money market funds (MMFs), financial vehicle corporations, insurance corporations (ICs), pension funds (PFs) and other financial institutions gradually increased to almost €46 trillion in June 2019, and represented 56% of total financial sector assets.
Also what do you expect if you drive some corporate bond yields negative by buying so many of them?
But more recently, the low cost of market-based debt has supported a further increase in NFCs’ debt issuance – particularly of investment-grade bonds.
Can anybody remember a time when relying on bond ratings went wrong?
Negative interest-rates again.
As yields have fallen, non-bank financial intermediaries hold a growing share of low-yielding bonds, which decreases their investment income in the medium term and encourages risk-taking.
Comment
The press release is if we read between the lines quite damning.
Low interest rates support economic activity, but there can be side effects
Signs of excessive risk-taking in some sectors require monitoring and targeted macroprudential action in some countries
Banks have further increased resilience, but have made limited progress in improving profitability.
It is welcome that we are seeing some confession of central banking sins but it comes with something else I have noticed recently which is that ECB related accounts are taking the battle to social media.
Dear fellow German economists, if you are wondering what you can do for Europe: Please help to dispel the harmful & wrong narratives about the @ecb ‘s monetary policy, floating around in political and media circles. These threaten the euro more than many other things.
That is from Isabel Schnabel who is the German government and Eurogroup approved candidate to be a new member on the ECB board. From the replies it is not going down too well but we can see clearly why she was appointed at least.
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