Read more: Will China drag down the world economy?
No sooner does one financial panic wind down than another one starts, and this week started with another humdinger. We have already had three horsemen appear in the form of China’s slowdown and confused economic and financial policies, the dark side of the collapse in oil and commodity prices, and angst-ridden tales of the coming US recession. Now we have the fourth, and wouldn’t you know it? It’s the banks.
This time, though, it’s not the same as it was in 2007-08 when banks were chronically over-leveraged, under-capitalised and unregulated after more than a decade of an anything-goes culture. Instead it’s complex but in a different way. It’s more about the income statement of the banks than the balance sheet, and it’s not unimportantly about more of the unintended consequences of central bank actions. You know about QE, and you’ve become familiar with ZIRP or Zero Interest Rate Policy. Now let me introduce to the latter’s progeny, NIRP, Negative Interest Rate Policy, who you will get to know shortly.
While we have all been fretting about what Captain Renault in Casablanca would have called “the usual suspects”—China, oil and the United States—bank share prices didn’t reflect what investors in credit markets were worrying about. These markets are where bonds and credit instruments are traded, rather than shares. Here, the instruments relating to many sectors, including energy, commodities but in particular banks, had been on a steadily weakening trend. The bank sector had become risky, if not toxic, as investors expressed concerns about several things. These included the losses imposed on creditors of the Portuguese bank Novo Banco among on-going concerns about the robustness of the new bank resolution regime in Europe; the overall health of a handful of large Italian banks; the situation of other European banks, including two in the UK; and the growing concerns about Deutsche Bank as articulated in the last months of 2015 by its own new CEO, culminating in the announcement a couple of weeks ago of a fourth quarter loss.
This particular institution was seen as symbolic because of its size and influence. And it was also regarded as a sort of poor cousin when it came to the endowment of capital on its balance sheet. The combination of poor earnings, lowly capital, bad markets and trading conditions, and a sizeable restructuring challenge ahead contrived to turn investors against Deutsche, whose share price fell this week to a 24 year low. But they also turned their backs on the European banking sector in general, despite the upturn in lending in European countries, as shown by central bank surveys in the Eurozone and the UK, and notwithstanding previous earnings announcements from, say, US banks, that had been received relatively favorably at the time. As of last night, the “S&P 500” stock market index in the US had fallen by 18.5 per cent in the year to date.
Curiously, a variety of idiosyncratic stories about an array of financial institutions in various countries one moment has become a more themed narrative about new banking sector ailments in a very challenging economic environment, exacerbated by some of the unintended consequences of new central bank policies.
It is certainly true that the steep fall in energy and commodity prices is contributing to distressed loans in these sectors, and that banks will have to spend a lot of time on restructuring them and will also have to take losses. But this alone wouldn’t have been enough to fell the banking sector. Similarly, it is well understood that even if the western world isn’t in a fully fledged downturn, industrial companies are facing a rough time, profits are weak or declining, and a world of low nominal growth makes it hard for companies to lift revenues, and banks to keep their loan books stable. Moreover, bank earnings suffer if, as recently, financial markets are in a bad mood, and equity and other risk markets are falling, and trading volumes fall.
These factors have patently contributed to a malaise in the banking sector, but the catalyst that has turned a tough income-generating environment into a major sell-off has been the perception that negative interest rates will weigh more and more on income streams. Unexpectedly, this situation has been worsened by complex transmission effects of a financial instrument called “Cocos,” or “contingent convertible bonds” that have been issued by banks in significant quantities in the wake of the financial crisis.
The Bank of Japan is the latest central bank to have introduced negative interest rates and follows the examples of ECB, and the central banks of Switzerland, Sweden and Denmark. The idea has become a bit of a fad for monetary policy nerds, and there is speculation as to whether they might be introduced in the US and the UK in future, if circumstances warranted. It may be that with most governments abandoning the use of fiscal and public investment policies, central banks are the only game in town, but that doesn’t mean that what they are doing now is either effective or benign. The Bank of Japan undertook the policy of negative rates partly to weaken the Japanese Yen, since when it has appreciated by about 3 per cent.
What negative rates have done is expand considerably the volume of bonds bearing negative yields, which is to say that holders would be repaid less than the full value of their outlays and that they can only make a profit on selling, if negative yields become even more negative. Some $6 trillion of government bonds in Japan and Europe now trade on negative yields.
Negative interest rates have worked their way through financial instruments so that longer-term yields have fallen considerably. This means that a traditional method for banks to earn more money, from which they can build up capital—borrowing cheaper money at short maturity and lending it out at higher yields at longer maturities—has been negated. In the US, the gap between 2 and 10 year bonds is barely over 1 per cent, and as low as it was before the financial crisis in 2007. It has narrowed similarly in the UK gilt market.
Perversely, Coco’s, which were designed to convert from debt to equity when losses at a bank force the institution’s capital to drop below a given prudential level, may be exacerbating the consequences of negative interest rates. Investors were attracted to them because as one of the riskier instruments in credit markets, they paid interest rates of 6-7 per cent. But the downside is that they could be forced to have their investment converted into equity at an inopportune time, and the bank has the right to withhold the dividend payment on the instrument. With income constrained, this seems like a likely outcome. Even though the developments surrounding Deutsche Bank were quite specific to the bank, investors have taken fright that other banks in Europe and maybe further afield could be affected. Hence the recent sell-of in bank debt and shares. Investors have been buying credit default swaps to mitigate risk but this creates the danger that default risk, financial instability and falling share and bond prices become locked in a vicious circle.
It’s hard to know how this is going to end. Deutsche Bank announced late yesterday that it was mulling a proposal to buy back some of its bonds from the market, and this could help to calm nerves. After all, the turbulence in the banking sector is more about earnings and instruments, as opposed to the kind of solvency and liquidity issues that stalked it in 2007-10. And valuations have fallen sharply. Moreover, the Coco conversion actually boosts bank capital precisely at a time it is needed. On the other hand, we don’t know whether the Coco problem will become a system-wide issue, we can rightly suspect that central banks running negative interest rate policies are contributing to market turbulence, if only passively, and the macroeconomic issues we had in January haven’t gone away. It’ll take some time and slowly improving economic perceptions to bring confidence back to these markets.
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