An Unexpected Systemic Crisis Is for Sure
Downturns in bank credit expansion always lead to systemic problems. We are on the edge of such a downturn, which thanks to everyone’s focus on the coronavirus, is unexpected.
We can now identify 23 March as the date when markets stopped worrying about deflation and realised that monetary inflation is the certain outlook. That day, the Fed promised unlimited monetary stimulus for both consumers and businesses, and the dollar began to fall.
The commercial banks everywhere are massively leveraged and their exposure to bad debts and a cyclical banking crisis is now certain to wipe many of them out. In this article we look at the global systemically important banks — the G-SIBs — as proxy for all commercial banks and identify the ones most at risk on a market-based analysis.
In these bizarre markets, the elephant in the room is systemic risk — visible to all but simply ignored. This is partly due to everyone in government and central banks, as well as their epigones in the investment industry and mainstream media, believing our economic problems are only a matter of Covid-19. In other words, when the pandemic is over normality will return. But Covid-19 has acted like a conjurer’s distraction: it has deflected us from the consequences of Trump’s trade wars with China and the liquidity strains that surfaced in New York last September when the repo rate soared to 10%.
The liquidity strains and the severe downturn in the stock markets that followed earlier this year before mid-March have been buried for the moment in a tsunami of central bank money. Liquidity problems following last September’s repo crisis and the S&P 500 index collapsing by one third between 19 February and 23 March were a clear signal that the multiyear cycle of bank credit expansion had already peaked. Ever since the last credit crisis in 2008, the banks had recovered their lending confidence and expanded bank credit, a classic expansionary phase.
If we take US dollar M1 money away from M2 money, we get a rough approximation of the growth of bank credit and that tells us two things. It has slightly more than doubled in the long expansionary phase, and since early June, despite the unprecedented injection of base money into the banking system by the Fed, bank credit is now stalling.
We are moving into this contractionary phase of credit with some significant banks dangerously leveraged. That is usual ahead of a credit crisis, but never to the extent we are experiencing today. And thanks to Covid-19, this danger is universally ignored.
Why bank market capitalisations matter
Not only are some of the global systemically important banks (G-SIBs) highly leveraged on their balance sheets, but in most cases stock markets are valuing their equity at a fraction of their balance sheet book values, contrasting with outrageously high valuations for non-financial stocks in the most severe economic downturn ever seen in peacetime. It would be reasonable to expect a new bull market for equities to include the banking sector, but this is not so.
Table 1 below illustrates the point by incorporating the combination of balance sheet gearing and stock market valuations for all the G-SIBs to give a multiple of balance sheet assets to market capitalisation, ranking them from most dangerous to the least on this measure. The only banks in the list with market capitalisations higher than balance sheet equity — price to book ratios of more than one — are North American banks, which might explain why critical leverages are not recognised as a systemic problem in US financial markets.
The three highest leverages are of Eurozone banks: remember these are just the G-SIBs — there will be many large and smaller commercial banks as highly leveraged which are not on this list.
To have your equity valued at less than 20% of book value, which is the indignity suffered by the French bank, Société Générale, should send warning signals to French banking regulators. But they insist on only looking at the ratio of balance sheet assets to balance sheet equity; which for Soc Gen is still an eye-watering 21.4 times. Unlike the regulator, investors appear to think this bank is most likely bankrupt, its share price little more than a call option bet on its survival. To be clear, the effect of every euro of new bad debts declared by this bank is magnified 118.8 times in pain for shareholders. It is worth taking a moment to let the implications sink in and to understand how little it would take to bankrupt the bank.
It is a problem which particularly affects banks in the Eurozone. In its twin towers in Frankfurt, a mere sneeze could destabilise Deutsche Bank. In France the regulator dismisses the balance sheet gearing and share prices with a Gallic shrug. Société Générale’s balance sheet gearing is 21.4 times, Credit Agricole’s is 28.1 times — the highest of all the G-SIBs — and BNP is 20.1 times. And experience tells us that the numbers reported by banks are bolstered by their gaming of the regulatory system, which is why when a bank fails the outcome is always worse than the pre-failure numbers would suggest possible.
Large banks do not operate in national silos, having trade finance activities, foreign exchange and derivative trading, lending in foreign currencies and even substantial branches and subsidiary operations abroad. The idea that a crisis in the Eurozone, or China for example, can be contained to national boundaries is wishful thinking. With the exception of Wells Fargo, US G-SIBs come out better than those of other jurisdictions, but that will not save them from a systemic crisis originating elsewhere.
While we can point to the end of the credit cycle, there is no doubt that Covid-19 has precipitated a more immediate crisis. We are now seeing the initial effects on GDP of lockdowns being reported, and doubtless their subsequent revisions will make them even worse. The official talk is of a V-shaped recovery, and indeed, government spending has increased with that result in mind. It is reported that we, the general public, have saved our money in the lockdown, and that we will resume spending as normal once Covid-19 passes. All that failing businesses have to do is just hang on in there, and as President Reagan famously put it, wait for the knock on the door: “I’m from the government and I’m here to help”.
But there is a truth swept under this proposition: in both the US and UK, with their co
Article from LewRockwell