I've railed against Eurozone banks for a long time.
To be honest, it's hard not to.
They really are facing a hell of a lot of trouble, especially over the next ten years, and I'd argue that the virus crisis has exacerbated these issues.
The difference between what I say versus what other commentators tend to allude to is that I don't think they will simply blow up - that's not necessarily what a low share price indicates.
No, it's worse.
I think they will simply truck on and keep piling on sh*t upon sh*t into their books until they lead themselves and Europe into the most unproductive quagmire that any economy has ever experienced.
An Optimus (non)Prime (I'll come back to that analogy later).
I want to do a bit of a historical track here of how Eurozone banks have gotten into this mess by looking at how the fallibilities of the Eurozone's design & ECB policy making have led to this train wreck.
Where do we start?
Let's start at the very beginning; that's a very good place to start 🎶
Let's take a holistic view here.
The problems of the Eurozone are, by definition, created by the Eurozone itself.
I have mentioned a number of times that the overriding issue in the bloc is that you simply cannot have a single monetary policy for that many different countries.
It cannot work.
Germany, for example, is a far different economy to that of, say Cyprus.
To illustrate this, I want to point out my favourite chart; one which came up time and time again when debating my position on Brexit.
This shows Target2, which essentially shows transfer from sovereign central banks (in Germany's case, the Bundesbank) to other central banks.
Look at the top purple line (Germany).
They are a net creditor to the rest of the zone.
For a single currency union to survive in a specific geographical area, there needs to be sufficient wage flexibility and labour mobility, sufficient price flexibility and capital mobility, a fiscal mechanism for redistributing resources from regions with trade surpluses to those with deficits, and for the different areas within the union to have broadly similar business cycles.
The reality is different.
Varied business cycles and inadequate labour and capital market flexibility within the Eurozone mean that systematic trade surpluses and deficits develop.
To deal with these trade imbalances, the more efficient economies in the Eurozone, such as Germany, need to recycle their trade surpluses back to deficit regions using fiscal transfers in order to keep the Eurozone economies in balance.
This is done via the Target2 mechanism, since there is no official method to redistribute these surpluses across the bloc (yes, a big failure in the design).
So we are left with the solution also being a problem.
To be able to rectify the issue, fiscal and political union would likely have to be enacted.
This is a great solution on the face of it.
But it's a problem too.
See the magnitude of action that would have to take place to achieve this would be ridiculous.
Either a war pops off to solidify integration, or the EC become so authoritarian that they directly impose fiscal and political union - personally, I don't actually think they're horrible people to go that far, they're just very much useless bureaucrats...
What's the problem here?
Debts are being built up by deficit nations - you can be a deficit spender, but of course, not all deficit spending nations have weak economies.
Take the US and UK for example.
The trouble is, pretty much all of the deficit spending nations in the Eurozone have gone through a crisis and still have very fragile economies.
Take a look at Trading Economics and search the pre-Covid data for the economies with T2 liabilities.
It's not a pretty sight, although better than the days of the European sovereign debt crisis (or crises - or even current crisis, since I don't think they're out of it yet).
So what happens when the German taxpayer finally gets fed up of practically financing the rest of the bloc's woes?
Well, I don't actually know that answer because it seems a long time off still.
But this is just one conundrum that I think faces the EC in terms of deeper integration, fiscally and politically - if they go down this route, then the current system will have to be brought to the foreground, rather than where it is now...
The data, languishing on Yardeni's website, with a mere 72k hits per month.
What's the ECB's role in all of this?
Here's the broad take.
Low rates lead to unproductive economies.
And the ECB has one of the lowest rates in the world, whilst also expanding their balance sheet to ridiculous levels.
A recent paper by Ernest Liu (Princeton University) Atif Mian (Princeton University and NBER) and Amir Sufi (University of Chicago Booth School of Business and NBER) highlighted the relationship between low rates an productivity.
I've read it for you so you don't have to.
Here are the main points.
This study provides a new theoretical result that a decline in the long-term interest rate can trigger a stronger investment response by market leaders relative to market followers, thereby leading to more concentrated markets, higher profits, and lower aggregate productivity growth.
Equity risk premium compression, anyone?
The line above is exactly the reason why the Nasdaq has rallied - why tech stocks go up in a world of chaos.
The market leaders have become innovators, whilst others are not able to, which leads to huge market concentrations.
Let's keep going.
In traditional models, lower interest rates boost the present value of future cash flows associated with higher productivity, and therefore lower interest rates encourage firms to invest in productivity enhancement. This study highlights a second strategic force that reduces aggregate investment in productivity growth at very low interest rates. When firms engage in strategic behavior, market leaders have a stronger investment response to lower interest rates relative to followers, and this stronger investment response leads to more market concentration and eventually lower productivity growth.
Lower rates have a similar effect to crowding out - that is when the government becomes involved in a market which stifles most private firms' ability to operate within said market.
The dominance of the strategic effect at low interest rates is a robust theoretical result. This result is shown first in a simple example that captures the basic insight, and then in a richer model that includes a large state space and hence richer strategic considerations by firms. The existence of this strategic effect and its dominance as interest rates approach zero rests on one key realistic assumption, that technological catch-up by market followers is gradual. That is, market followers cannot “leapfrog” the market leader in the productivity space and instead have to catch up one step at a time. This feature provides an incentive for market leaders to invest not only to reach for higher profits but also to endogenously accumulate a strategic advantage and consolidate their leads.
Again, this may provide us with insight as to why 'value' isn't necessarily 'value' anymore.
In the model, a low interest rate affects steady-state growth through two competing forces. As in traditional models, a lower rate is expansionary, as firms in all states tend to invest more (Lemma 7). On the other hand, a low rate is also anti-competitive, as the leader’s investment response to a decline in r is stronger than follower’s response. This anti-competitive force changes the distribution of market structure toward greater market power, thereby reducing aggregate investment and productivity growth. Theorem 1 shows that the second force always dominates when the level of the interest rate r is sufficiently low.
Don't worry about the model.
I am not too sure what the maths is suggesting so I won't put you through the pain of looking at it too, although the worded assumptions that it spits out makes sense.
In essence, it is saying that cheap cash leads to investment from all firms, just that market leaders are more responsive and more aggressive with investment than other firms.
I think a prime example of this might be with Amazon versus traditional retail.
Yes, your high street firm might invest, but into what?
Will it be game changing?
Will Amazon's investment be game changing?
So Amazon's investment force will override anything a traditional high street retailer does.
The expectation of tougher resistance by market leaders in a low interest rate environment reduces competition and growth. In these situations, regulation that reduces the expectation of tougher competition from market leaders can help raise investment and productivity growth. The model therefore shows why anti-trust regulation may become more important in a low interest rate environment.
Perhaps this is why the EU go so hard on anti-trust regulations.
Could this be the next big war?
Well, the EU certainly wouldn't win that one when up against the US.
The slowdown started well before the Great Recession, suggesting that cyclical forces related to the crisis are unlikely to be the trigger. Furthermore, the slowdown in productivity is highly persistent, lasting well over a decade. The long-run pattern suggests that explanations relying on price stickiness or the zero lower bound on nominal interest rates are less likely to be the complete explanation. This paper introduces the possibility of low interest rates as the common global factor that can potentially explain the slowdown in productivity growth.
Call me mental, but this slowdown could possibly be identified by the change in M2 velocity...
Did it start at the DotCom bust then?
Could it mean that 'no physical product' tech firms are the cause of productivity issues?
Is the hunt for data as a product the basis of all our woes?
Probably not, but something to think about, I guess.
Where do EZ banks come into all this?
Well, here's where Eurozone banks are Optimus (non)Prime.
We've spoken above and shown a theory as to why there are concentrations in a market, and why value might not be value.
But this theory might simply suggest that these firms should just go bust, right?
Well here in lies the problem.
Since low rates (and negative real rates especially) are so easy to obtain, especially in Europe, we have a situation where you're just feeding something that should really be dead.
In Europe, firms are less likely to go to capital markets for funding versus the US.
Instead, they go to banks.
And banks make money from loans.
If they can provide loans to firms that can repay, who cares if those firms aren't actually able to improve?
The banks make money.
The problem is that wages don't increase - there is likely little net benefit to the wider economy other than staving off the inevitable, such as when a tail risk event like the response to the Corona virus happens.
S&P sees European corporate default rates spiking to 8.5% from 3.5% in the back end of this year...
Alexandra Dimitrijevic, S&P’s Global Head of Research, said that with the number of firms on downgrade warnings at record levels -- 37% of the companies S&P rates and 30% of the banks -- and credit quality dropping, default rates are set to jump.
“One third of speculative-grade companies are rated B- or below in Europe, which is up 10 percentage points compared to before the (COVID) crisis. So that is why we expect the default rate to effectively double”.
The US has higher rates of corporate defaults, but I'd expect these to be mainly in energy, which has taken an absolute hammering due to the demand side totally drying up.
If we look at European non-performing loans, we can also get a broader picture of what the situation is.
This article sums up the NPL situation well...
Last week the ECB published devastating data on the Eurozone banks. It was considered significant as it revealed a ROE of 0.01% in Q2’20 compared with 6.01% a year earlier; a figure that was negative in the major institutions in 7 of the 19 countries in the euro area.
These figures were provided in a context in which non-performing loans remained almost stable at 503 billion euros, allowing the NPL rate of the large banks in the EMU to fall to 2.94%. This was in a fictitious manner, however, as it was thanks to state guarantees and, above all, the moratoriums on loan payments.
And an ECB report showed a pretty stark picture for European bank lending in Q3...
The ECB’s quarterly survey of banks found “a tightening of credit standards on loans to firms in the third quarter of 2020 indicating credit risk considerations due to the coronavirus pandemic”.
Banks told the ECB they expected “credit standards for enterprises to tighten further, reflecting concerns around the recovery as some sectors remain vulnerable as well as uncertainties around the prolongation of fiscal support measures”.
ECB's chairman of the supervisory board, Andrea Enria said this in an FT piece about the EU needing a 'bad bank' to cope with the rise in NPLs stemming from the pandemic.
Yet the macroeconomic outlook is uncertain and we cannot rule out a weak recovery with a significant build-up of bad loans. The European Central Bank estimates that in a severe but plausible scenario non-performing loans at euro area banks could reach €1.4tn, well above the levels of the 2008 financial and 2011 EU sovereign debt crises.
Enria is essentially saying that he would like asset management firms to pick up the slack in the rest of the piece, and that would entail them buying the NPLs at a discount and somehow receiving payment.
But, rather than them be private, he wants an EU wide asset management initiative to be able to clear up bank balance sheets and restore ability to lend.
I just see that as shifting the hot potato, which then comes back down to what the core issue is - that is one of how low interest rates affect the behaviours of banks and the transmission mechanism of credit flow.
What's the short term theme then?
This is where the Optimus (non)Prime analogy comes in.
I reckon that Eurozone/EU wide bank consolidation is going to be the next big theme.
They will end up turning into a transformer - something that looks all powerful, but at the end of the day, is still just a car on the inside (we will ignore the actual storylines of Optimus Prime being able to destroy whatever he wanted).
What will likely occur is that, like the FCA/PSA Groupe merger, we'll see many Eurozone banks consolidate their balance sheets to be able to somehow convince the market that all is well.
But all is likely not well, even after this consolidation.
Basel regulations on capital adequacy are likely a big driving force behind consolidations, with the desire to avoid deleveraging a big factor.
It feels like more can kicking to me.
If we use the German 10y yield as a proxy for interest rates, we note that there's a pretty strong correlation between Eurozone bank share prices and the interest rate path.
This comes down to the net interest margin - how banks make money, which I have explained many times before.
So there seems to be a feedback loop where credit provision to firms which shouldn't really be provided it occurs because banks don't necessarily care who receives it, as long as it is judged to be an adequate loan origination according to their models.
In turn, this creates a big spread in concentration between market leaders and market followers, the outcome of which leads to dampened productivity and lower growth (and inflation).
On the QE side, central bankers are foolish to believe that more QE will lead to their inflation aims being met.
So what are we left with?
I feel that we have a big elephant in the room in Europe.
There is a bit of a sickness whereby this constant pushing of lower rates, more printing and lack of (but unattainable) fiscal and political union will simply lead to a worsening of conditions.
Bank consolidations will work in the short term, and there will be no doomsday blowing up of banks, but they will just trudge along with a worsening return on equity over time.
The same could probably be said about UK firms; the difference is that we are probably more malleable in how our policy path can change.
One thing is for sure though.
The powers at be in the ECB and European Union will keep the cogs turning for as long as there is no total civil uprising against them.
“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” Henry Ford
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