The Daily Update - European and Japanese Banks Cheap and Stressed for a Reason

Northern Rock became world infamous for a mortgage business that gradually slipped from great net margins to margins no more than 20 basis points above costs. This trend lasted the entire duration of its membership of the FTSE 100 (from 2000 to 2007). At the crisis, these paltry margins were around 60 times leveraged to yield approximately 18% return on equity with a total income as a proportion of mean risk-weighted assets of 3.56%. And so the bank maintained a degree of profitability over a long trend of increased sensitivity to potential credit losses – which of course soon came thick and fast and spurred the Global Financial Crisis.

Contrast Northern Rock’s almost enviable net margins with Japanese regional banks at present (as highlighted by hedge fund manager Shannon McConaghy) which are estimated to run at costs around 1% per annum with lending rates averaging less than 80 basis points for the first half of 2019, i.e. loss-making businesses even before any credit losses. McConaghy believes the losses are masked by a convoluted system of transfers and conventions that allow them to gradually account years’ of JGB capital gains as interest income.

If only Deutsche Bank had been able to do this with Bunds (and also had not amassed €288bn of loss-making derivatives) it may have been able to maintain a tolerable ROE profile. But it’s not just DB that has a problem, European banks are generally struggling with already thin margins, and although not to the extent of Japanese regional banks, are cheap relative to historic valuations for a reason. And it’s no coincidence that the sector has cheapened globally and seems more pronounced in Japan and Europe where policy rates have been negative, both deeper and for longer… Pushing interest rates negative almost inevitably suppresses bank margins and leads to reduced lending which leads to slower economic growth (which if already flat could lead to a recession…)

Thus monitoring the evolution of banks’ lending rates and volumes as we enter a new round of monetary easing will act as another potential warning system that the monetary medicine may be beginning to do more economic harm than good for each new (and likely ever more frequent) dosage. So although now banks globally are much better capitalised than they were leading into the Global Financial Crisis – and there is indeed relatively little chance of such sharp credit losses causing a recession – there remains this possibility that further monetary easing erodes remaining profitability enough to dry up lending. So the capital losses may still come, but in this scenario after the recession has already started. The only thing that is certain is that whenever the next crisis comes it will seem so different as it unfolds and yet so familiar and obvious to our hindsight-equipped future-selves.

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