Down in Fredrick, MD, visiting with the KBRA FIG team this week. Last week we published a research note, "Will Negative Interest Rates Save Europe’s Banking System?" You can read the full report with footnotes at the link below (registration is free).
The striking thing about the situation in the EU is that German Chabcellor Angela Merkel refused to take the political risk of restructuring the EU economy, yet has allowed hundreds of thousands of refugees from the surrogate war in Syria to enter. Nations such as Italy are clearly in distress, yet the EU leadership refuses to take action to address bank solvency.
This leaves ECB chief Mario Draghi to try and keep the situation stable using negative rates and debt monetization, a recipie for distaster. Draghi proposes to pay EU banks to lend, an idea that raises huge questions of moral hazard. Yet so far the Eurobanks don't seem to be interested in Draghi's proposal. The best case view of Euro banks is that they are all sovereign credits, one way or another. -- Chris
Kroll Bond Rating Agency
April 1, 2016
In the immediate aftermath of the 2008 financial crisis, German Chancellor Angela Merkel made a fateful choice and refused to allow a rescue of the European banking system to be guaranteed on a Europe-wide basis. She rightly felt that the prevailing German public opinion would be opposed to it. Thus, nothing was done. While this decision was correct in a political sense and, in the view of some observers, may have enabled Merkel to remain in office, in economic terms it left the European Union with a banking system hobbled by bad debts and, in some cases, arguably insolvent.
EU officials also have refused to “bail in” bond holders of EU banks by converting debt to equity, an obvious solution to the solvency problem that apparently is unacceptable politically. At the end of 2014, non-performing loans (NPLs) in the EU totaled over €1 trillion. Banks in many nations of Southern and Eastern Europe had Texas ratios over 100%, according to the International Monetary Fund. As of year-end 2014 (latest data available), Cyprus, Greece, Ireland, Slovenia, Italy, and Spain all reported ratios of non-performing to total–banking-system assets in double digits. By comparison, the peak in NPLs for all loans held by US banks was 5.5% in Q1 of 2010. Today, non-current loans held by U.S. banks are just 1.5% of total assets, according to the Federal Deposit Insurance Corporation.
The IMF notes that EU accounting standards, as implemented across Europe, weaken incentives for banks to resolve NPLs and lead to under provisioning for future losses. KBRA believes that the actual amounts of NPLs held by EU banks are significantly higher than the published figures and that the totals for NPLs to total assets probably increased during 2015. For example, EU banks are not required to (1) suspend the accrual of interest income on NPLs once the loan is 90 days past due or (2) write down the loan balance on the bank’s balance sheet to fair value after six months, as is the case in the U.S. under GAAP.
Moreover, the International Financial Reporting Standard (IFRS) allows for the indefinite accrual of interest income from NPLs, which tends to inflate published statistics regarding bank profitability above the real amount as measured in cash terms. Also, IFRS allows banks to defer provisions for loan losses until the loss is actually realized, a policy that lowers the incentives to dispose of NPLs (and is expected to be revised in 2018 when IFRS 9 becomes effective). Because of these differences between GAAP and IFRS, KBRA believes that investors should treat published financial statements and estimates of non-performing exposures from EU banks with caution.
The Solution: Monetization & Subsidies
Now, eight years since the financial crisis, the ECB has embarked upon a radical policy of debt purchases and outright subsidies for banks. ECB Governor Mario Draghi seeks to do via monetary policy what Merkel and other elected officials in the EU cannot or will not do, namely deal directly with the asset quality problems festering inside the EU banking system by writing down bad debts and converting debt to equity. The latest ECB policy move is effectively a work-around for a political system that has not been able to deal with the uncollectible debts on the books of EU banks as well as the public and private debts of a number of EU member states.
As KBRA has noted in previous research notes, EU nations such as Italy have for years sought to establish mechanisms for removing bad debts from the balance sheets of that nation’s banks. The EU prohibition on state aid for private banks, however, has made such initiatives impossible. Thus the problem of bad debts on the balance sheets of EU banks remains unresolved, hurting the prospects for economic recovery and growth in the EU.
First, the ECB has enlarged the program of open-market asset purchases (referred to euphemistically as “quantitative easing” or QE), and has expanded the securities eligible for purchase by the central bank. The ECB has also lowered several policy interest rates. Some of those policy rates are now at zero, and one of them is now negative, at -0.40%, Cumberland Advisors notes in a research commentary.
Second, and more significant, the ECB has put in place an aggressive policy to encourage EU banks not only to sell assets, but to expand their balance sheets and extend new credits. The ECB’s policy will allow banks to borrow at zero cost, and, if the bank expands lending by at least 2.5% by the end of 2018, the ECB will actually pay the bank 40bp for borrowing to cover these new extensions of credit. To be clear, in June the ECB reportedly will put in place a second targeted long-term refinancing operation (TLTRO2) whereby banks in Europe will be able to borrow at zero cost or under certain conditions borrow at the negative -40bp policy rate. Barclays Capital notes in a March 22, 2016 research report:
“In fact, the ECB appears to be attempting to support the European banking sector by allowing banks to borrow from the TLTRO2 at a rate as low as -40bp. We believe this is a direct acknowledgement by the ECB of the potential damage to the margins of banks caused by negative rates."
Draghi and his colleagues rightly understand that the continuation of zero rates in the EU for years to come threatens banks and other financial institutions with insolvency. Since Merkel and other political leaders lack the fiscal resources and political support to deal with Europe’s debt problems directly, the ECB has been left with the task of monetizing the bad debts on the books of EU banks without causing the collapse of these same financial institutions. Of note, EU banks have so far have been reluctant to borrow from the ECB under TLTRO1, suggesting that the scheme will provide little relief to the banking sector.
KBRA has long been skeptical of efforts by the Federal Reserve and ECB to use negative interest rates and other expedients to deal with the problem of excessive debt, yet the reality is that none of the Group of Twenty industrial nations have sufficient income and economic growth to do otherwise. Negative interest rates and open-market debt purchases represent a last, desperate attempt by the EU, Japan, and even the US to avoid a 1930s style debt deflation in which obligors would default on mounting public and private debt obligations. While the leaders of the central banks in these nations believe that negative interest rates and open-market operations are a form of economic stimulus, KBRA is concerned that these policies are hurting credit creation and may ultimately increase deflationary pressures.
The Global Debt Overhang
Last year consulting firm McKinsey & Company noted that since 2007, global debt has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage points. McKinsey notes that no major economy has decreased its debt-to-GDP ratio since 2007 and that this debt accumulation “poses new risks to financial stability and may undermine global economic growth.” In this regard, KBRA notes that there are growing calls for a debt moratorium in Europe to deal with the increases in public sector indebtedness which has occurred since the 2008 financial crisis.
Growth estimates for the U.S. and other industrial nations reflect the structural obstacles to more robust expansion, as savers reject official efforts to make them borrow and spend, and instead direct resources from current consumption to the repayment of private debt. In some respects, the use of open-market asset purchases by the Fed, ECB, and other monetary agencies was inevitable given the exponential growth of public and private indebtedness and the concurrent decline of private sector growth.
Starting from the Great Depression, when private capital formation essentially came to a halt, governments took up the slack and used public debt issuance to restructure whole economies and drive economic growth until several decades after WWII. In a historical sense, the global economy has seen the evolution of debt capital markets over the last century in which government issuers are at the pinnacle of the credit stack, with private obligors below in order of perceived credit quality. The more recent excessive accumulation of public-sector debt calls this government-centric hierarchy into question.
Over the past century, the progression that sovereign obligors have followed fits a model familiar to students of financial history, with three distinct phases of lending: fully hedged, speculative and, finally, the Ponzi phase, as outlined below:
• Fully Hedged Phase: Lenders make a loan and are paid back in full. The borrower has sufficient capital and operating cash flows to cover both interest and principal. Thus, the lender faces little or no economic risk of default. Prior to WWII, private borrowers were often required to pay down commercial loans at the end of each year to demonstrate solvency.
• Speculative Phase: The lender is covered by the operating cash flows of the borrower for interest payments, but the debtor relies upon refinancing for principal repayment. As this type of lending becomes accepted and, over time, as the principal is refinanced and the interest payments are not missed, lenders loosen credit terms even further.
• Ponzi Phase: In the third phase, obligors must borrow even to service the interest on the debt, have no ability to repay principal, and over time have increased difficulty refinancing existing debt. Because of low or no growth, today the EU, U.S., Japan, China, and many other industrial nations find themselves facing rising debt-to-GDP ratios and no ability repay the principal balance or interest on public-sector debt.
Since the 2008 financial crisis, the Federal Reserve, the ECB, and Bank of Japan have essentially created a fourth phase of this historical progression of public indebtedness, widely known as “financial repression.” Major central banks state publicly that negative interest rates and other policy actions are taken in the name of pursuing increased job growth. An alternate view, however, says that zero interest rates and QE are really intended to manage excessive public sector debt at the expense of private investors, while allowing political leaders to avoid the inconvenience of outright default by public and private issuers. The cost of this exercise falls squarely upon bond investors, who must endure an effective tax in the form of negative real interest rates so that public and private debtors can avoid default.
Negative Interest Rates & Deflation
The ECB’s embrace of ever more radical applications of negative interest rates and asset purchases suggests to KBRA that the financial and economic situation in Europe is far more serious than is appreciated by most investors. The idea that the ECB needs to pay banks via negative interest rates to borrow in order to make new loans strikes KBRA as confirmation that excessive debt is a serious problem in Europe. As the U.S. learned during the S&L crisis of the 1980s, allowing troubled banks to try to grow their way out of insolvency is a recipe for disaster, since the new loans they make will likely be uncollectible. Providing a subsidy in the form of a negative cost of funds is likely to only increase the moral hazard already operating in the EU.
But even more serious in KBRA’s view is the obvious conflict between zero-interest-rate policy and the greater need to safeguard the solvency of financial institutions, insurers, and pensions, both in the EU and around the world. Providing EU banks with a small subsidy by allowing them to borrow at zero or even negative 0.4% is unlikely to be sufficient to avoid serious structural problems in the years ahead. Mohamed El-Arian wrote recently:
“[M]uch of the institutional setup for providing financial services to millions in systemically important advanced economies was not designed to operate for long with negative nominal interest rates, and with the associated flattening of the yield curve. For example, with pressures on net interest margins, banks face greater challenges in intermediating funds and are increasingly inclined to turn away deposits. Moreover, providers of long-term financial savings, protection and assurances –from pension funds to insurance companies –find it harder to meet client expectations of meaningful safe returns many years in the future. There are no meaningful substitutes available in the short-term.”
Negative numbers do not exist in the natural world of mathematics, economies, companies and people, only in the theoretical realm inhabited by economists. Negative interest rates are deleterious to the well-being of financial institutions, commercial enterprises and consumers. Negative interest rates suggest liquidation, destroy the private capital stock, and ultimately cause a shrinkage in the amount of credit creation – precisely the opposite of what ECB Governor Mario Draghi is trying to achieve.
Hans-Werner Sinn, one of Germany’s leading economists, said in a commentary: “The European Central Bank’s latest policy moves have shocked many observers. While the goal – to prevent deflation and spur growth – is clear, the policies themselves are setting the stage for severe instability.”
Further, the great American economist Irving Fisher, in his classic 1933 essay “The Debt Deflation Theory of Great Depressions,” outlined nine phases of debt deflation. He wrote:
“Just as a bad cold leads to pneumonia, so over-indebtedness leads to deflation. And, vice versa, deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debts cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself.”
We believe that investors and policymakers need to consider whether interest rates are low because of the action of central banks or because of unresolved debt deflation. Instead of driving interest rates down to or below zero, KBRA believes that the ECB, Federal Reserve, Bank of Japan and other global central banks should recall Fisher’s warning about the deadly combination of excessive unresolved debt and falling velocity of money. The proper policy mix to help Europe emerge from the threat of debt deflation is for the ECB to go forward with asset purchases as planned, for the EU states to increase public spending to provide short-term relief from unemployment and economic malaise, and for the ECB to raise rather than lower interest rates in order to increase the cash flows moving through the financial institutions of Europe and the wider global economic system.
While the issues facing central bankers today are different from those confronted in the 1930s, the principal of avoiding debt deflation by increasing the income in the global financial system remains valid. KBRA believes that a better strategy for the EU would be for the ECB to go forward with the planned purchase of bad debts from EU banks, but instead of subsidizing borrowing costs to encourage new lending, offering high-yield deposits and securities to banks, pensions, and other financial intermediaries that are presently underwater with respect to their long-term liabilities. By increasing the cash flow of assets held by banks and other financial intermediaries, KBRA submits, the ECB (as well as other central banks) would better address the true risk facing industrialized nations, namely prolonged debt deflation.