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It is somewhat ironic that the fine being imposed by the Department of Justice (DOJ) on Deutsche Bank (DB) for mis-selling mortgage backed securities (MBS) in the US, the financial products largely blamed for the onset of the financial crisis, threatens once again to destabilise the financial system in Europe and perhaps beyond.
Although DB’s DOJ imposed fine may well be marked down from the initial reported figure of $14bn (not far from DB’s market cap) the whole episode highlights the problems of a considerably tighter regulatory framework, coupled with ultra-loose monetary policy, on the banking system, particularly in Europe.
Historically low and pan-flat yield curves, largely brought about by ECB QE purchases across the spectrum of debt tenors, have prevented commercial banks from profiting from maturity transformation (borrowing cheaply at short tenors and lending, at a higher yield, longer dated debt to their customers). Basel IV, as anyone who has been trying to negotiate swap credit spreads with European institutions recently will know, has considerably pushed up capital requirements that banks must hold against liabilities. Given these capital requirements are an attempt to prevent the kind of issues of undercapitalisation seen in the banking system post financial crisis, this can hardly be seen as destabilising over a longer term horizon. However, in the short term it is causing considerable pain in banking markets across Europe where competition from international banks, institutional investors and fintechs is very high. As regards capital requirements, European banks are being made less competitive versus their non-European peers.
The cumulative effects of such regulatory and central bank policy, combined with external fines, will surely have the impact of causing banks to contract their balance sheets, thereby undoing the very job such policy was enacted to perform.
It is little wonder that European banks are complaining that ultra-low ECB rates are eating into their lending margins; so much so that Credit Suisse chief executive Tidjane Thiam declared recently European banks are in a “…very fragile situation” and are “…not really investable as a sector”. The ECB's chief economist Peter Praet, whilst acknowledging the problem also noted, not entirely unreasonably, that it was not up to the central bank to sure up banks’ profit margins. "Very low interest rates will probably prevail for an extended period of time," he added.
In the peculiar, unfamiliar and often confusing world of negative interest rates further unintended, negative implications of ultra-loose monetary policy can be seen, and will surely be seen more regularly, in businesses that have traditionally been used to garner income from savings. Banks have been discussed above but the solvency of insurance companies and pension funds is no different. These institutions by their nature require long-dated returns to match their liabilities that are, in some instances, becoming underfunded and storing problems, no doubt for governments and their central banks to deal with, further down the road. Such institutions can’t simply buy stocks and enjoy the obvious flip side of such accommodative monetary policy. The idea that central banks can force asset appreciation to such a degree that the wealth creation creeps down to the majority of the population is flawed for major sectors of the economy. At some stage, such policy will no longer serve to promote capital creation.
As a consequence of this ultra-loose policy one of the central tenets of capitalism, asset allocation, becomes diminishing in its influence to correctly reward risk over return. Witness Italy selling its first 50-year bond in October. About EUR18.5bn of orders were placed for the bond - five and half times the expected sale amount. All this despite concerns over Italy's banks and an upcoming referendum on 4 December that could unseat its prime minister, potentially bringing an anti EU government with it. Rather than considering the downside of this potentially explosive referendum, investors are betting the ECB may soon add ultra-long debt to its asset-purchase stimulus scheme. Correspondingly any serious mention of the ECB tapering its asset purchase program is likely to cause benchmark yields to sky rocket.
One sector of the economy that has been a prime beneficiary of record low borrowing costs and the search for yield, particularly from the insurance and pension funds market, has been infrastructure. Pension funds have been able to match their liabilities to long term stable cashflows and have increasingly become an alternative to commercial bank debt. Liquidity levels have been rising across Europe over the last two years, but infrastructure deal flow has remained relatively passive given the ideal financial conditions for new projects to close. The Netherlands has been most progressive in the EU in pursuing infrastructure spending, closing a host of new transport, sea lock and government building over the past two years.
Infrastructure programs of this nature, and the tax payers that ultimately fund their development, are clear winners from the current interest rate environment. However, the unintended consequences of central banks’ policy, namely mis-allocation of risk and pressure on the banking system, could prove more costly in the long run.
All view expressed here are the author's own and are based on information available at the time of writing.
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