It is an often unappreciated fact that Europe escaped the 1929 depression that began in the US, until the 1931 collapse of Creditanstalt, a large Austrian bank, which unleashed the full brunt of the depression Europe.
Perhaps history does not repeat itself, but will it rhyme?
We are currently experiencing a sea change in the financial environment, moving from an environment of very low to much higher levels of inflation and from a low/negative interest rate environment to higher levels.
This puts the European Central Bank (ECB) between the proverbial rock and hard place. It has unenviable options: it can leave interest rates low, in which case inflation will likely worsen, or it may raise interest rates to curtail inflation, which could trigger a wave of defaults for highly leveraged governments, corporations and individuals, ushering in a recession or depression.
European bond yields have shot up considerably over the past weeks, but have considerably farther to go if the intent of the ECB is truly to curtail inflation. For this to happen, government bond interest rates in the more developed countries such as Germany (currently close to 0%) would need to move higher than the inflation rate (currently at around 5% according to official statistics in the Eurozone, and still rising). Bond yields in peripheral countries (e.g. Greece) are skyrocketing as of the beginning of February, 2022, already approaching 3%.
This author has argued in previous articles that the US Fed is unlikely to raise interest rates to curtail inflation; for the ECB, this would be even more difficult. It simply cannot afford to trigger a wave of defaults in an economic environment that has been more anemic than in the US.
The current negative real interest rate environment does, however, create an opportunity: to inflate away the national debt. Despite the fact that inflation amounts to a form of legal theft against savers (whose savings will not keep up with inflation—hence the name ‘financial repression’), inflating debt away seems to be the lesser of evils, when compared to raising interest rates, triggering defaults, and a recession or depression.
A by-product of financial repression will involve negative effects on European banks. This article first takes a quick overview on the recent condition of European banks; and then speculates on how an inflationary, financial repressive environment may affect European banks.
European banks were typically much slower to write off bad loans and work out their bad debt portfolios than US banks. They also have lower returns on equity. It does not help that macroprudential regulation has encouraged European banks to load up with large amounts of negative yielding Government debt, as a means of helping Governments finance their deficits. Hence European banks have difficulty accumulating retained earnings which might help them withstand a future crisis; and must dilute ownership considerably should they need to raise additional capital.
Societe Generale, perhaps the weakest G-SIB (Globally Systemically Important Bank) in Europe, according to a recent analyst report by Saxo Bank, has a market capitalization under EUR 10 billion, trades at only 17% of its book value, and has a less than15% Tier 1 ratio (e.g. reflecting leverage and the percentage of capital available to withstand losses). Its expected return on equity over the next two years is below 4%.
Other European G-SIBS such as Deutsche Bank, and Commerzbank have marginally higher Tier 1 ratios but even lower expected ROE. (In fairness, the Tier 1 ratios are higher than during the 2009-2011 crisis). Deutsche Bank’s share price fell from EUR 100 in 2007 to EUR 13 in 2022. It also has considerable exposure to derivatives. (Warren Buffet, you may recall, called them “weapons of mass destruction.” Because of inadequate disclosure requirements, it remains difficult to ascertain the precise level of derivative exposure of banks. Such uncertainty can be extremely dangerous in times of crisis, as it was during the 2009-2011 crisis).
Rising bond yields in Europe could result in large losses for banks holding Government bonds, suddenly reducing Tier 1 ratios. This was also at the heart of the 2011 European banking crisis.
While certain European G-SIBS have limited ability to withstand a major financial crisis, there are risks also with Europe’s non-globally systematically important banks and non-bank financial institutions. The latter constitute about 40% of financial assets in Europe, are barely regulated, and are highly pro-cyclical.
The IMF has stated that the weakest spot of the global financial system is likely European banks.
A default of a European G-SIB would send shock waves around the world. Remember, this is in the context of global debt having reached astronomic portions—355% of global ‘GDP. It would also likely trigger an immediate explosion of risk premia on highly indebted/low growth countries like Italy and Greece. The ECB had enough trouble to keep Greece from going off the rails; if it were necessary to rescue a major country such as Italy, that could be a shock of sufficient magnitude to trigger the demise of the Euro, perhaps the European Union itself.
We are currently experiencing a sea change in the financial environment, moving from an environment of very low to much higher levels of inflation and from a low/negative interest rate environment to higher levels.
This puts the European Central Bank (ECB) between the proverbial rock and hard place. It has unenviable options: it can leave interest rates low, in which case inflation will likely worsen, or it may raise interest rates to curtail inflation, which could trigger a wave of defaults for highly leveraged governments, corporations and individuals, ushering in a recession or depression.
European bond yields have shot up considerably over the past weeks, but have considerably farther to go if the intent of the ECB is truly to curtail inflation. For this to happen, government bond interest rates in the more developed countries such as Germany (currently close to 0%) would need to move higher than the inflation rate (currently at around 5% according to official statistics in the Eurozone, and still rising). Bond yields in peripheral countries (e.g. Greece) are skyrocketing as of the beginning of February, 2022, already approaching 3%.
This author has argued in previous articles that the US Fed is unlikely to raise interest rates to curtail inflation; for the ECB, this would be even more difficult. It simply cannot afford to trigger a wave of defaults in an economic environment that has been more anemic than in the US.
The current negative real interest rate environment does, however, create an opportunity: to inflate away the national debt. Despite the fact that inflation amounts to a form of legal theft against savers (whose savings will not keep up with inflation—hence the name ‘financial repression’), inflating debt away seems to be the lesser of evils, when compared to raising interest rates, triggering defaults, and a recession or depression.
A by-product of financial repression will involve negative effects on European banks. This article first takes a quick overview on the recent condition of European banks; and then speculates on how an inflationary, financial repressive environment may affect European banks.
European banks were typically much slower to write off bad loans and work out their bad debt portfolios than US banks. They also have lower returns on equity. It does not help that macroprudential regulation has encouraged European banks to load up with large amounts of negative yielding Government debt, as a means of helping Governments finance their deficits. Hence European banks have difficulty accumulating retained earnings which might help them withstand a future crisis; and must dilute ownership considerably should they need to raise additional capital.
Societe Generale, perhaps the weakest G-SIB (Globally Systemically Important Bank) in Europe, according to a recent analyst report by Saxo Bank, has a market capitalization under EUR 10 billion, trades at only 17% of its book value, and has a less than15% Tier 1 ratio (e.g. reflecting leverage and the percentage of capital available to withstand losses). Its expected return on equity over the next two years is below 4%.
Other European G-SIBS such as Deutsche Bank, and Commerzbank have marginally higher Tier 1 ratios but even lower expected ROE. (In fairness, the Tier 1 ratios are higher than during the 2009-2011 crisis). Deutsche Bank’s share price fell from EUR 100 in 2007 to EUR 13 in 2022. It also has considerable exposure to derivatives. (Warren Buffet, you may recall, called them “weapons of mass destruction.” Because of inadequate disclosure requirements, it remains difficult to ascertain the precise level of derivative exposure of banks. Such uncertainty can be extremely dangerous in times of crisis, as it was during the 2009-2011 crisis).
Rising bond yields in Europe could result in large losses for banks holding Government bonds, suddenly reducing Tier 1 ratios. This was also at the heart of the 2011 European banking crisis.
While certain European G-SIBS have limited ability to withstand a major financial crisis, there are risks also with Europe’s non-globally systematically important banks and non-bank financial institutions. The latter constitute about 40% of financial assets in Europe, are barely regulated, and are highly pro-cyclical.
The IMF has stated that the weakest spot of the global financial system is likely European banks.
A default of a European G-SIB would send shock waves around the world. Remember, this is in the context of global debt having reached astronomic portions—355% of global ‘GDP. It would also likely trigger an immediate explosion of risk premia on highly indebted/low growth countries like Italy and Greece. The ECB had enough trouble to keep Greece from going off the rails; if it were necessary to rescue a major country such as Italy, that could be a shock of sufficient magnitude to trigger the demise of the Euro, perhaps the European Union itself.