Chart and Quote of the Day: European Banking System's Doom Loop

CFR's Benn Steil and Emma Smith writes:

Italian banks have taken a pounding of late from the ECB, the markets, and the media. They currently hold a whopping €360 billion in nonperforming loans (18 percent of their portfolio), the most in the European Union and double that of the next worst performer—Spain.

As shown in the graphic above, Italy is also the worst performer among major EU nations along another metric of banking-sector fragility—the dreaded “doom loop” of indebted banks and sovereigns.

A doom loop is set in motion when banks load up on debt issued by their government, and the government in turn guarantees, explicitly or implicitly, the debt of the banks. As banks’ balance sheets weaken with rising bad loans, this impairs the fiscal position of the government backstopping their debt. And as the government’s fiscal position deteriorates the loss exposure of the banks holding its debt rises. Thus do weak banks drag down weak sovereigns, which in turn further weighs on the banks—ad infinitum.

The graphic also shows that Portugal’s doom loop metric has soared over the past two years. Portuguese banks have been gorging on Portuguese sovereign debt, taking it from 7 percent of total assets to 10 percent—the same level as Spain. If they continuing loading up at this pace, they will reach Italian levels by 2018.

This is worrying because Portugal has a government debt-to-GDP ratio of 129 percent (just below Italy’s 136 percent) and is set to fall short of its deficit target for a third year running. Spain, with debt to GDP at 101 percent, will fall short for the 9th straight year. And slowing growth means that current budget projections may prove overoptimistic yet again, leading to ratings downgrades.

What does this mean from a practical perspective? Well, we calculate that a 15 percent fall in the bond prices of their respective sovereigns would erase 35 percent of Italian bank capital, 22 percent of Portuguese bank capital, and 18 percent of Spanish bank capital. This would fuel already heightened tensions with the EU over new bailout restrictions and revive speculation of a Eurozone break-up.

This shows why ECB's negative policy regime emerged. Unsustainable debt has bounded both Europe's governments and their respective national banking system where both have been locked in a deadly embrace.

The aim of negative rates has not only been to redistribute wealth to the beleaguered triumvirate -- the insolvent governments and banking system, as well as to the ECB, but to buy time and keep the unsustainable status quo afloat. 

But as pointed out above, doom loop to ad infinitum or the debt trap translates to an eventual breaking point.

Infographics: Timelie of the Epic Collapse of Deutsche Bank

The unfolding banking crisis in Europe in the lens of Deutsche Bank 

From the Visual Capitalist

A TIMELINE SHOWING THE FALL OF ONE OF EUROPE’S MOST ICONIC FINANCIAL INSTITUTIONS

It’s been almost 10 years in the making, but the fate of one of Europe’s most important financial institutions appears to be sealed.

After a hard-hitting sequence of scandals, poor decisions, and unfortunate events, Frankfurt-based Deutsche Bank shares are now down -48% on the year to $12.60, which is a record-setting low.

Even more stunning is the long-term view of the German institution’s downward spiral.

With a modest $15.8 billion in market capitalization, shares of the 147-year-old company now trade for a paltry 8% of its peak price in May 2007.

THE BEGINNING OF THE END

If the deaths of Lehman Brothers and Bear Stearns were quick and painless, the coming demise of Deutsche Bank has been long, drawn out, and painful.

In recent times, Deutsche Bank’s investment banking division has been among the largest in the world, comparable in size to Goldman Sachs, JP Morgan, Bank of America, and Citigroup. However, unlike those other names, Deutsche Bank has been walking wounded since the Financial Crisis, and the German bank has never been able to fully recover.

It’s ironic, because in 2009, the company’s CEO Josef Ackermann boldly proclaimed that Deutsche Bank had plenty of capital, and that it was weathering the crisis better than its competitors.

It turned out, however, that the bank was actually hiding $12 billion in losses to avoid a government bailout. Meanwhile, much of the money the bank did make during this turbulent time in the markets stemmed from the manipulation of Libor rates. Those “wins” were short-lived, since the eventual fine to end the Libor probe would be a record-setting $2.5 billion.

The bank finally had to admit that it actually needed more capital.

In 2013, it raised €3 billion with a rights issue, claiming that no additional funds would be needed. Then in 2014 the bank head-scratchingly proceeded to raise €1.5 billion, and after that, another €8 billion.

A SERIES OF UNFORTUNATE EVENTS

In recent years, Deutsche Bank has desperately been trying to reinvent itself.

Having gone through multiple CEOs since the Financial Crisis, the latest attempt at reinvention involves a massive overhaul of operations and staff announced by co-CEO John Cryan in October 2015. The bank is now in the process of cutting 9,000 employees and ceasing operations in 10 countries. This is where our timeline of Deutsche Bank’s most recent woes begins – and the last six months, in particular, have been fast and furious.

Deutsche Bank started the year by announcing a record-setting loss in 2015 of €6.8 billion.

Cryan went on an immediate PR binge, proclaiming that the bank was “rock solid”. German Finance Minister Wolfgang Schäuble even went out of his way to say he had “no concerns” about Deutsche Bank.

Translation: things are in full-on crisis mode.

In the following weeks, here’s what happened:

May 16, 2016: Berenberg Bank warns that DB’s woes may be “insurmountable”, noting that DB is more than 40x levered. June 2, 2016: Two ex-DB employees are charged in ongoing U.S. Libor probe for rigging interest rates. Meanwhile, the UK’s Financial Conduct Authority says there are at least 29 DB employees involved in the scandal.

June 23, 2016: Brexit decision hits DB hard. The bank is the largest European bank in London and receives 19% of its revenues from the UK.

June 29, 2016: IMF issues statement that “DB appears to be the most important net contributor to systematic risks”. June 30, 2016: Federal Reserve announces that DB fails Fed stress test in US, due to “poor risk management and financial planning”.

Doesn’t sound “rock solid”, does it?

Now the real question: what happens to Deutsche Bank’s derivative book, which has a notional value of €52 trillion, if the bank is insolvent?

Courtesy of: Visual Capitalist

The Four Horsemen of Financial Market Armageddon? European (Italian) and Japanese Banks, UK Property, Brexit and the Chinese Yuan

Looks as if Risk OFF has returned!

First horseman. Yesterday 3 UK property firms announced that they have suspended investor redemption on their funds.

From CNBC:

The news that Standard Life, Aviva and M&G Investments have suspended dealing in their U.K. property funds has both investors and fund managers worried about the consequences on the broader sector.

Shares of Standard Life were down nearly 5 percent on Tuesday. Meanwhile, shares across other asset management companies were sharply negative too. Aberdeen Asset Management saw its shares down nearly 8 percent, while Schroders was down nearly 6 percent. 

Standard Life was the first to announce suspension on Monday. Aviva Investors and M&G Investments followed the lead to announce a temporary suspension on Tuesday. All three companies have attributed the decision to a massive increase in investor redemptions because of high levels of uncertainty in the U.K. commercial property since the outcome of the referendum on June 23. 

While all three companies have claimed that the decision was taken in order to protect the interests of investors who may be negatively impacted by this, the fear that this may be followed by more property funds has started to worry many.

Second horseman. Pressures on European banks led by Italy has exacerbated:

From CNBC

Italy's bank bailout fund might not be enough to beat back the Brexit. More key Italian financial services firms are under pressure and face the potential need to raise capital, leaving Italian government officials and its banking system trying to steer clear of a crisis. 

As Italian bank bonds and share prices are seeing their value slammed in the face of rising uncertainty, banks with substantial bad loans are facing greater pressure, with rates around the world slipping into negative territory. It's an anxiety some in Italy and throughout the European Union may have been hoping would be eased by the Brexit vote last month — but then the U.K. referendum delivered the opposite outcome from the one they had sought….

Many banks in Italy, including its largest, UniCredit SpA, have seen share prices pounded; its stock is down more than 60 percent so far this year. A staffer at UniCredit could not provide comment when contacted.

Already, Italian officials and executives appear to be pulling out all the stops to stave off banking sector contagion. The lingering question for banks is whether they can continue to support lending operations at a time when creditors face potential losses and as some of the country's leading financial services firms could be subject to shotgun M&A marriages by regulators.

Chart from Zero Hedge

It's not just Italian banks, Europe's banks have been crushed! 

The collapse in Europe's Stoxx banking index was followed up with yesterday's 2.73% meltdown.  

The bank index now approaches the European crisis low. Systemic risks banks Deutsche bank, Credit Suisse and HSBC holdings were slammed by 3.67%, 5.52% and 3.29% last night

Has the European banking crisis returned?

And it has not just been European banks, as yields of Japanese bonds crash deep into record negative zone, Japan’s banks appear to be taking it to the chin!

 

Note the Topix bank still trades at the moment. So the above represents the momentary quote

For the third horseman. Will Europe’s and Italy’s banking problem exacerbate the disintegration of the EU?

One analyst thinks so.

From CNBC

The problems facing the Italian banks could cause Italy to become the next country to try to leave the European Union, strategist Brian Jacobsen said Tuesday. 

That's because many Italian banks may need to raise more capital and European Union banking regulations won't allow recapitalization.

And that could hit the wallets of Italian retail investors, many of whom hold bank bonds, he told CNBC's "Power Lunch."

"The bigger issue here [is] the fact that you have so many pensioners and depositors who have purchased some of the slightly higher-yielding securities issued by Italian banks, who by EU rules would effectively need to be wiped out before there could be a recapitalization," said Jacobsen, chief portfolio strategist at Wells Fargo Funds.

Looks like JM Keynes’ observation of the destructive effects of inflationism—Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency—have become apparent: worsening economic conditions compounded by a potential banking crisis prompted by central bank inflationism may accelerate the EU’s demise and magnify global political risks

So from Brexit to Italexit?

For the fourth horseman, the offshore yuan has significantly dropped for the past two days! The USD-CNH (offshore yuan) has already breached, as of this writing, the January 2016 highs!

It seems that not only one, but four major deflationary forces have now combined to produce a lethal cocktail mix that now serves as structural headwind or nasty unintended consequences to the previous inflationary (invisible transfers) booms brought about by central bank policies. 

Has market forces taken over? Has the moment of reckoning arrived?

Brexit’s Risk OFF to Risk ON: Central Banks Powers Titanic Short Squeezes!‏

Global stocks mounted a colossal rally to offset mostly last week’s losses from a mini crash 

While I noted here that central banks panicked last week and that such panic has failed to stave off the markets from crashes, it’s a different story this week. Direct and indirect central banks actions have incited a remarkable short squeeze. 

Abe eyeing more stimulus (again!) From Reuters: 

Japanese Prime Minister Shinzo Abe on Monday instructed Finance Minister Taro Aso to watch currency markets "ever more closely" and take steps if necessary, in the wake of Britain's historic vote to leave the European Union. 

Abe made the comments at an emergency meeting with Aso and Bank of Japan Deputy Governor Hiroshi Nakaso as some analysts speculate the central bank may ease if it calls an unscheduled policy review before its planned July 28-29 gathering. 

While Abe ordered the BOJ to ensure ample liquidity in markets, his government is ready to provide the economy fiscal support, with an eye on expanding planned stimulus steps to total more than 10 trillion yen ($98.03 billion), sources told Reuters. 

Taiwan central bank slashes rate for the fourth time. From Bloomberg 

Taiwan’s central bank lowered its benchmark interest rate in a widely expected decision as the export-dependent economy’s growth prospects remain under pressure. 

At its quarterly board meeting Thursday, the Central Bank of the Republic of China (Taiwan) cut the benchmark rate to 1.375 percent from 1.5 percent. Twenty four of 27 economists had seen a cut of at least 12.5 basis points this quarter.

Taiwan is battling three consecutive quarters of economic contraction and global demand for its goods has fallen every month since February 2015. Central banks around the world have offered fresh funds to financial systems and intervened in currency markets to offset panic generated by the U.K.’s vote to exit the European Union. 

The US Federal Reserve gave a go-signal for 31 of 33 banks to lift dividends and engage in buybacks. The result has been a torrent of buyback announcement to the tune of tens of millions of dollars 

The Chinese central bank, the PBOC reportedly intervened to shore up the yuan last Wednesday. From Bloomberg: 

Chinese authorities intervened via banks to support the offshore yuan in morning trading, according to people with knowledge of the matter. 

The People’s Bank of China wants to maintain stability in the currency, the people said, declining to be identified as the move hasn’t been publicly announced. The yuan strengthened as much as 0.26 percent against the dollar in mid-morning in Hong Kong’s freely traded market, paring its discount to the onshore rate. 

The Bank of England reportedly injected £3.1 billion last into their domestic financial system last Tuesday June 28. In addition, BOE governor proposed to ease “within months” as well as to consider a “host of other measures”. 

The ECB likewise offered to loosen rules on their bond buying program. From Bloomberg 

The European Central Bank is considering loosening the rules for its bond purchases to ensure enough debt is available to buy in the aftermath of the Brexit vote, according to euro-area officials familiar with the discussions. 

Policy makers are concerned that the pool of securities eligible for quantitative easing has shrunk after investors piled into the region’s safest assets and pushed down yields on some sovereign debt too far to meet current criteria, said the people, who asked not to be identified because the matter is confidential. Some Governing Council members now favor changing the allocation of bond purchases away from the size of a nation’s economy toward one more in line with outstanding debt, one of the people said. 

Later. the ECB denied this. From CNBC 

The European Central Bank is not currently considering buying government debt out of proportion to euro zone countries' shareholding in the bank, and the hurdle for abandoning this "capital key" is high, sources close to the ECB said on Friday. 

Bond markets rallied after Bloomberg reported that the ECB was considering giving up the capital key due to a shortage of German paper, which investors see as safe and have bought heavily in the aftermath of Britain's vote to leave the European Union. 

But sources familiar with the ECB's thinking said that several other changes would be considered before any such move, which would have heavy political ramifications, especially in Germany, where many are already uneasy about the ECB's 1.74 trillion euro quantitative easing scheme. 

The ECB seem to be using trial balloons and false info to jumpstart the market

Nevertheless, Italy’s troubled banks got a reprieve from EU’s $166 billion of liquidity guarantee. From Bloomberg 

Italy was given the go-ahead by the European Commission to supply as much as 150 billion euros ($166 billion) in government liquidity guarantees for its struggling banks until the end of the year, according to an EU official. 

Liquidity support for solvent banks is a “precautionary measure” requested by Italy, the EU said in an e-mailed statement. The guarantees of senior debt allow lenders to maintain access to financing, often at a better price. 

“There is no expectation that the need to use this” should arise, the commission said. The support was approved on June 26, the EU official said on condition of anonymity, and wasn’t made public before now. 

Saddled with some 360 billion euros in soured loans and a sputtering economy, Italy’s lenders have been sliding toward the type of crisis that other European countries dealt with years ago. The government’s latest effort -- getting the biggest banks to back a fund to rescue the weakest -- failed to convince investors. 

Italy asked for liquidity support that the EU has approved for countries including Greece, Cyprus, Portugal and Poland. The financial backstop is provided under EU state-aid rules, usually for six months. 

Finally, an Italian bank had been bailed out last week, even as the bailout fund runs the risks of depletion From theFinancial Times 

An Italian bank bailout fund has taken control of a second lender after Germany rejected a plea for a more sweeping state-funded recapitalisation of the country’s banking system. 

Angela Merkel, the German chancellor, turned down the plea from Matteo Renzi, Italy’s prime minister, at an EU summit in Brussels on Wednesday evening, prompting a sharp fall on Thursday in Italian bank shares, which have now dropped 54 per cent this year. 

The rejection renewed questions about how to shore up Italy’s banking system, given scant interest among private investors and strict EU rules that limit government action. 

Atlante, a privately backed €5bn fund rushed into existence in April to quell the threat of contagion from struggling lenders, took control of Veneto Banca after a €1bn capital increase demanded by EU bank regulators attracted zero interest. 

The fund, known as Atlas in English, was intended to hold up the sky for Italian banks. But is showing signs of strain, having depleted more than half of its war chest after taking control of Popolare di Vicenza, another regional bank, last month. 

That has left little in reserve to tackle about €200bn in non-performing loans run up during Italy’s three-year recession, of which €85bn have not yet been written down. Bad loans are weighing on bank lending and crimping an already weak recovery. 

Central bank actions were mostly directed at banks, liquidity and currency support. 

Curiously while much of headline indices soared, much of where actions of support were directed seem to have hardly reciprocated.

Despite the PBOC’s intervention the yuan fell by .6%. 

Banks of major economies sputtered or underperformed. Japan’s Topix bank index was down by .4% (-37% y-t-d) even as the Nikkei zoomed 4.89%! Europe’s Stoxx banking index dropped 2.4% (-31% y-t-d). The risk on eluded Italian banks even when they had been were provided with liquidity and one which had been bailed out. Italian bank stocks slumped another 5.4% (-54% y-t-d). Deutsche bank which the IMF named as “the most important net contributor to systemic risks” plummeted 5.5%. The other two systemic risk posted variable outcome HSBC Holdings Plc (+2.11%) and Credit Suisse Group AG (-5.5%). Even as the S&P and Dow Jones Industrials posted over 3% in gains to surge back into near record highs, the KBW Bank (BKX) Index increased by only 1.08% and the S&P Bank index (BIX) jumped by only 2.2% 

If the abovementioned banks fail to meaningfully recover and reflect on the gains of their non-bank peers then it is likely these furious central bank inspired rally could come to an end.