12 Feb 2016
The fear implicit in the sell-off – up to 40 per cent in Europe, around 30 per cent in the US and 10 per cent in Asia and Australia (just this year) – reflects more than just a loss of confidence in banks.
"Banks are in for a period of upheaval. And stock markets always discount upheaval."
Andrew Cornell, Managing Editor
More significantly, it reflects a fear about economies and those who manage them, governments and central banks.
That the fear goes beyond the threat to individual banks can be seen in the case of global giants like Citi which are trading below their book value, effectively their net tangible asset backing.
Equity markets value banks based on the return on investment, the dividend stream, discounted for future uncertainty. That dividend stream, in turn, depends on a bank's ability to generate earnings and capital to pay dividends.
Earnings come from revenue less costs, including bad debts and operating costs.
This is where the “headwinds" bank analysts and executives talk about are coming into play.
Revenue is under pressure, globally, because economic growth is anaemic. Banks are essentially a leveraged play on growth in an economy – because they borrow their funding to gear up the amount they can lend.
When global growth was around 5 per cent or higher, banks were enjoying revenue growth 3 to 5 percentage points above that. But today, forecasts by global institutions like the International Monetary Fund are much lower. In January, the IMF downgraded its forecast for 2016 to 3.4 per cent – with considerable risks.
Obviously different banks earn their revenue in different geographies and segments. But all these ultimately depend on growth or at least some confidence in the future of growth.
Consider emerging markets, in recent years the engine room of global growth as the US recovered slowly and Europe languished.
But the Institute of International Finance, a global industry body for banks, reported last week “Asian economic growth has slowed markedly". Even more worrisome, said the IIF, is the collapse in Asian trade.
“Our analysis suggests the changes depressing Asian trade are mostly structural in nature," the organisation said. That structural issue is the – necessary – shift in major economies like China (but also the US) towards less trade intensive services and away from trade heavy manufacturing.
“Asian economic growth will remain disappointing in 2016, and we see little chance of a significant rebound in trade despite weaker currencies," the IIF said. “For Asian exports to enjoy a sustained rebound, a deepening of intraregional horizontal trade ex-China would be necessary."
That environment feeds into the charges banks must make against their profits for bad debts. Lower economic growth inevitably means more companies get into difficulty and fail. But at the moment there's considerable concern really steep falls in the prices of commodities like oil, iron ore and coal, collateral damage from weak global growth, will see more companies in those sectors under pressure.
Not only does that hit the loans banks may have made to these companies directly it flows into the cost of the debt banks borrow to fund themselves. That's because major providers of debt capital, governments and sovereign wealth funds, particularly in the energy-based economies of the Middle East, have to use their investment funds to support pressured sectors, leaving less for banks.
Many market analysts have looked at the prices for what are called Credit Default Swaps, essentially insurance policies debt investors buy to protect themselves against the issuers of debt defaulting. The cost of insurance has spiked, in the case of some major banks to levels not seen since the global financial crisis.
But that has been reinforced by another, newer barometer. That's the price of what are known as “CoCos", contingent capital notes, new, hybrid debt introduced after the financial crisis in the desire to shelter taxpayers from bank bail-outs.
The idea is that while CoCos count as Tier 1 capital, under stress national regulators can convert the debt into equity to recapitalise a listing institution. Something governments did directly in the crisis.
So while CoCos are neither truly debt nor equity, their prices do respond to fears banks might need new capital. And indeed this is what is happening.
According to Dr Philip Bayley, principal of ADCM Services, in his debt capital markets review, “one of the problems that investors are now facing up to in this period of increased risk aversion is that the CoCos are too complex".
“CoCos come with all the downside risks of equity and none of the upside, and in Basel III form, have yet to be tested in a crisis."
And he adds: “They may actually work as intended."
That said: “European investors are increasingly pricing in the risk of coupon payments being suspended and notes not being called when expected. No-one is yet pricing in the risk of mandatory conversion in to ordinary equity or the more likely scenario in Europe, of a complete write-off of the obligation."
Yet even that view is further complicated by a growing sense the old backstops, governments and central banks, not only won't be there to bail out banks but are failing to bail out economies.
Central bank “jaw-boning", now are central plank of policy, seems to be becoming more and more plaintive.
So bank revenue is flat, the chance of bad debts, the cost of funding and risk premia are all increasing.
What can banks do? They can cut costs and clearly we are seeing considerable effort in this regard.
But there are two cost lines banks will find difficult to ignore: the cost of new regulation and the cost of new technology.
Both potentially will help better run banks differentiate themselves from the pack.
While all banks are subject to the same regulatory forces, some are more efficient at complying than others and, even more significantly, evidence is emerging that some banks are actually gaining a competitive advantage around how they structure their compliance, particularly in using the data they are required to capture.
That leads onto the next cost line: technology. Banks may well not face an existential threat from the new disruptors in financial services but equally they can't ignore new, more efficient ways of providing banking services.
High profile technologies like “blockchains" may well revolutionise the clearing and settling and capital requirements of markets but they also require considerable investment. Big data promises rich new understanding of customers and market opportunities but it requires big dollars too.
There's much talk of banks evolving, of adapting as the environment changes, and this is certainly true. But students of evolution will remember it can be punctuated, with periods of gradual change and periods of quite rapid upheaval.
With global uncertainty, funding constraints, technological change and revenue challenges, it seems banks are in for a period of upheaval. And stock markets always discount upheaval.
Andrew Cornell is managing editor at BlueNotes
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
12 Feb 2016
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