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Part I – The Upcoming European Banking Crisis

How resilient are the largest banks of the eurozone? We looked at their balance sheets and recent stress test results in great detail. What we have found out is not reassuring.

 

The coronavirus pandemic might trigger a severe economic shock. Will the European banking system withstand this storm? (Photo: lenalindell20)

 

The coronavirus pandemic struck Europe completely unprepared. The old continent ignored the key lesson that Asian countries like South Korea, Singapore, or Hong Kong learned when dealing with SARS in 2003: You better be prepared.

 

When a new virus spreads, it is all important to act as fast and as determined as you possibly can. The same lesson applies when your banking system is collapsing.

 

 

 

 

Right now, bankers, regulators and economists assure us that the European banks can easily withstand the economic shock caused by the Coronavirus pandemic. They argue that the post-crisis regulatory framework has made them much more resilient. The CEO of Deutsche Bank claimed that the bank’s balance sheet is more robust than at any other point throughout his 30 year career at the bank. Meanwhile, Germany’s financial regulator declared: they see no systemic risks.

 

Only in Italy that has been struck first by the Coronavirus pandemic people are waking up to the possibility of an upcoming banking crisis. And while the European Central Bank (ECB) is publicly emphasizing that there are no material strains or liquidity risks in the banking system, it acts rather differently. It injects hundreds of billions of Euros into the system. With the ECB and other central banks preemptively flooding financial institutions with money, well, it is indeed hard to see how material liquidity risks could arise – it is impossible to dehydrate while swimming in a freshwater lake.

 

Can central bank liquidity alone, however, prevent a banking crisis in the long run? We do not think so – it may be impossible to dehydrate while swimming in a lake, but if you are unable to keep your head above the water, you will ultimately drown. All the liquidity injections in the world cannot prevent banks from sinking into insolvency.

 

There is more to life than money

 

The concepts of solvency and liquidity often get confused. Especially for banks, it is important to make a difference between the two.

 

When it comes to liquidity, banks and other financial institutions enjoy unlimited support from central banks. They are considered systemically important: If banks need money, central banks are willing to lend at favorable terms to prevent the collapse of the financial system. With central banks pumping hundreds of billions of euros into the banking system every single day, liquidity simply cannot be an issue.

 

Nevertheless, central banks and governments know that the unlimited credit card they give to the banks is a dangerous thing. Banks, if left unchecked with that credit card, would rack up way too much debt and take too much risk, what will ultimately crash the financial system.

 

Therefore, governments and regulators put limits on the amount of debt a bank is allowed to have. For example, the leverage ratio requirement tells a bank that it has to have a minimum ratio of equity relative to the balance sheet total. Only then is the bank considered to be solvent. The illustration below clarifies this concept:

 

How a minimum leverage ratio requirement is setting a lower bound on the size of a bank’s equity buffer. (Source: Own Illustration)

 

Bankers call this type of rules “capital requirements”.

 

Governments around the world implemented a minimum leverage ratio of 3% and a slightly higher ratio for global systemically important banks (G-SIB) as part of an international banking regulation framework called “Basel III”. So for every $100 of assets, a bank must hold about $3 of equity.

 

If the bank’s equity falls below this threshold, it has to be either recapitalized or liquidated – similarly to what banks force upon their borrowers when they are approaching insolvency.

 

More robust than ever?

 

So how solvent are the banks of the Eurozone? Let us look at a specific example: Per its latest financial statement, Deutsche Bank’s balance sheet has a size of € 1’300 bn and a minimum leverage ratio of 3.75% as it is considered a G-SIB. Therefore, it must hold roughly € 50 bn of equity.

 

Deutsche Bank claims that its leverage ratio as of December 2019 is 4.2% and that it has an equity buffer of € 56 bn. Compared to € 1’300 bn and amid the severe economic crisis we are currently facing, € 56 bn is a disturbingly low number. If the assets of Deutsche Bank only lose 1% of their value, the leverage ratio drops below 3.75%, and the bank needs to raise capital or ask for a bailout.

 

Unfortunately, Deutsche Bank is no exception. We have delved into the financial statements of all the G-SIB of the eurozone that are traded on the stock exchange. The numbers are not reassuring: Even the best capitalized G-SIB in the Euro-Zone – Crédit Agricole – will need a recapitalization if the value of its assets drops by less than 3%.

 

 

Enlarge graph by clicking on it. The leverage ratios of the global systemically important banks (G-SIB) in the Eurozone, per 31.12.2019. (Source: financial reports of the respective banks)

 

 

How does that reconcile with the claims of Banks?

 

Despite low leverage ratios, banks nonetheless emphasize their “capital strength”. When they say so, they usually don’t refer to the leverage ratio but to another, more complex measure called the Common Equity Tier 1 (CET1) ratio. The Deutsche Bank CEO underscored his claim about the robustness of the balance sheet by citing a CET1 ratio of 13.6%.

 

Without doubt, 13.6% is a more reassuring number than 4.2% in the context of an equity buffer. We have collected the respective CET1 ratios for the large European banks below and you can see that the numbers are much higher than the leverage ratios.

 

 

Enlarge graph by clicking on it. For all global systemically important banks (G-SIB) in the Eurozone, the CET1 equity ratios are much higher than the leverage ratios, per 31.12.2019. (Source: financial reports of the respective banks)

 

 

What is the CET1 ratio, and why is it systematically higher than the simple leverage ratio? The CET1 ratio does not compare the amount of equity to the size of the balance sheet. Instead, it divides the amount of equity by the amount of so-called risk weighted assets. The lower the amount of risk weighted assets, the higher the CET1 ratio will be for a given amount of equity.

 

The determination of risk weights is based on complex statistical calculations. Over time, banks have truly mastered the art of downsizing them to inflate CET1 ratios. The former head of the Federal Deposit Insurance Corporation (FDIC), Sheila Bair, once commented on these sophisticated models: “That would be like a football match where each player has his own set of rules.” When she left office in 2011, she expressed deep worries about risk weights, as they have led to continuing declines in capital levels.

 

We agree with her. The leverage ratio is a more reliable indicator than the CET1 ratio to assess the solvency of banks. But that does not mean that we can blindly trust the leverage ratio either. The leverage ratio, too, is based on the accounting calculations of the respective bank. For instance, a leverage ratio of 4.2% is the result of Deutsche Bank’s own calculations about the value of its assets.

 

It is important to note that financial institutions like Deutsche Bank do not only perform simple lending. Rather, they trade in complex financial products and manage a derivative book of epic proportions. It requires hundreds of accountants to calculate the value of these assets, to determine the size of the balance sheet, and to estimate the value of the equity. To do so, these accountants have to make many assumptions and revert to highly complex models with sometimes unobservable parameters.

 

We could not find more appropriate words about the reliability of the financial numbers reported by the banks than Deutsche Bank’s very own research department:

 

 “Much bank reporting has now become so complex it has spiraled out of all control and meaning.”

 

Investors do not trust the banks

 

Given all these shortcomings, do we have a more reliable figure than the CET1 or the leverage ratio to measure the strength of banks? Fortunately, we do. There are people out there who provide independent estimates about the value of banking institutions: investors. They buy and sell shares on the stock markets, and through these prices one can calculate a market-based equity ratio using market capitalization. Per 16.03.2020, the share price of Deutsche Bank declined to EUR 4.91, and its market capitalization collapsed to EUR 10 billion.

 

This translates into a market-based equity ratio of merely 0.75% – a freak-out number in the context of a buffer against insolvency.

 

Unfortunately, the numbers for the other Eurozone G-SIBs do not look much better, as illustrated below. Most of them trade below a 2% market-based equity ratio.

 

Enlarge graph by clicking on it: For the global systemically important banks (G-SIB) in the Eurozone, the market-based equity ratio is much lower than its regulatory counterparts, the CET1 equity ratio and the leverage ratio. (Source: Financial reports of the respective banks, market data per 16.03.2020.)

 

 

Based on this analysis, we cannot see any “strength” or “resilience” within the European banking sector. The only ratio painting a comforting picture is the CET1 ratio, but this ratio is most likely artificially inflated. The less we build on the calculations and assumptions of banks themselves, and the more we incorporate unbiased information, the worse the situation looks. The leverage ratios and the market-based equity ratios imply that the G-SIBs of the Eurozone are unable to absorb large losses.

 

Maybe, however, the economic impact of the Coronavirus pandemic might be small enough. Maybe the European banks are able to withstand the expected losses despite low equity levels. To check this assumption, we need additional information, which is fortunately available, because the European Banking Authority (EBA) biannually conducts so-called stress testing exercises.

 

European stress testing without stress – but still revealing

 

The last stress testing exercise was conducted by the EBA in 2018. The media releases of both the EBA and the banks suggest that it was highly successful. Banks claimed that they would stay solvent in an adverse economic scenario without requiring a bailout and that they would remain capable of lending to the real economy.

 

That sounds reassuring. Once you look under the hood of this stress testing exercise, however, the story falls apart. The stress test conducted was more of a nice weather exercise. The EBA basically tested for an average recession. We picked some of the “stressed” market indicators used in the scenario and compared them to reality. Once again, the result is not reassuring.

 

 

Enlarge graph by clicking on it: Today’s reality is already much worse than the adverse scenario of the stress test that was conducted by the European Banking Authority in 2018. (Source: European Banking Authority, market data per 18.03.2020.)

 

 

Until March 18, 2020, we saw a sizeable stock market crash, a rapid blowout in government yields, unprecedented equity volatility, and an unprecedented oil price crash. Although we are still at the beginning of this crisis, the real course of events is already worse than anticipated in the stress test scenario.

 

Some may object now and argue that a pandemic is an exceptional situation. True, it is an event with a low likelihood. But everyone knew it was a question of when, not if, a global pandemic would happen again. We were warned repeatedly. A Ted talk held by Bill Gates five years ago on this issue has been viewed more than 13 million times. Even the banks themselves have contingency plans to cope operationally with exactly that situation.

 

So a pandemic, like a blackout or a large-scale terrorist attack should be covered in the scope of possible adverse scenarios. Looking at the assumptions of the EBA, one can only arrive at the harsh conclusion that this stress test does not deserve its name. This conclusion is also backed by the stress test conducted by the Fed in the US. There the severely adverse scenario assumes a harder hit on the economy – and guess what: The US unit of Deutsche Bank failed the test in 2018.

 

As predictable as an epidemic

 

Looking at the key facts and figures of the largest banks in the Eurozone is not building confidence in their strength. Already before the Coronavirus pandemic forced an economic shutdown, these banks operated with tiny equity buffers. We have no reason to believe they can withstand a major economic shock. It is actually hard to conceive a future state of the world with no recapitalization necessary.

 

All the numbers we used are publicly available, we only brought them to the surface without adding any assumptions on our own. But this is also not necessary. The naked numbers already predict a European banking crisis just as Italian case numbers in February predicted the spread of the Coronavirus in Europe. And as every day of inaction costs us dearly when dealing with the ongoing pandemic, we will have to pay a high price for inaction when it comes to the upcoming banking troubles. Wishful thinking is no strategy, we must prepare now.

 

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Blog series
The Coronavirus pandemic and its impact on global finance

 

This blog post is the first in a series of articles that we will publish over the coming weeks. We think that the Coronavirus pandemic will have a thorough impact on the global financial architecture. With our analysis, we want to shed light on how the banking systems in Europe, the US, and China might be affected, and what the impact on the global monetary system could be.

 

Prologue
Economics in the time of Corona
To be published next week

 

Part I
The upcoming banking crisis in Europe
March 27, 2020

 

Part II
How bank regulators and the European Central Bank should prepare
To be published next month

 

Part III
The Golden Age of banking in the United States
To be published next month

 

 

 

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admin, 2020-04-16 20:19:25:
"Hi John, Corporations, households, mortgages, given this huge economic shock that affects everyone, we would expect credit losses on all these actors. The problem really is that both households, financial companies, and nonfinancial companies have way higher leverage than what is sensible.".
John Howell, 2020-04-14 14:39:05:
"In the 2008 crash bank insolvency originated from defaults on housing mortgages, and then, of course, was amplified by failures in derivatives. Can one identify this time a particular set of loans that are defaulting to trigger bank insolvency, like those of the housing market in 2008?".

What do you think?

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