Illustration: Chaitanya Dinesh Surpur
Today, there are over $3 trillion in stressed loan assets globally, compared with around $1 trillion of US sub-prime loans in 2008, which was the catalyst for the financial crisis. The World Bank estimates that the current ratio of non-performing loans (NPLs) to total gross loans is around the 2009 levels of 4.2 percent.
European banks have around euro 1.2 trillion of problem loans. Italian banks alone have an estimated euro 360 billion of NPLs, or around 20 percent of its GDP. Italian NPLs comprise around 15 percent of total loans in the country, compared with around 5 percent in the US during the 2008 banking crisis.
Banking systems in many other advanced economies also face increasing risks. Loans are supported by artificial collateral values, especially real estate and equity, are inflated by unconventional monetary policies. Debt sustainability is based on artificially-maintained low interest rates and any normalisation of rates could threaten the solvency of over-indebted borrowers.
NPL problems are also apparent in emerging markets, especially India, China and Brazil. India’s stressed loans total more than $150 billion, or over 15 percent of bank assets. The problems are driven by over-leveraged borrowers, including state-owned enterprises, family-owned conglomerates, as well as infrastructure concerns—government-driven trophy projects with dubious economics to which state-owned banks are pressured to lend.
China’s official bad debts are under 2 percent of total credit and if ‘special mention’ loans are included, around 6 percent. However, estimates say it could be as high as 15-16 percent. Studies by the International Monetary Fund indicate there are $1.3 trillion of risky loans, with potential losses equivalent to 7 percent of GDP, lower than other forecasts which peg it at as much as 20 percent of GDP.
Old and New Causes
Traditional banking crises are caused by bad lending, often to an individual sector, most commonly real estate. Lending to leveraged buy-outs and telecommunications contributed to the 1994 and 2001 crises, while real estate lending was responsible for the 2008 problems.
The current problems have some similar causes. Banks have significant exposures to the troubled resource sector, to emerging markets and to overvalued housing markets. Lending to the energy sector alone amounts to around $3 trillion, where borrowers are struggling to service debt in an environment of falling commodity prices, weak growth, overcapacity, rising borrowing costs and (in some cases) a weak currency. Banks in the US, Canada, some European countries, Asia, Australia and New Zealand are exposed to over-valued property markets.
There are also some non-traditional factors contributing to banking instability. A weak recovery from the 2008 crisis is a problem. In advanced economies like Italy, low growth and deflation rather than aggressive real estate lending are driving loan stresses; in other European countries, it is the byproduct of a lack of global competitiveness exacerbated by the effects of a single currency.
Since 2009, official policies have targeted expansion of bank lending to increase growth and inflation. With safe assets offering low returns, risk in the financial system has risen. Seeking higher returns, banks have financed less credit-worthy borrowers. Abundant liquidity has increased asset prices and banks have lent against this overvalued collateral. Low rates have allowed weak borrowers to survive. This has encouraged a persistent failure to address asset quality problems, by writing off bad loans.
In developing economies, strong capital inflows, seeking higher returns or fleeing depreciating currencies, has encouraged increases in leverage. State policies encouraging debt-funded investment or consumption to create economic activity has also led to banking problems.
Banking sector problems can trigger a familiar doom loop. Banks are highly leveraged, around 10-12 times; hedge funds are leveraged 3-5 times on average. This means a small loss can wipe out a significant portion of their capital, increasing the risk of insolvency; for example, a loss of 5 percent of banking assets can reduce the capital buffer by half.
In advanced economies, many banking systems are large relative to the real economy. They are vital in facilitating payments and supplying the essential credit. Any disruption results in a real economic slowdown.
Banks are networked both domestically and globally through inter-bank borrowing and lending and derivative transactions. Problems at one bank can quickly spread, affecting other firms and the financial system. International banks, primarily European ones, are exposed by varying degrees to Italian banks and sovereign debt as well as to other weaker European issuers. These banks have a more than euro 500 billion exposure to Italy, with French and German banks holding a large proportion of this.
Bank deposits, bonds and shares act as other channels for transmission. Principal losses, deferral of interest payments or cut in dividends affect investors. Loss of wealth and income affects real consumption. Public finance problems flow as governments and central banks are forced to support banks to prevent failure of essential payment and credit flows.
Solution of banking crises requires strong earnings, capital infusions, isolation of bad loans, and industry reforms. But the ability of banks to earn their way out of the crisis to allow losses to be written off is limited. Many troubled banks have low profitability, which is compounded by the current monetary policies. Low and negative interest rates lower banking profitability as banks are unable to cut deposit rates to the same extent as lending rates because of the need to maintain deposits and comply with regulatory requirements for stable funding.
Traditionally, banks have built capital by earning the margin between low deposit rates and safe, long-term fixed rate assets, such as government bonds. Today, the term premium, the difference between short- and long-term rates, has collapsed, reducing this option.
Access to new capital may be limited. Several structural factors have created uncertainty about the long-term future of banks and may have reduced available returns, reducing the attraction for potential investors. Many bank business models are in need of major reforms, entailing consolidation and cost reductions that are unlikely to be embraced by governments fearing job losses and lack of competition.
Poor institutional and legal frameworks, especially inefficient bankruptcy procedures, are barriers to new investments in banks or distressed assets. Emerging market procedures for dealing with corporate restructurings are complex. There is reluctance to foreclose because of politically difficult business closures and job losses.
Political factors are impeding the recapitalisation of banks. This can be seen in Italy. Resolution of insolvent banks under EU procedures require progressively writing down equity, subordinated debt and senior debt, protecting only insured deposits. However, “bailing in” creditors would result in writing down around euro 200 billion of securities held by retail investors in part due to a quirk of the tax code. Further write-downs would create political difficulties for the government. At the same time, EU banking regulations and budgetary and debt limits make it hard for the government to intervene.
After the 2008 crisis, new banking regulations were introduced to make the system safer and eliminate the need for a future taxpayer-financed bailout. The success, or failure, of the new regulatory regime will not be known until the next crisis. But in a major crisis, governments and public funds are still likely to be required to guarantee the payment system and supply of essential funding for the economy. Whether governments have the financial capacity to do that and if the public is willing to countenance another bailout is uncertain.
A new banking crisis will be significant. For example, European banks alone may need euro 150-900 billion in new capital. Given that they are significant owners of sovereign debt and the main source of lending to the small- and mid-sized companies, which make up 70 percent of the economy, banking problems represent a major source of continued economic instability.
In modern economies, the financial system acts as a reservoir of a deadly pathogen—bad debts—which is spread by banks, creating financial crises. A new such episode may be beginning.
(Satyajit Das is a former banker. His latest book is Age of Stagnation.
He is also the author of Traders, Guns & Money and Extreme Money.)