Having bailed them out and then helped to repair their balance sheets with record-low interest rates and bond-buying, policy makers may assist the financial industry once more when the U.S. Federal Reserve begins tightening monetary policy.
That’s according to two recently published reports by the Bank for International Settlements and McKinsey & Co., both of which have highlighted the downsides of ultra-easy borrowing costs in the past. Based on seven years of data from 109 large international banks in 14 countries, the BIS confirmed a relationship between short-term rates and the slope of the curve for bond yields with bank profitability.
The conclusion drawn by Claudio Borio, the head of the monetary and economic department at the BIS, and colleagues is that the positive impact of being able to earn income by lending money out for higher rates over time is bigger than the hit of defaults and income that doesn’t carry interest.
Even better news for the banks is that the effect is strongest when rates are lower and the yield curve isn’t that steep, as is now the case.
That provides another reason for the BIS’s economists to again decry the unintended side-effects of accommodative monetary policy. They reckon that between 2011 and 2014, the average bank of those studied lost one year of profits as a result of low rates.
“All this suggests that over time, unusually low interest rates and an unusually flat term structure erode bank profitability,” said Borio, Leonardo Gambacorta and Boris Hofmann in the report, which was published on Oct. 1.
Return on equity at 500 global lenders was unchanged in 2014 at 9.5 percent, about the average of the last 35 years, according to the Sept. 30 study by McKinsey. Profit margins also continued a steady decline, dropping by 185 basis points in 2014, in part because of lower rates. It reckons tighter policy would boost return on equity by about 2 percentage points.
“Many in the industry are waiting for an interest rate rise or some other structural lift to profits,” McKinsey said.
There is a sting in the tale. It warned that even if rates do rise, profit margins may still not return to their pre-crisis highs.
“Much of the benefit will get competed away, and risk-costs will likely increase, especially in economies where the recovery is still fragile,” McKinsey said.
MOST CRITICAL TIPPING POINT ARTICLES THIS WEEK - Oct 11th, 2015 - Oct 17th, 2015
RISK REVERSAL - WOULD BE MARKED BY: Slowing Momentum, Weakening Earnings, Falling Estimates
JAPAN - DEBT DEFLATION
EU BANKING CRISIS
MACRO News Items of Importance - This Week
GLOBAL MACRO REPORTS & ANALYSIS
US ECONOMIC REPORTS & ANALYSIS
CENTRAL BANKING MONETARY POLICIES, ACTIONS & ACTIVITIES
TECHNICALS & MARKET ANALYTICS
COMMODITY CORNER - AGRI-COMPLEX
THESIS - Mondays Posts on Financial Repression & Posts on Thursday as Key Updates Occur
Talks FINANCIAL REPRESSION & THE EFFECTS ON THE US BANKING SECTOR
FRA Co-Founder Gordon T. Long interviews Jeff Davis of Mercer Capital, and discusses financial repression and its effects on the banking sector.
Davis is currently a Managing Director of Financial Institutions Group at Mercer Capital. Davis also provides financial advisory services primarily related to the valuation of privately-held equity and debt issued by financial services companies and advisory related to capital structures and M&A.
FINANCIAL REPRESSION’S EFFECT ON THE US BANKING SECTOR
“Financial repression is a price control that relates to all facets of the economy and has profound impact.”
The 3 major cycles: Business Cycle, Credit Cycle and Rate Cycle.
“The banks straddle all 3 to be a key contributor of capital in the US economy. Financial repression impacts at a very base level for all 3 cycles.”
“Financial repression has artificially pumped up asset value.
“Commercial real estate values really pivoted in 2010. There is additional risk in the system now that asset values are pumped up”
Commercial Real Estate Values
“If you look at the leverage ratio we can see that over the last 20 years the industry has been raising capital. I don’t think that’s a bad thing. We are significantly much better capitalized than Europe which is a good thing, but as it relates to an investor there is a lower return on equity.”
“Regarding financial repression, if you think about interest rates today, it is very painful for an institution to hold cash. There is significant risk taking occurring amongst commercial banks in taking additional credit risk and duration risk. Structurally banks aren’t as spread in terms of their assets relative to their borrowings that fund these assets.”
“Companies don’t go broke because they don’t make money. Companies go broke when they have no liquidity, so what financial repression has done is push liquidity into the system. So now heavily indebted companies are able to borrow money and we will soon see the consequences of that.”
HOW BANKS FUNCTION
“The banks are special for being separated from commerce.”
“The objective for a bank is to earn a spread on assets. Loans being the highest yielding asset, followed by bonds, and finally cash. The banks role is to take the deposits and prudently while still taking risk, lend the money into the economy to help finance the economy.”
“Over the last several decades the shadow banking system has developed into an alternative lender as well as another place for people to put their money.”
The term “shadow bank” was coined by economist Paul McCulley in a 2007 speech at the annual financial symposium hosted by the Kansas City Federal Reserve Bank in Jackson Hole, Wyoming. In McCulley’s talk, shadow banking referred mainly to nonbank financial institutions that engaged in what economists call maturity transformation.
Commercial banks engage in maturity transformation when they use deposits, which are normally short term, to fund loans that are longer term. Shadow banks do something similar.
“Shadow banking system is separate from commercial banking system, but is a very large piece of the credit allocator. A lot of risk has been pushed out of commercial banks and is now in the shadow banking system, where it is not as opaque as a commercial bank.”
CONCERNS WITH SUSTAINED LOW INTEREST RATES
One day there will be a reckoning. It’s simply a buildup of risk; an attempt by central authorities to guide the economy.
Malinvestment: A mistaken investment in wrong lines of production, which inevitably lead to wasted capital and economic losses, subsequently requiring the reallocation of resources to more productive uses.
“A delay of lost recognition and mass malinvestment which is all a credit risk within the banking systems. However, my biggest concern is a dramatic slowdown in the economy, short rates at zero.”
Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.
THE CONTENT OF ALL MATERIALS: SLIDE PRESENTATION AND THEIR ACCOMPANYING RECORDED AUDIO DISCUSSIONS, VIDEO PRESENTATIONS, NARRATED SLIDE PRESENTATIONS AND WEBZINES (hereinafter "The Media") ARE INTENDED FOR EDUCATIONAL PURPOSES ONLY.
THERE IS RISK OF LOSS IN TRADING AND INVESTING OF ANY KIND. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.
Gordon emperically recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, he encourages you confirm the facts on your own before making important investment commitments.
Information herein was obtained from sources which Mr. Long believes reliable, but he does not guarantee its accuracy. None of the information, advertisements, website links, or any opinions expressed constitutes a solicitation of the purchase or sale of any securities or commodities.
Please note that Mr. Long may already have invested or may from time to time invest in securities that are discussed or otherwise covered on this website. Mr. Long does not intend to disclose the extent of any current holdings or future transactions with respect to any particular security. You should consider this possibility before investing in any security based upon statements and information contained in any report, post, comment or recommendation you receive from him.
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