On Monday, Deutsche Bank’s shares had the dubious distinction of hitting their lowest level since 1992.Reuters
The worst was supposed to be over for the European, North American and Japanese banks. Endlessly restructured, recapitalized and in some cases merged out of existence since the financial crisis, they were on a roll. By the middle of last year, the European banks, riding on the back of the economic recovery, had outperformed the broader stock indexes. Now they're circling the drain again, to the point where some investors apparently worry the market faces a repeat of the dark days of 2008 and 2009.
Tuesday was another gruesome day for bank shareholders everywhere, with some big banks – including Japan's Nomura Holdings and Citigroup – hitting new 52-week lows. The banks' reversal has been swift and alarming. How did this happen?
Because banks are hideously complex and diversified beasts, no one reason can explain their downturn. But fears about the sustainability of their profit model as European and Japanese interest rates turn negative and the bond yield curve flattens out (more on this in a moment) can take a lot of the blame.
In the financial crisis, the bogeyman was Lehman Bros. When confidence in Lehman evaporated, the game was up, not just for Lehman, but for the global financial system. This time around, there is no Lehman, and there may never be one. But the bank now sending shivers through the markets is Deutsche Bank. On Monday, the German lender's shares had the dubious distinction of hitting their lowest level since 1992.
On Tuesday, they were down again, taking their one-year loss to 51 per cent. The shares now trade at about one-third of their net worth (or "book") value. The cost of insuring Deutsche Bank's debt, through credit default swaps, has more than doubled this year. The selloff was so ugly that the bank was forced to reassure investors and clients on Monday evening that it had enough cash to pay the coupons on its riskiest debt – contingent convertible capital instruments, known as CoCos, the hybrid securities that are designed to turn into shares when the bank, facing trouble, needs a quick boost to its capital levels.
Even Wolfgang Schauble, the rock-steady German finance minister, felt compelled to steady the nerves of Deutsche Bank investors. "No, I have no concerns about Deutsche Bank," he told Bloomberg Television on Tuesday.
While Deutsche Bank has been the poster child of the bank selloff, virtually no bank on either side of the Atlantic has gone unscathed. In Europe, the Stoxx 600 bank index has lost almost 27 per cent since the start of the year alone; almost a third of that loss came on Monday and Tuesday. The Italian banks, collectively saddled with €350-billion ($547-billion) in loans – a reflection of the dire state of the Italian economy – have been mauled. Heartwood Investment Management estimates that 16.7 per cent of Italian bank loans are non-performing, triple the European average of 5.6 per cent.
Banca Monte dei Paschi di Siena, Europe's oldest lender and Italy's third largest bank, is down 71 per cent in the last year in spite of a massive financial cleanup in 2014. Its non-performing loans are two-and-a-half times its equity. The Greek banks are also getting cruelly punished. The American and Canadian banks are in better shape than their European counterparts, but even they have been sucked into the maelstrom. Since the start of January, Bank of America, Morgan Stanley and Citigroup have each lost more than 25 per cent.
The usual suspects can take some of the blame – but only some – for the selloff. The "dangerous cocktail" of ingredients, as one London market strategist described it, includes the slowing economic growth in China and in the rest of the world; the euro zone's perennial inability to trigger inflation and compelling growth; the commodities plunge, which raises the spectre of bad loan exposure to ailing energy and mining companies, some of which could go bust; and negative interest rates in the euro zone and, now, in Japan, which means that banks operating in those regions are paying the central banks to hold the banks' reserves – effectively a tax on bank profits.
Taken together, all these elements have worked their dark magic. The most compelling reason for the slaughter may have come from an entirely different source: the U.S. Federal Reserve.
The Fed raised short-term interest rates in December, the first time it had done so in almost a decade. With economic growth slowing pretty much everywhere, few investors expect another hike any time soon. They do, however, expect the Fed's move to build deflationary pressures. When that happens, investors typically rush into long-term bonds, where the yields are higher, pushing their price up and, hence, their yields lower (prices and yields work inversely, like a teeter-totter). The result is the so-called flattening of the yield curve, where long-term bond yields are barely above those on two-year bonds.
Banks don't like flattening yield curves – they damage their profit model. That's because they make their profits by borrowing at short-term rates and lending at long-term rates. In crude terms, the profit comes from the "spread" between the two rates. When that spread gets crunched, profit margins on lending get crunched, too. No wonder the bank slaughter is getting bloodier.
Are we facing another Lehman moment? Hardly likely; the banks in Europe and in North America are in far better health than they were seven or eight years ago, in spite of the recent turmoil. Still, the share selloff, the negative interest rates in the euro zone and in Japan, the threat of deflation and the flattening yield curve do not bode well for their fortunes. Scared banks, of course, are wary of lending and that may hurt the economy.
Eric Reguly