Monday, August 19, 2019

Thinking aloud about bank margins - Part 1

Pre-warning: this series of posts is called "thinking aloud about..." because I do not know where it ends. I am genuinely exploring things that I do not understand very well - but are central to how the economic world and how markets will turn out over the next year or two and maybe the next decade. I do not know the answers and maybe this blog series will not end or will fizzle out....

Also I will be on the road for six weeks. Expect the posts to be sporadic at best.


The most interesting thing I have seen in the past three months was an interview on Real Vision by Shannon McConaghy of Horseman Capital entitled "Prepare for a Japanese Banking Meltdown?".

The title on the interview has a question mark. I am not sure that Shannon would include the question mark.

But the argument is pretty simple really. Japanese regional banks have - for decades - had excess funds. They have found it extremely hard to lend at adequate rates as excess funds is the Japanese condition. Rates the banks can achieve on loans are very low.

The result is that Japanese banks (especially regional banks) have very low returns on equity and generally trade below book.

As an extreme example about fifteen years ago I asked Bank of Kagoshima why they could not achieve their four percent ROE target and they said that it would "put too much strain on the local community." That bank is gone now - but the problem remains right across Japanese banking.

Shannon McConaghy's thesis is that "Abenomics" has made the problem much worse. He states that the average interest rate achieved on a loan by a Japanese regional bank in the first half of this year was about 79 basis points. The rate was 62 basis points in May but there may be some seasonality.* He thinks it costs about a percent to run the bank. There are staff and systems to pay and the like. So he thinks that Japanese regional banks will be loss making before they have any credit losses. Then of course they have been rolling credit losses in zombie businesses for decades and so after the credit losses settle there won't be any equity left to earn any return on anyway.

Shannon thinks the problem has been masked because the banks have typically invested their excess funds in Japanese Government Bonds (JGBs) and the yield on JGBs has gone pretty sharply negative. The banks this decade have sold significant amounts of these JGBs and reflected the gains on these sales as one-off income. They then shifted much of their securities holdings into a unique type of investment trust, largely invested in domestic equities, which under unusual accounting conventions allowed the banks to report capital gains as interest income. This means they are still showing positive ROEs but earnings are highly reliant on a constantly rising domestic equity market to generate gains, which is problematic as the Japanese equity market is still down by more than 10% from its peak last year. The situation is unlikely to improve as the underlying margins are already near zero and incremental loans actually lose money after costs.

[Shannon runs a Japan fund. This talk was so interesting I wrote to Shannon and got on his mailing list. I recommend readers do the same. There is plenty there that is interesting.]

Anyway all this accords a little with my view of bank margins and crises. The determining factor of how well your banks recovered from the financial crisis by-and-large wasn't how many or few losses your banks took (Iceland excepted), rather it was what was the underlying pre-tax, pre-provision profitability of your banking sector.

The US banking sector has pretty decent margins - and pre-tax, pre-provision profits were about $300 billion per year. In three and a bit years they had covered a trillion dollars in losses. The banks are mostly okay now.

German banks have very thin margins and whilst they had less credit losses they had considerably less income to offset them. The German banks (notably Deutsche and Commerzbank) look deeply problematic. Italian banks are also very low margin and slightly higher credit losses and they have been catastrophic investments.

Bank margins are really important

Bank margins were once a concern to bank investors and not really to the general public. After all low margins generally meant cheaper finance. High margin banks (like Australian banks) leave you with the uneasy feeling you are being ripped off.

But the world has changed. Abenomics - which includes the deliberate pushing of interest rates to very low or negative levels may suppress bank margins. And if you suppress bank margins enough your banks go bust. And if your banks are stressed they stop lending and your economy slows down.

In this view of the world monetary policy (cutting rates when you need a stimulus) not only stops working but becomes counter-productive. It blows up your bank and causes an economic crisis.

The Raoul Pal view of the world

Raul Pal runs real vision and has a twitter account that is absolutely worth following. He has been harping on about a single chart - the Eurostoxx Bank Index going back for thirty years.

This index is bouncing along its thirty year low. [No dear Americans, stocks do not always go up over a generation.]

Raoul rather grandly says that "this level in the Eurostoxx Banks Index is probably THE most important level of ANY chart pattern in the history of equity markets". [Emphasis is in the original.]

And to some extend I think he is right. What the Bank of Japan is doing to Japanese regional banks the European Central Bank is doing to European banks. The possibilities are that:

1. The ECB cuts rates further, blowing up the banking sector and causing the mother of all recessions starting with the weakest banks outwards (ie starting in Germany) or

2. At some point they can't cut rates and you get a recession anyway and as the banks have almost no margin left the credit losses leave them pretty darn impaired.

And the stakes couldn't be higher. A generalised collapse of the European banks would be a pretty big risk to the European experiment. It won't have been caused by Europe per-se, the English banks look pretty dire too, but it will be blamed on Europe, and the resultant unemployment will have large political consequences. When Raoul suggests that "this level in the Eurostoxx Banks Index is probably the most important level of any chart pattern in the history of equity markets" he is being appropriately alarmist - at least if the Eurocrats do not act accordingly.

Whatever - the Raoul Pal view of the world is unremittingly bearish. The usual central banks will bail us out narrative gets exposed as impossible. It gets ugly from here.

My view

I am not sure it is that simple always - but the reason Shannon McConaghy thinks that Japanese regional banks are uninvestable is the same reason European mega-banks and the Eurostoxx Bank Index is uninvestable. The European banks are deeply problematic.

But it doesn't have to be that way and it isn't irrevocably that way for the whole sector. And the ECB isn't totally trapped either.

But those are really the subject of the next few blog posts.


PS. I have mostly equity market readers. For this series I probably should have a few readers in the central banks too. Pass it on if you can.


*I asked Shannon for the source of this data - he sent me this link.

Also for avoidance of doubt I am long some European banks and currently short only one. The banks look super-cheap. But Japanese regionals looked super-cheap for decades and got cheaper and cheaper and cheaper.

If I entirely believed the Raoul Pal view of the world I would not hold any European banking stocks. My doubts about th Raoul Pal view are explored in the next few posts.


Anonymous said...

Japanese NIMs have declined in a way that EZ have not - despite EZ having more -ve rates over the last three years. Japan rarely offers a good comp set for most businesses and it’s just not worth going down that rabbit hole here.

What this skin deep analysis misses is:
-sustained share price pressure is reducing competition in ez. Banks are able to increase margins on both asset and deposit side (listen to santan last call, they expect 10bp improvement near term)
-if the ecb lowers rates without mitigation the reversal rates effects will only increase. Bigger banks will improve margins, less competitive banks will withdraw from particularly products due to pressure to release capital. Japanese banks don’t make decisions for economic reasons, the same is not true of Europe (except Germany)
-the low shares reflect a combination of the war on value, general pessimism about Europe, pessimism about the ECB and their approach. However the wood is missed from the trees. Whilst EZ is facing an external shock from Germany exports and autos, the internal shale is hugely better than 7 years ago with budgets under control, strong domestic economies and importantly a gov/central bank reaction function predicated on stimulus first/soon as opposed to German austerity.

I would argue we are in the sweetest spot for EZ banks in the last 20 years with minimal competition pressures and pressures to produce ROE, a super benign and stimulative eco output, and the cheapest valuations in history. Buy with both hands

Anonymous said...

I would avoid reading people like the one you mentioned. He is a doom porn seller. I have read about his outlandish claims of impending disaster for yrs. Maybe go back and see if any of them have panned out. How it plays out. Have no idea but I will take the non doomer side of the bet. Always sounds smarter to predict doom vs hmm I don't know things will work out.

Anonymous said...

First, bank profitability is over the longer run driven by the structure of the underlying Banking market: eg highly concentrated markets such as Canada, Sweden, Australia have higher ROEs than very diversified markets such as Germany or Italy. In the latter, you have the problem that some competitors have different profitability targets.
Secondly, post the GFC, some banking regulators have forced their Banks to clean up their loan books faster than others. The obvious comparisons would be Spain vs. Italy. In the latter, we are still discussing how fast the banks should reduce their bad loans, capping their ability to commit capital to new lending. As a result, C&I credit growth in Italy is still falling, and will for the foreseeable future whereas in Spain, it is starting to expand again.
Thirdly, the increasing ratchet of capital requirements by the EBA has not been helpful. As US Banks have started paying out >100% of earnings, European Banks are still adding to their capital as the EBA continues to move the goalpost. Leaving less space for actually providing loans.
Thirdly, there is an issue around ZIRP and net interest margins. Most Banks are still reluctant to charge negative interest rates on deposits. However, the compression is driven by competitive pressures. Witness Switzerland, where negative interest rates have become quite common, or Sweden where they just kept loan yilds high. Mind, the repo rate in both countries has been negative for a while. But Swedbank is still producing ROEs around 15%.

G. Sylvie Davies said...

Banks in Japan have a different relationship with their customers compared to the rest of the world.

Take a look at this:

Especially the section titled "The Personal Touch".

Unknown said...

Which European bank are you short?

Are you short UK banks (I assume not since UK banks are European, at least until Halloween)?

If not, why not?

David said...

I am looking forward to your comments regarding those banks. As a fellow registered Real Vision viewer, I would admit I have been disenchanted of late with the lack of fundamental content to the caliber of what can be seen on that Japanese Banks piece and, unlike two years ago, I have seen little diversity in the point of views displayed by the interviewees. (i would still buy Grant Williams a beer if he comes to Sydney for making a convincing arguments for Aussie treasuries in December. A GREAT call, made me money!)

On the subject of European banks. having been Sydney based for the past five years, but still French by birth, heart (which is big enough to have France and Australia together) and on my passport, I see people out there sometimes having a different perspective on the issue of European banks.
Not to go into the arcanes of NPL’s in Italian banks and issues related to the Eurodollar market, the general ideas, at least as I understand what is exposed by JP Betbeze, former Credit Agricole chief economist, is that there is too many banks in Europe, therefore too much competition (ie zero profit at explained by Peter Thiel in Zero to One about over competitive markets, although people still try to open restaurants in Sydney), and some need to fail. Negative interest rates will allow just that with QE to buy bank debt a way to avoid the failure of the larger entities (not pretty, the bigger fishes survive). One big question I am interested in, is Europe reliant on external funding and to which extent. With positive NIIP for the Eurozone, the circus can go on for a long time…
Another point to keep in mind is the current ideological conflict in the ECB between the pro-hard currency proponents (hello Bundesbank) squealing about QE and negative interest rate on one side and the doves on the other side ready to do anything to get to the 2% inflation target including helicopter money.
Not sure it is going to blow up for the sole reason that monetary policy was never ran this way before. Developed world population, world interconnection and the health of our planet have never before decreased together at this rate either.

Sandymount said...

Raoul Pal has missed the entire bull market penning a super bearish anytime now thesis the whole way. I honestly have no clue why anyone listens to these people when you can costlessly and with a few key strokes just back check their record. I'm not sniping I truly find it confusing why they get any air.

e.g. 2010... Raoul Pal: Here's Why A Crash Is Coming In Two Days-To-Two Weeks

John Hempton said...

Raoul Pal rather got the bull market in bonds...

Mike Smitka said...

Ah, what G. Sylvie Davies links to indicates the other half of the problem: not only are gross margins low, operational costs are high. Hands-on monitoring of customers is expensive. Now during my last trip to Japan, in January, I only used ATMs, so things could have changed. But go into any branch and observe the number of people who physically handle the money in any deposit, and use your watch to count transactions per minute per teller. I have no reason to think this is anything other than a horribly low number.

PS: I have lived in Japan, and speak/read/write Japanese. A few years back I helped a friend set up a new business. The legal and regulatory part took little time; the local government officials were not just efficient, but tried to be helpful. Setting up a bank account was another story, it took the better part of a day.

Sandymount said...

Good point. I guess we have to know which of his forecasts to listen to and which to ignore.

Eduardo Valera said...

John, wouldn't this: "The ECB cuts rates further, blowing up the banking sector and causing the mother of all recessions starting with the weakest banks outwards (ie starting in Germany)" actually cause capital gains on the holdings of the banks and postpone the hypothetical EU banking crisis? I think it is in this way that the ECB is trapped, that to postpone a financial crisis they need to continue easing.

1leone said...

Any thoughts then as to why US banks can't catch a bid?

Earnings are extremely strong and set to improve yet....

Anonymous said...

He made that call before with less success

Anonymous said...

Looking briefly at annual reports of US banks vs Germany's main banks. I first assumed that the German banks must be incredibly inefficiently run I mean holy crap DB has how many directors????? American banks have like 12 directors at the most, but I digress. A couple things stand out: non-interest revenue at German banks is incredibly subpar. Another thing is that the provision for credit losses is unbelievably small in German banks. So they are either under reserving or they are not taking enough risk. The margins of banks that lend solely to single family houses in the US compared to banks that lend to businesses is visibly disparate.

Taking risks but not gambles is apparently an under appreciated part of banking? Japanese and German bankers are gun shy?

Anonymous said...

Thanks - informative and entertaining post. These low rates and their implications for the banks is now coming to Australia with the already very low interest rates and intent to drive them lower. The looming legislative action on cash transactions means negative rates are also on the agenda. I agree ultimately these will be rather destructive for insurance companies and the banks, and ultimately will end in a debt trap, where rates cannot be increased because of the huge amount of debt.....

Doishpelota said...

What this shallow comment misses is Santan’s improvement hinged on higher yielding loans from its Brazil loan book. Santan’s Spain and UK net interest income (from a large share of its loan book) has remained low and in-line with John’s point.

I would further add to this discussion the credit element here - TLAC requirements and its dilutive effect on bank share prices. The amount of AT1 & T2s has weighed down on bank ROE.

I would chart out the historical price to tangible book value to see the real trend here.

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