A Great Banking Backlash Is Coming…

A Great Banking Backlash Is Coming…

Mr Market sure is a moody fellow at times, isn’t he? Last week it was all panic…now we’re back showing some green!

The US markets closed up strongly overnight. And shiver me timbers! It happened with the 10-year bond yield still heading up.

Stocks are volatile. They go up and they go down.

And no wonder…the world never sits still.

Aussie bank shares are the ones to keep an eye on. Here’s why…

New rules to rein in the banks

The banking regulator is finalising some proposed changes to the regulatory framework around the banks.

It’s to do with the capital levels the banks need to hold against their loan books.

The banks will need to hold more money against interest-only loans and investment properties in general.

This is to protect them if a high number of loans go bad.

The bog-standard owner-occupier loan, especially those with a low loan-to-value ratio, are to be treated as less risky. Therefore, they need less money set aside.

Regulatory pressure is not so good for bank investors — which is pretty much all of us, because they make up so much of the index.

Here’s why. Higher capital levels reduce the return on equity the banks can generate off these loans…unless they raise interest rates on them to compensate.

If they have to raise rates here, they can be undercut on price.

Already the pressure on banks has forced more money into the non-bank lenders, who APRA does not regulate.

This sector is booming because of the crackdown since 2015.

I suspect all this is already priced into bank stock prices despite the ‘news’ today.

But I bring it to your attention anyway. It’s very important long term…

Joe Public to be sold down the river

The government will sell the public the notion that the banks are on their way to becoming ‘unquestionably strong’.

However, history says the banks will do everything they can to block these changes and/or find a way around them.

It was forcing banks to hold capital against their loans that spawned the original securitisation market in the 1980s….and we know where that ended up, don’t we?

The international framework for banks is known as Basel III.

We’re up to III because I and II didn’t stop further bank collapses and financial crises.

That’s because fiddling with bank capital levels does not work. It treats banks as financial intermediaries — which they are not.

A bank’s tier 1 capital comes from shareholder equity and retained earnings. That means in the good times their capital ratios look wonderful.

You see…in a healthy economy, banks expand their lending…make more money…and meet their capital requirements.

But as the boom rolls on…they reach for more marginal borrowers to sustain their profit growth…and the quality of their loan book deteriorates. Their credit-creation powers go into overdrive.

It’s not until interest rates start rising, alongside high asset values, that suddenly trouble begins to brew on the marginal borrower.

Loans start going bad and bank capital begins to look weak…because asset values are crumbling all around them.

Indeed, there’s a perfect little story in the news at the moment about this issue.

How to find five billion pounds in a hurry

The Serious Fraud Office in the UK is charging Barclays bank with fraud.

In the blast zone of 2008, Barclays lent five billion pounds to Qatari and Gulf investors.

They in turn invested in Barclays equity…to prop up its capital base!

This was designed for Barclays to avoid a UK government bailout.

It was also probably illegal, which is why the charge has been brought against it.

But how did the bank find five billion pounds during the crisis in the first place?

Why…it did what all commercial banks do when they create loans. It created it from nothing!

You have to see this to understand the economy.

The question is not whether banks have a strong capital base…but whether they are creating credit for productive or unproductive purposes.

If they are lending to business, which in turn generate healthy growth, then the banks are on a much stronger footing.

That’s because the economic growth than comes from investment provides a steady stream of income to pay off the loans.

But if banks create huge levels of credit for speculative purposes…hedge funds, margin loans and housing loans…unfortunately the clock is ticking on that banking system.

That’s because asset prices inflate…and go higher again…but must eventually come down. Then the banks are left with a bunch of soured loans…and an economy mired in a credit depression.

Their capital ratio isn’t worth a damn at that point.

Australia is a long way from this point, in my view. Rising real estate prices and low unemployment will prop up bank assets for the foreseeable future.

However, do remember that 60% of bank loans go into mortgages here.

It will go over the top eventually…but not for a while…so the thing to watch for is to see how the banks try and get around the limits being put on them now.

Stay tuned.

Sincerely,

Callum Newman Signature

Callum Newman
Editor, The Daily Reckoning Australia