Why Bank Stocks Blow Up

Why Bank Stocks Blow Up
  • The industry that needs a periodic bailout
  • Sell your bank stocks now
  • Plus, this week’s best and fairest…

Not many major stock market listed companies can crater 35% in a day.

But the UK’s Metro Bank did on Wednesday.

Why?

The bank applied the wrong risk weighting to a chunk of its loan book. A ‘misinterpretation of the rules’, said the CEO.

In other words, nothing on the bank’s balance sheet actually changed. The loans are the same. Nobody defaulted. Nothing went wrong. It’s just that the bank applied the wrong risk calculation, causing a 35% plunge.

It’s not exactly a Lehman Brothers moment. But even that event is a reminder of just how fragile banks are.

When banks get into trouble, they don’t just struggle. They blow up spectacularly. And they often take the rest of the banking system with them. And then the economy.

Banks are so inherently risky, I don’t think it’s safe to own them. If you disagree, consider this: Why do bankers get government guarantees and central bank rescues?

I don’t get either. Neither do you. Nor do any of the other investments you own.

Deposit your garden furniture at a storage company and the government won’t promise to replace the chairs if they happen to disappear. But bank deposits are ‘safe’.

(Except in Europe, where the governments are so broke they can’t rescue their banking system. So they’ve written legislation to take depositors’ money to help rescue the bank.)

Invest in a construction company that can’t pay its debts and the government won’t bail you out. Especially not shareholders.

But banks get special treatment. They have since 1694 — when the Bank of England was founded to provide emergency lines of credit to the banking system. And the rest of the world followed suit.

Sure, banks are important to the economy. But so are Woolworths and Coles. But they don’t get a central supermarket to provide free spare ribs and Brussel sprouts if they run out.

Despite all their backing and rescues, banks still have a suspicious habit of failing. Not gradually declining into oblivion like other companies that fail. Bank failures are very different.

The regulator just announces the failure one day, to the surprise of shareholders and depositors. It’s the moment people realise that their shares aren’t worth the paper they’re written on. The assets are worth less than the liabilities. And the liabilities have come due.

Australians haven’t known that sort of a collapse since Storm Financial. But even that wasn’t a bank failure in the sense I mean. It was fraud.

Banking is a confidence game. All it takes to send a bank bust is a lack of confidence.

In fact, banks are effectively insolvent. That’s why bank runs can happen in the first place. It’s why governments have to provide deposit guarantees and set up central banks to bail out struggling lenders. And it means the value of your investment can disappear overnight.

But what makes banks so fragile? Well, they can’t actually meet all their obligations. They just hope depositors won’t demand their money at the same time. But if they do, the bank can go bust. This creates an incredibly fragile situation. A multibillion-dollar bank can simply cease to exist — go insolvent overnight. No other business is as fragile.

So, what sort of event might trigger the next bout of bank failures?

Metro Bank got into trouble for classifying loans as lower risk than they really were.

Well, European banks classify all European sovereign bonds as RISK FREE. Not low risk. No risk. By law.

Try getting that sort of claim past ASIC for any other investment out there…

And yes, the risk-free classification includes the likes of Greece, whose bonds fell in value by 90% during the last sovereign debt crisis.

The classification of risk is so important to banks because it determines how much of a capital buffer the bank needs to hold. Think of it as a reserve to protect against losses. AAA-rated subprime loan CDOs (collateralised debt obligations), for example, needed a minimal capital buffer. In 2007, anyway.

When losses struck those CDOs, the banks got into trouble because they didn’t hold enough capital to protect them against losses. Not only did the banks lose their own money, they began to lose money they didn’t have. The value of the bank went below 0.

Well, European banks don’t need to hold any capital at all against European sovereign bonds. Every euro of losses in the value of the bonds is a euro loss in the value of the bank.

What could possibly go wrong?

Just a global banking crisis that makes 2008’s Lehman Brothers debacle look boring.

Buy gold, not bank stocks.

Until next time,

Nick Hubble Signature

Nick Hubble,
For The Daily Reckoning Australia