- 2021-06-09
Banks are still the weak link
Why has the price of bank stocks fallen so much? Part of the answer lies in the overall decline in the stock market. However, banks are still the weak link in the entire economic chain. They are very fragile, and at the same time they can transmit this vulnerability to the surrounding links.
Between January 4 and February 15, 2016, the Standard & Poor’s 500 index fell 7.5%, while its bank stock index fell 16.1%. During the same period, the FTSE Eurofirst 300 Index (FTSE Eurofirst 300) fell 9.5%, while its bank stock index fell 19.5%.
The decline of European stock markets was slightly larger than that of the US stock markets, but the performance of European banks was also inferior to that of US banks. Relative to the entire U.S. stock market, the U.S. bank stock index fell 9.1%, while European bank stocks fell 11% relative to the European stock market—so the latter’s decline was only slightly larger.
If you look at it in the longer term, the dismal performance of European banking stocks will become more apparent. Bank stocks failed to recover from the huge decline during the 2007-09 financial crisis. On February 15, 2015, the S&P 500 index was 23% higher than on July 2, 2007, but the U.S. bank stock index was still 51% lower than then; the FTSE Eurofirst index was 21% lower than the level in 2007, reflecting Europe's poor recovery situation, but its bank stock index is 71% lower than then. For Europe, bank stocks fell another 40% to the bottom of 2009.
So how to explain the current situation? The short answer is always the same: who knows? Mr. Market is subject to huge mood swings. However, there is an important consideration (especially in the U.S. stock market) that the "Robert Shiller's price-earnings ratio" (Robert Shiller's price-earnings ratio, also known as Shiller P/E) adjusted for cyclical factors, only in 1929 and 2000 When the stock market bubble reached its peak in 2015, it was significantly higher than the current level. Investors may just realize that the downside risk of bank stocks is greater than the upside possibility.
Seemingly reasonable concerns may also trigger such recognition. There is no shortage of such concerns. People may worry about a slowdown in the US economy, which is partly caused by a stronger U.S. dollar, declining corporate profits, and the Fed’s erroneous promise to tighten money. People may be worried about the short-term harm caused by the collapse of commodity prices-causing economic and fiscal pressure on commodity exporting countries and financial pressure on commodity producing countries.
People may worry that sovereign wealth funds have to sell their assets to provide funds to governments with tight finances (especially oil exporters). People may worry about a sharp slowdown in the Chinese economy and the ineffectiveness of the Chinese government's policies. People may worry about a new crisis in the Eurozone. People may be worried about geopolitical risks, including the threat of war between Russia and Nato, the disintegration of the European Union, and the possibility that the next US president will be a hardline populist.
More importantly, the chronic lack of demand syndrome is worsening, and China's economic slowdown can be described as worse. It can be considered that a financial crisis is unlikely, but the euphoria in the market has disappeared. One possible answer is that the euphoria for China has ended. However, the better answer is that high-income economies have not yet recovered from the financial crisis and subsequent Eurozone crisis, as indicated by the ultra-low interest rates.
This series of worries—especially the current deflationary pressures—projects a bright light on the banks' plight. Banks have high leverage on the basis of the economy. If the economy becomes ill, the bank may become more ill. To make matters worse, the more sick the banks, the more sick the economy will be. Today, concerns about banks are not only manifested in their stock prices, but also greatly manifested in the price of contingent convertible bonds. These bonds are all hybrid securities: they are bonds when the market is good, but when the bank’s ordinary equity is too small relative to the bank’s balance sheet, it can be converted into equity. The price collapse of emergency convertible bonds of many banks can be seen as evidence that they are working and converted into equity, or it may herald the beginning of a death vortex. In such a vortex, the pressure signal makes a wider range of fragility. Bank funds dried up.
Why are banks so vulnerable after all the hyped re-regulatory measures are implemented? One answer is that they are still highly leveraged. If people ignore the disappearance of risk weights, the true leverage of many large banks is still higher than 20 to 1. The other answer is that banks have exposure to almost all assets. The poor market environment has destroyed the income of bank brokerage and wealth management businesses.
The risk of deflation increases the possibility of negative interest rates on deposit reserves. The impact of this on banks is uncertain, but it is equally worrying. At least as important, as longer-term bond yields plummet (see chart), the yield curve flattens out. A flat yield curve is not conducive to bank profitability, because the bank's business is short-term borrowing and long-term lending. The decline in commodity prices has also triggered market concerns about borrowers' solvency. The more important issue is the new rules for dealing with banks in trouble. The new regulations put creditors facing the threat of forced share swaps. For shareholders, this will mean dilution of equity. For creditors, this may mean unexpected losses.
The global economy does not necessarily fall into crisis, it may just be slowing down-but risks are everywhere. In addition, such risks will definitely affect banks, especially European banks-the European economy is very dependent on banks. Then, weakened banks will harm the economy.
Policymakers must be vigilant about these downside risks and do everything possible to avoid worsening the situation. One thing remains clear: banks are still the weak link in the global economic chain. People worry about the health of these highly leveraged, extremely complex, and opaque behemoths. Their worries are undoubtedly correct.