Negative interest rates and quantitative easing have wrecked the economic system. Negative interest rates destroy the profitable portion of a bank’s asset base, and no amount of cost-cutting or efficiency initiatives can compensate for this loss. Furthermore, persistent quantitative easing has transformed the investment side of the balance sheet into a ticking bomb.
Deutsche Bank is the latest to make headlines after Credit Suisse. Nonetheless, everyone was aware that Credit Suisse faced enormous obstacles and a lack of profitability. On the other hand, Deutsche Bank was recovering from years of losses. Since 2019, Deutsche Bank has launched a solid rebalancing plan, with a goal of increasing return on tangible assets to 8 percent, a massive cost-cutting initiative, and a shift from investment banking to its core lending activities. After years of losses, the core capital ratio grew and profits began to emerge, indicating the apparent success of the plan.
Deutsche Bank followed the recommendations of authorities and the central bank to the letter. No strategy can counteract the erosion of the balance sheet caused by monetary policy and regulation.
Credit Suisse, Deutsche Bank, and Silicon Valley Bank aren’t at the root of the banking issue. These are the symptoms.
The banking industry wasn’t damaged by rate hikes but by years of negative interest rates and monetary excess.
The economic aberration of negative interest rates has destroyed the banks’ profitable assets. Hence, most assets don’t create a profit above the cost of capital for banks. Furthermore, investment risk surged during the period of monetary excess, obscuring any risk analysis.
Central banks constructed the time bomb that is exploding today through the insanity of negative interest rates and perpetual quantitative easing. Even during moments of boom, they made the assets with the lowest risk and volatility—sovereign debt—enormously expensive and volatile by acquiring bonds without control. As described numerous times in this column, this concealed danger but didn’t eliminate it.
What took place in 2022? Central banks have reported astronomical losses on their portfolios of national bonds. In 2022, the ECB reported losses of 1.6 billion euros that had to be covered by reversing provisions. The Federal Reserve and the Bank of England also suffered tremendous losses.
The financial void caused by the central bank’s accumulation of “safe assets” became the limit for many firms. These identical unrealized losses in a commercial bank, when combined with negative returns on loans and deposit losses, indicate disaster. Quickly, the bank’s equity evaporates.
How is it possible? Is the issue the absence of regulation?
Regulation is the cause of this void. According to the regulation, taking risks in the public sector doesn’t require capital because there’s no risk involved. Negative interest rates are mandated by regulation through the supervisor. The regulation penalizes an increase in the cash ratio. And it’s the supervisor who creates the risk in sovereign bonds by uncontrollably purchasing them while printing money.
Currently, the major issue is centered on the star financial instrument of these years. Regulation and oversight prompted banks to issue contingent convertible bonds in excess of $250 billion (AT1, or CoCos). These bonds have a particularly important equity component because if the entity’s highest quality capital falls below 6 percent—a lower figure than the norm for banks in 2008—they’re promptly converted into shares and the bank is automatically recapitalized. It looks like a terrific idea ... until it causes a big stock market meltdown, as everybody who has purchased a convertible bond is aware.
At the time of writing, the average coupon yield on CoCos issued by European banks is 10.46 percent, while the average capital ratio (tier 1) of the largest European banks is 14.5 percent, according to Bloomberg. When the capital ratio falls below 6 percent, convertible bonds would immediately convert into common stock. Consequently, a substantial cushion of money exists before the necessity to convert arises. Right?
We can’t assume that these bonds are without danger. Low-risk bonds don’t yield 10.4 percent. There are CoCos with a 19 percent yield from German banks and 15.7 percent yields from French banks. This doesn’t imply that they’re inexpensive but rather that they carry a higher risk.
There’s no return without risk, and if a convertible bond offers a 15 percent return, it isn’t due to the issuer’s generosity but to the bond’s extremely high risk.
In certain instances, in Europe, the amount of AT1 bonds issued by a firm is comparable to its present market capitalization. The number of AT1 bonds issued represents around half of the banking sector’s overall capitalization.
A convertible bond is only a good financial instrument if investors have perfect faith in the issuer’s balance sheet. When confidence wanes, the bond depresses the stock price, and the stock price, in turn, depresses the bond price, creating a vicious cycle that may have a negative outcome. The majority of credit investors can’t hold the shares if these bonds are converted; therefore, they must sell them or short the equity to mitigate the risk. It isn’t an issue with the instrument itself, but rather with the complacency of those who believe that having this financial buffer eliminates the need to normalize policy.
As stated, many investors who purchase convertible bonds can’t hold the stock when it converts, so they must either short the security or sell the shares when it converts, which can have a significant impact on the share price. If the amount of convertible bonds issued is comparable to the bank’s market capitalization, it’s possible that the conversion won’t strengthen the bank’s capital but instead cause it to collapse due to selling pressure, since the value of both the new and old shares is less than the bank’s previous market capitalization. In other words, a convertible bond is a good idea if its conversion into shares doesn’t cause a subsequent decline in the stock market’s value. However, this danger is difficult to assess.
In the case of European banks, it’s important to recall that during the era of negative interest rates, they increased their high-quality capital. Today’s banks are better prepared for a shock of this scale, but it would be irresponsible and dishonest to claim that these are unique incidents that don’t influence other entities. The balance sheets of the banks have been destroyed by monetary policy and regulation. Thus the significance of addressing the anomaly of negative interest rates.
To prevent financial crises, regulators must also abolish the penalty for saving and the incentive to amass risk in the public sector.
No entity acquires large risk in its assets. Crises are always caused by the building of positions in assets that are regarded as posing almost no risk.
You wanted negative types and uncontrolled printing, correct? Lending without economic criteria? Welcome to the repercussions.
Currently, the issue may appear to be controllable, but if the financial repressions persist, it will generate a systemic risk in the entire financial system by extending a slowly building but rapidly exploding risk.
