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Will Our Global Banking Sector Let Us Down Again When the Crunch Comes?

The global economic picture continues to grow cloudier with each passing week, and as GDP growth rates slip another notch, uncertainty is increasing as to whether another crunch time is imminent. The threat of rising interest rates and the deflationary death spiral of commodities in general have rekindled fears that the financial crisis of 2007-2008 was just a bump in the road. Could there be something worse beyond the near-term horizon? Will our global banking sector save us this next time around or will it collapse in a heap of its own making, demanding once more to be bailed out?

As analysts survey the global economic landscape, their observations inevitably focus on banking infrastructure and if it is capable of withstanding a massive cycle of non-performing loans. Since 2008, the Dodd-Frank Act and countless similar regulations in other jurisdictions have been enacted to prevent a repeat of the last financial crisis. Banks have fought each step of the way tooth and nail and have managed to delay or defuse many of the stiffer corrective measures of the new laws. Global banking monoliths have, as a result, returned to their old ways, but in a new form. Trading revenues are still a mainstay, and executive bonuses have never been better.

The band of naysayers have been quick to criticize the banking situation in China, surmising that rapidly declining growth and an abundance of state-run organizations that drain the national treasury will lead to loan and bond defaults in the trillions of dollars. Chinese officials scoff at these notions, but the signs are everywhere. Manufacturing plants are downsizing at best and closing at worst. Real estate bubbles have formed in the major metropolises, while building projects in less populated areas have been halted due to low demand. Equities on the Shanghai exchange have tanked, while the PBoC expands the money supply and supports the Renminbi in currency markets. Foreign currency exchange reserves have also been rapidly declining. Something has to give.

And then the fickle finger of fate swings around to Europe, where bank stocks are taking a beating right and left. Mario Draghi and the ECB have continued to bloat the central bank’s balance sheet with asset purchases, while pressing forward with negative interest rate policies (NIRP) on banking reserves. Banks have been gradually increasing loans in their respective business sectors, but NIRP is an anathema. Since banks refuse to pass along negative returns to their depositors, their profit margins are shrinking, and investors picked up on this line of reasoning very quickly. The sell off in banking stocks was immediate and substantial. The situation is not much better in the UK. The threat of a “Brexit”, a withdrawal by the UK from the EU, has generated more uncertainty.

Is the banking situation in the United States any better off?

Is what goes around, comes around? Risky business practices of both commercial and investment banks in the United States were the root cause of the last financial crisis. The “Too big to fail or jail” crowd of major banking institutions have buckled under to accept the blame, but have done little, as a group, to assure us that it will not happen again. There have been a few standouts, but their actions were shunned by the “status quo” of miscreants throughout the industry. Not one banker has paid for his sins, but hefty fines, on the order of $170 billion, have been meted out globally since 2008.

Did U.S. banks learn their lessons? According to a recent report, the big ones seem to still be dragging their feet when it comes to one key provision of Dodd-Frank legislation. Large banking institutions are supposed to submit credible plans to federal regulators that demonstrate how they would wind down operations, if and when another crisis were to arise and in such a way that no public bail outs would be necessary. What kind of grade did the Bank of America, Bank of New York Mellon, JPMorgan Chase, State Street and Wells Fargo receive when they complied with the act? The regulators failed them all out of hand.

Banks were quick to defend their actions and claim that they were better prepared than before 2008. One analyst, however, noted that, “The rejection appears likely to fuel populist concerns that U.S. banks are still “too big to fail.” It comes as many in the banking sector are preparing to report weaker financial results for the first quarter of the year.  Volatility in the stock market, China’s slowing economy and the fall in oil prices have battered their bottom lines. JPMorgan on Wednesday reported a 7 percent drop in profits for the three-month period.”

How did the market react to this information? Investors were more interested in the earnings release by the largest bank in the U.S., namely JPMorgan Chase. Yes, there was a decline in profits, but first quarter data exceeded expectations. Their shares, as well as those for their rivals, were suddenly in vogue once more. Values improved, without much notice being given to the bad news from the regulators. Perhaps, Jamie Dimon, JPMorgan’s highly visible chairman and chief executive, had calmed the waters when he said, “We’re trying to meet all the regulations, all the rules and all the requirements. They have their job to do and we have to conform to it.”

Undaunted by the whims of the market, regulators are also responding to potential threats from other financial firms, the so-called next tier down from banks. Firms like AIG, which “required a $182 billion taxpayer bailout” last time around, will receive more regulatory oversight. The regulators also singled out three other entities for increased scrutiny — General Electric’s financing arm and MetLife — as “systemically important financial institutions.” As you might expect, these companies are already beginning legal action to block the regulators at every turn. When shareholder profits and executive bonuses are under siege, management teams suddenly focus on personal priorities.

What are the real causes for concern going on behind the scenes?

Bankers may have avoided jail sentences, but their employers have had to bear the brunt of a tepid economic recovery on a global basis. The concern for the U.S. banking industry, as expressed in a host of articles, has been its exposure to oil and gas producers. As one reporter noted, “Banks around the world have been hit by a slide in commodity and oil prices, a slowdown in China, near-zero interest rates, mounting regulatory costs and hefty capital requirements.” As of the end of 2015, JPMorgan had roughly $14 billion in oil and gas loans on its books.

Marianne Lake, JPMorgan’s chief financial officer, revealed in its first quarter release that it had boosted bad debt reserves by $529 million for oil and gas exposures, and that it expected to add another $500 million before 2016 had run its course. Lake also mentioned that, “There was a high degree of variability in that estimate.” She added that the bank was not “seeing signs of a broad contagion and did not expect to endure significant losses.” Is 7% enough to protect the bank? Are other banks following suit?

The word on the energy beat is that banks are cutting credit lines to the oil and gas industry right and left. According to Reuters, “Since the start of 2016 lenders have yanked $5.6 billion of credit from 36 oil and gas producers, a reduction of 12 percent, making this the most severe retreat since crude began tumbling in mid-2014, according to data compiled by Bloomberg. And it isn’t over yet. Banks are in the middle of a twice-yearly review of energy loans, where they decide how much credit they are willing to extend to junk-rated companies based on the value of their oil and gas reserves.”

Oil prices may have climbed above $40 a barrel, but the breakeven point for most shale producers is up around the $50 level. Natural gas prices, however, remain depressed. Firms have done just about all they can handle with cost cutting and shutting down low-performing rigs. The real problem is cash flow, as the following graphic depicts:

Chart

Since early 2015, 51 North American oilfield service companies have gone belly up, while since late March of this year, another 59 oil and gas producers have filed for bankruptcy protection. Interest and loan payment defaults are already a common occurrence. According to Moody’s Investors Service, “Goldman Sachs, Morgan Stanley, JPMorgan, Bank of America and Citigroup could need an additional $9 billion to cover souring oil and gas loans in the worst-case scenario.”

Goldman Sachs just released a report on the concentration of oil and gas exposures at our largest institutions. The news: “Bank of America leads the list with $21.3 billion. Citigroup is next at $20.5 billion. Wells Fargo is third at $17 billion. JP Morgan Chase is at $13.8 billion. Morgan Stanley is at $4.8 billion, PNC Bank has $2.6 billion and US Bancorp is at $3.1 billion. Goldman Sachs has $10.6 billion in total oil sector exposure.” If you do the math, that is over $90 billion in capital at risk in the energy sector.

Are there other areas of concern? Analysts also point to commercial real estate as a problem waiting to happen: “Delinquencies have been increasing and there has been trouble in the area of hotel financings and bonds backed by commercial real estate loans.” UBS is also bothered by a developing credit bubble in U.S. corporate debt. A report published last week states that, “As much as $1 trillion of corporate credit could end up as ‘distressed debt’ in the next credit cycle – which is already starting to take shape.” It appears that pressure is mounting on several fronts.

Concluding Remarks

Will banks let us down again? The above analysis may sound disturbing, but there is a cadre of analysts that put a positive spin on things, suggesting that banks are well prepared to meet current challenges. The “Big Five” did fail to deliver when it came to their so-called “living wills” submissions, but resources will be devoted to regulatory compliance, or there will be more fines and increased capital requirements.

The other thorny issue is the industry’s profit from trading room activities. Price fixing scandals aside, banks are heavily dependent of this revenue stream. When interest rates ramp up, bond values head south. No one is currently talking about banking exposures in the global bond casino. Collateral devaluations and associated margin calls could be just around the corner. Hmmm? That scenario sounds eerily similar to what happened in 2008.

Fasten your seatbelts!

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