Optimus (non)Prime: A Eurozone Banks story

I've railed against Eurozone banks for a long time.

To be honest, it's hard not to.

They really are facing a hell of a lot of trouble, especially over the next ten years, and I'd argue that the virus crisis has exacerbated these issues.

The difference between what I say versus what other commentators tend to allude to is that I don't think they will simply blow up - that's not necessarily what a low share price indicates.

No, it's worse.

I think they will simply truck on and keep piling on sh*t upon sh*t into their books until they lead themselves and Europe into the most unproductive quagmire that any economy has ever experienced.

An Optimus (non)Prime (I'll come back to that analogy later).

I want to do a bit of a historical track here of how Eurozone banks have gotten into this mess by looking at how the fallibilities of the Eurozone's design & ECB policy making have led to this train wreck.

Where do we start?

Let's start at the very beginning; that's a very good place to start 🎶

Let's take a holistic view here.

The problems of the Eurozone are, by definition, created by the Eurozone itself.

I have mentioned a number of times that the overriding issue in the bloc is that you simply cannot have a single monetary policy for that many different countries.

It cannot work.

Germany, for example, is a far different economy to that of, say Cyprus.

To illustrate this, I want to point out my favourite chart; one which came up time and time again when debating my position on Brexit.

This shows Target2, which essentially shows transfer from sovereign central banks (in Germany's case, the Bundesbank) to other central banks.

Look at the top purple line (Germany).

They are a net creditor to the rest of the zone.

For a single currency union to survive in a specific geographical area, there needs to be sufficient wage flexibility and labour mobility, sufficient price flexibility and capital mobility, a fiscal mechanism for redistributing resources from regions with trade surpluses to those with deficits, and for the different areas within the union to have broadly similar business cycles.

The reality is different.

Varied business cycles and inadequate labour and capital market flexibility within the Eurozone mean that systematic trade surpluses and deficits develop.

To deal with these trade imbalances, the more efficient economies in the Eurozone, such as Germany, need to recycle their trade surpluses back to deficit regions using fiscal transfers in order to keep the Eurozone economies in balance.

This is done via the Target2 mechanism, since there is no official method to redistribute these surpluses across the bloc (yes, a big failure in the design).

So we are left with the solution also being a problem.

To be able to rectify the issue, fiscal and political union would likely have to be enacted.

This is a great solution on the face of it.

But it's a problem too.

See the magnitude of action that would have to take place to achieve this would be ridiculous.

Either a war pops off to solidify integration, or the EC become so authoritarian that they directly impose fiscal and political union - personally, I don't actually think they're horrible people to go that far, they're just very much useless bureaucrats...

What's the problem here?

It's simple.

Debts are being built up by deficit nations - you can be a deficit spender, but of course, not all deficit spending nations have weak economies.

Take the US and UK for example.

The trouble is, pretty much all of the deficit spending nations in the Eurozone have gone through a crisis and still have very fragile economies.

Take a look at Trading Economics and search the pre-Covid data for the economies with T2 liabilities.

It's not a pretty sight, although better than the days of the European sovereign debt crisis (or crises - or even current crisis, since I don't think they're out of it yet).

So what happens when the German taxpayer finally gets fed up of practically financing the rest of the bloc's woes?

Well, I don't actually know that answer because it seems a long time off still.

But this is just one conundrum that I think faces the EC in terms of deeper integration, fiscally and politically - if they go down this route, then the current system will have to be brought to the foreground, rather than where it is now...

The data, languishing on Yardeni's website, with a mere 72k hits per month.

Tragic.

What's the ECB's role in all of this?

Here's the broad take.

Low rates lead to unproductive economies.

And the ECB has one of the lowest rates in the world, whilst also expanding their balance sheet to ridiculous levels.

A recent paper by Ernest Liu (Princeton University) Atif Mian (Princeton University and NBER) and Amir Sufi (University of Chicago Booth School of Business and NBER) highlighted the relationship between low rates an productivity.

I've read it for you so you don't have to.

Here are the main points.

Equity risk premium compression, anyone?

The line above is exactly the reason why the Nasdaq has rallied - why tech stocks go up in a world of chaos.

The market leaders have become innovators, whilst others are not able to, which leads to huge market concentrations.

Let's keep going.

Lower rates have a similar effect to crowding out - that is when the government becomes involved in a market which stifles most private firms' ability to operate within said market.

Again, this may provide us with insight as to why 'value' isn't necessarily 'value' anymore.

Don't worry about the model.

I am not too sure what the maths is suggesting so I won't put you through the pain of looking at it too, although the worded assumptions that it spits out makes sense.

In essence, it is saying that cheap cash leads to investment from all firms, just that market leaders are more responsive and more aggressive with investment than other firms.

I think a prime example of this might be with Amazon versus traditional retail.

Yes, your high street firm might invest, but into what?

Will it be game changing?

Likely not.

Will Amazon's investment be game changing?

Probably.

So Amazon's investment force will override anything a traditional high street retailer does.

Perhaps this is why the EU go so hard on anti-trust regulations.

Could this be the next big war?

Well, the EU certainly wouldn't win that one when up against the US.

To conclude...

Call me mental, but this slowdown could possibly be identified by the change in M2 velocity...

Did it start at the DotCom bust then?

Perhaps...

Could it mean that 'no physical product' tech firms are the cause of productivity issues?

Is the hunt for data as a product the basis of all our woes?

Probably not, but something to think about, I guess.

Where do EZ banks come into all this?

Well, here's where Eurozone banks are Optimus (non)Prime.

We've spoken above and shown a theory as to why there are concentrations in a market, and why value might not be value.

But this theory might simply suggest that these firms should just go bust, right?

Well here in lies the problem.

Since low rates (and negative real rates especially) are so easy to obtain, especially in Europe, we have a situation where you're just feeding something that should really be dead.

In Europe, firms are less likely to go to capital markets for funding versus the US.

Instead, they go to banks.

And banks make money from loans.

If they can provide loans to firms that can repay, who cares if those firms aren't actually able to improve?

The banks make money.

The problem is that wages don't increase - there is likely little net benefit to the wider economy other than staving off the inevitable, such as when a tail risk event like the response to the Corona virus happens.

S&P sees European corporate default rates spiking to 8.5% from 3.5% in the back end of this year...

The US has higher rates of corporate defaults, but I'd expect these to be mainly in energy, which has taken an absolute hammering due to the demand side totally drying up.

If we look at European non-performing loans, we can also get a broader picture of what the situation is.

This article sums up the NPL situation well...

And an ECB report showed a pretty stark picture for European bank lending in Q3...

ECB's chairman of the supervisory board, Andrea Enria said this in an FT piece about the EU needing a 'bad bank' to cope with the rise in NPLs stemming from the pandemic.

Enria is essentially saying that he would like asset management firms to pick up the slack in the rest of the piece, and that would entail them buying the NPLs at a discount and somehow receiving payment.

But, rather than them be private, he wants an EU wide asset management initiative to be able to clear up bank balance sheets and restore ability to lend.

I just see that as shifting the hot potato, which then comes back down to what the core issue is - that is one of how low interest rates affect the behaviours of banks and the transmission mechanism of credit flow.

What's the short term theme then?

This is where the Optimus (non)Prime analogy comes in.

I reckon that Eurozone/EU wide bank consolidation is going to be the next big theme.

They will end up turning into a transformer - something that looks all powerful, but at the end of the day, is still just a car on the inside (we will ignore the actual storylines of Optimus Prime being able to destroy whatever he wanted).

What will likely occur is that, like the FCA/PSA Groupe merger, we'll see many Eurozone banks consolidate their balance sheets to be able to somehow convince the market that all is well.

But all is likely not well, even after this consolidation.

Basel regulations on capital adequacy are likely a big driving force behind consolidations, with the desire to avoid deleveraging a big factor.

It feels like more can kicking to me.

If we use the German 10y yield as a proxy for interest rates, we note that there's a pretty strong correlation between Eurozone bank share prices and the interest rate path.

This comes down to the net interest margin - how banks make money, which I have explained many times before.

So there seems to be a feedback loop where credit provision to firms which shouldn't really be provided it occurs because banks don't necessarily care who receives it, as long as it is judged to be an adequate loan origination according to their models.

In turn, this creates a big spread in concentration between market leaders and market followers, the outcome of which leads to dampened productivity and lower growth (and inflation).

On the QE side, central bankers are foolish to believe that more QE will lead to their inflation aims being met.

So what are we left with?

I feel that we have a big elephant in the room in Europe.

There is a bit of a sickness whereby this constant pushing of lower rates, more printing and lack of (but unattainable) fiscal and political union will simply lead to a worsening of conditions.

Bank consolidations will work in the short term, and there will be no doomsday blowing up of banks, but they will just trudge along with a worsening return on equity over time.

The same could probably be said about UK firms; the difference is that we are probably more malleable in how our policy path can change.

One thing is for sure though.

The powers at be in the ECB and European Union will keep the cogs turning for as long as there is no total civil uprising against them.