Still stressed out
Stress-test results do little to dampen worries about Italy’s lenders
Aug 6th 2016
ANY big announcement about banks made after the markets close for the weekend is bound to bring back dark memories of the 2007-08 financial crisis. Although the results of the latest European bank stress tests, released on July 29th, contained much that was reassuring, they did not dispel investors’ doubts about the industry’s earnings prospects. And in the case of Italy, the tests seemed to exacerbate bigger worries. When the markets opened again on August 1st, they were marked by falls in banks’ share prices; the Euro Stoxx banks index dropped by 3% and almost 5% on successive days.
In aggregate the results suggested that European banks were in a healthier position than when the last exercise was conducted, in autumn 2014. This time the banks began with an average “fully-loaded” capital ratio of 12.6% and ended with one of 9.2% in the tests’ most adverse scenario; that compares with a fall from 11.1% to 7.6% last time. No country’s banking sector ended the tests with an average capital ratio below the 5.2% of Ireland; in 2014, the ratio for several countries was negative, implying systemic insolvency. These figures are flattered, however, by the absence of banks from the still-struggling economies of Greece, Portugal or Cyprus.
But the real focus was on the weakness of specific banks, notably in Italy. The worst of the bunch was Monte dei Paschi, Italy’s third-largest lender. Its capital ratio was the only one to turn negative in the test, at -2.4%, meaning that it would be bankrupt if the tests’ worst-case scenario came true. The bank anticipated this awful result by unveiling a plan of its own a few hours earlier to shore up its finances. The scheme involves increasing provisions on impaired loans from 29% to 40%; moving €27.7 billion ($30.9 billion) of the most troubled non-performing loans, discounted to 33% of book value, off its balance-sheet into a special-purpose vehicle; and securitising and selling these loans to investors.
The losses that Monte dei Paschi incurs as a result of this transaction will be offset by raising €5 billion of new equity, though this is conditional on the successful completion of the bad-loan spinoff. Although investors initially welcomed the plan, with the share price rallying early on August 1st, the bank’s shares fell by a precipitous 16% on the following day as concerns grew that the deal may fall through and that regulators may impose losses on creditors if the capital-raising is unsuccessful.
Health assessment
UniCredit was the second-worst test performer among Italian banks, with a capital ratio of 7.1%. Its second-quarter results reinforced worries about its thin capital cushion, which has dipped from 10.5% to 10.3% since March. Analysts at Morgan Stanley, an investment bank, expect that it will need to raise €6 billion in capital. The bank has already announced the sale of its card-processing business; in the wake of a 17.8% share-price plunge in just three days after the tests, more action to spruce up its balance-sheet is surely needed.
The fall in Italian bank shares extended even to those that performed well in the stress tests, such as Banco Popolare. One fear is that the bad-loan plan laid out by Monte dei Paschi sets a new benchmark for the whole sector. Many Italian lenders still have provisions on impaired loans of below 20%, and value their non-performing loans at much more than 33 cents on the euro. If the Monte dei Paschi deal does indeed set the standard for the rest, Italian banks could need up to €18 billion more in capital, according to Autonomous, a research firm.
The stress test also highlighted other poor performers outside Italy. Allied Irish Bank had a capital ratio of just 4.3% in the adverse scenario, a result that may delay the Irish government’s plans to float 25% of the bank in 2017. Further disappointments included Raiffeisen of Austria, the third-worst performer in the test with a 6.1% capital ratio, and two German behemoths, Commerzbank and Deutsche Bank. Yet despite share-price declines—exacerbated in Commerzbank’s case by the release of a set of poor second-quarter results on August 2nd—the test results are unlikely to force an urgent response.
Indeed, most investors are more worried by chronic ailments than the sort of shocks simulated by the stress tests. Hani Redha of PineBridge Investments, an asset-management firm, says markets are more concerned with bank profitability than solvency. The stress tests were based on the effects of a spike in long-term yields, when continued low interest rates seem more likely to weigh on a sector that depends for its earnings on the gap between short- and long-term interest rates. Banks are tied closely to the economic health of the countries they operate in. As long as low growth persists in Europe, no one should expect its banks to perform all that well.
Strong jobs growth will tempt the Fed to make an error
Aug 5th 2016, 15:47 BY R.A. | WASHINGTON
IT IS morning in America as, according to the newest figures from the Bureau of Labour Statistics, the economy added 255,000 new jobs in July, after a red hot June in which payrolls rose by 292,000. Truthfully it's actually late morning, or the morning has been around for a while at any rate, since July was in fact the 70th consecutive month of employment growth, which is pretty good. Granted, things looked dicey just two months ago, when only 24,000 new jobs were added. Yet America seems to have put that hiccup behind it. The thoughts of officials at the Fed would surely be turning to how soon they can raise interest rates again if ever they were anywhere else.
On the face of things, a hike might look like a not entirely unreasonable response to continued jobs growth. The economy seems to have survived the quarter-point rise in December of last year, which was the first in nearly a decade (though the hike was followed by a marked deceleration in both GDP and employment growth, not to mention a market-wrenching, inflation-smushing rise in the value of the dollar). The unemployment rate remains at 4.9%, which suggests that payroll growth at current levels cannot persist for much longer without generating lots of tightness, and wage growth, in labour markets. And indeed, measures of wage growth, which long seemed immune to better news on hiring, are showing signs of life. Though average hourly earnings were up a disappointing 2.6% over last year, they rose at a 3.8% annual pace from June to July. Other measures show a similar summer acceleration.
Despite all that, markets still think the Fed won't hike rates at all this year. Investors are assuming that the Fed won't make what would be a big mistake.
There are three main reasons why the Fed ought to wait. The first is that our low, low expectations for labour markets have blinded us to the fact that workers really ought to be doing better than they are. Both the employment-to-population rate and the labour-force participation rate remain seriously depressed relative to pre-crisis levels. Many economists suppose that much, and perhaps even all, of the decline in those rates represents a permanent loss thanks to ageing and hysteresis. But we don't know that the loss is permanent. The fact that the labour force has been growing by enough to keep the unemployment rate stable despite rapid employment growth suggests that there is the potential to bring more people into work. So, too, does the surprisingly weak response of wages; year-on-year growth in nominal wages of 3.8% would be really nice—assuming the American economy manages it, which it certainly hasn't done yet. But even in the limp expansion of the 2000s wages eventually got to a growth rate above 4% per year. Nominal wage growth really ought to do even better than that, to make up for the abysmal rise in pay workers suffered through over the first seven years of the recovery. Stamping out wage growth at the first sign of labour-market tightness wouldn't just hurt workers and risk the recovery; it could also undermine healing of America's long-run supply capacity.
But would a wee little quarter-point rise really put the American expansion at risk, I hear you ask? Yes, yes it would, which is the second big reason that the Fed ought to hold. As ought to have become clear to Fed officials, monetary-policy decisions cannot be taken without considering the ways in which they will ripple across the global financial system. They can control the short-run nominal interest rate, but they cannot do anything about the real, long-run interest rate, which is set on global markets and which certainly seems to be quite close to zero. American rate rises lead to capital inflows, which push up the value of the dollar and place a drag on growth. Those inflows could nonetheless keep demand from falling too much by boosting American investment, if investment were a thing that people did anymore. But tight American monetary policy also seems to put a chill on global risk appetite; inflows might primarily boost the price of Treasuries, which don't need boosting, and could lead to financial turmoil elsewhere in the world. The dollar is already enjoying some healthy gains today on the back of the jobs report, placing a drag on demand in America without the Fed needing to lift a finger.
The third reason, however, is the big one: the one that the Fed ought to have had front and centre in its collective mind from the moment it began planning to raise rates. With inflation and global interest rates very low, the risk to tightening too much is far greater and far more difficult to manage than the risk to keeping policy too loose. If the global real interest rate is close to zero, then the Fed simply cannot raise its short-term nominal rate very high without inducing disaster, unless inflation is much higher than it currently is. If the Fed messes up and over-tightens now, it cannot cut rates by very much either, since they are so close to zero. If the Fed goofs and allows inflation to rise faster than expected, it has unlimited room to raise rates. But faster than expected inflation would be a useful thing in its own right.
The Fed ought to have been focused on giving itself the maximum amount of room to cut rates in response to any future shock. To achieve that, the Fed needed to cultivate the highest sustained level of inflation expectations consistent with its stated 2% target for inflation, as measured by the price index for personal consumption expenditures. And to dothat it needed to actually achieve a rate of PCE inflation of 2%, and indeed to allow inflation to overshoot the target a bit to compensate for prior undershooting, in order to hit the target on average and in expectation. The Fed has done none of those things. PCE inflation remains well below target (it was 0.9%, year-on-year, at the latest reading). In recent months, PCE inflation has actually decelerated a bit. Year-on-year inflation has not actually been above 2% since the beginning of 2012—which, coincidentally, was when the Fed announced that 2% was the official target. It is perhaps not a surprise, then, that market-derived measures of expectations of inflation over the next five years are closer to 1% than 2% and have been declining in recent months.
The smart thing for the Fed to do at its next few meetings is to reiterate that it has a 2% inflation target, and then to demonstrate that the target matters by not raising rates while continuing to fail to hit the target month after month after month. The Fed's responsibility is not to raise rates as much as possible as fast as possible, even if that's the traditional route to central banker heaven. The Fed's responsibility is to encourage stable, healthy growth in demand. It can't do that if it leaves itself no cushion against bad economic news, and it cannot build a cushion if it heedlessly raises rates amid a dramatic, years-long undershooting of its inflation target of which it quite honestly ought to be ashamed.
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