Banks are in focus again. In several parts of the world. Here I'll look at the banks in China, Italy, and Norway. The problems are different, but have things in common. They also have things in common with the U.S. shadow-banking system in the buildup to the Global Financial Crisis (GFC).
The Chinese banks are facing losses, mainly on business loans as the economy slows down. Official Non-Performing Loan (NPL) numbers, still below 2% of bank balances, are manageable. Banks have reportedly made provisions for more than 150% of this part of their portfolios. However, when Special Mention Loans, a greyer area, are added, the percentage rises to almost 6% of balances. Uh, oh.
The good news is that the government is not standing idly by. The bad news is what the government is asking the banks to do about it. Via intricate processes involving debt-equity swaps, sales of this new equity to Special Purpose Vehicles (SPV), repackaging into Wealth Management Products (WMP), and further sales of these WMPs to other banks as well as to households, this is starting to look very much like the CDOs and the CLOs that were everywhere in the U.S. financial system before the crisis. Interestingly, many banks buy the WMPs in order to avoid regulatory limits on their loan-to-deposit (LTD) ratio. This not only amounts to regulatory arbitrage; it also means that idiosyncratic risk has been extensively pooled via this kind of diversification. Now, that should be good. It's just that, as pointed out by Gennaioli, Shleifer, and Vishny, it makes the system so much more vulnerable to aggregate risk. Securitisation raises the risk of system collapse. That is what happened in the United States in 2008; the question now is whether, or when, the same thing will happen in China.
Non-performing loans are perhaps an even greater challenge for some major Italian banks. Now, the European Union has established rules for the resolution of failing banks without the use of taxpayers' money and presumably without risk of system collapse. The remedy: Bail-in, meaning that the holders of bonds issued by the bank will have their debt converted to equity. That sounds great until you start looking at the debt structure of Italian banks. You see, in Italy, small savers have been persuaded to buy bank bonds rather keeping their savings on deposit accounts. So, a bail-in will be like a breach of the government-sponsored deposit guarantee—a guarantee that the bail-in was supposed to support. Not only that; many people who have applied for loans from these banks have been offered deals by which they can borrow more than they asked for, on the condition that they by shares in the bank for the balance. Such constructions prop up the banks' nominal capital adequacy, but undermines completely the intended effects of the capital adequacy requirements.
Strong, well designed government policies may yet manage to resolve these problems. Unfortunately, however, Italy risks getting thrown into political turmoil if the constitutional reform is rejected in the referendum on Dec 4. In that case, the effects of an Italian bank collapse could very well set off a string of repercussions throughout Europe.
That brings me closer to home. The banks in Norway are mostly in decent shape despite the protracted problems in the oil and gas business. There is one exception, however, namely, the new undergrowth of consumer loan banks. They advertise everywhere for fast loans, often without mentioning interest rates or other conditions. For many of their clients, I believe that means they have been tempted to take up loans that they can't really afford. That is very much reminiscent of the U.S. subprime market. I call it immoral. But that's not all. These banks also seem to underestimate their own risk, so their books look better than they are. Now, these banks are held by investor groups with rather limited membership, which makes me wonder why they'd to this. Shouldn't they be concerned about their own risks? I fear the answer is that these investors have very short horizons. They want to start these things up, make a big show of how great a success this is, then sell their shares and get out. Sell to a greater fool.
That's not a pretty story. Fortunately, I don't believe these Norwegian consumer banks are in any way systemically important. However, the damage that they have caused for naïve borrowers may be bad enough. Furthermore, there is some evidence that much of this consumer credit has been used as down payments for houses and apartments that people try to hurry up and buy before prices rise even further. That raises a risk for the stability of the housing market, which is much closer to being systemically important.
Not even that may be important in a global perspective. But the Italian banks are indeed important in a European perspective. And the global importance of the Chinese banks should be beyond any doubt.