I try to avoid writing blog posts on banks. I spent over a decade publishing research on banks – see here, and got well paid for my knowledge. If I’m going to write about banks, then I’d like someone to write me a (rather large) cheque to do it. But just this once, I’ve found something so interesting I couldn’t resist it.
Two papers caught my eye. This from John Hempton, Aussie short selling legend and all round good egg (I briefly chatted with him at a Financial Times Alphaville conference). And this from someone the Bank of England blog – who I’ve never met, but I enjoy reading their stuff.
I’ll summarise both pieces and then move on to my thoughts. But I advise you to read both links yourself, because they’re interesting, well argued.
Hempton’s piece: low interest rates are bad for bank margins and profitability. But that’s not the whole story. Bank margins were in decline for 10 years before the financial crisis, when interest rate environment should have been helpful for banks. In the UK, Lloyds went from a post tax Return on Equity of 35%, to needing to be rescued because their competition HBOS, RBS and Northern Rock were lending like idiots. Therefore, countries where banks have concentrated market share and competition is not too fierce (Ireland, maybe even the UK post crisis) should be OK. But German and Japanese banks look like they have a problem, because they’re in low interest rate environment and are in competition with quasi Govt institutions (eg Landesbanken in Germany). From this he states “If central bank policy is going to work the central bankers are going to need to learn from the banks that have maintained reasonable profitability in the face of negative rates. This may be the single most important lesson for central bankers in the next decade.”
Bank of England piece: they suggest housing is an asset, whose value should be determined by the expected future value of rents, rather than a textbook demand and supply for physical dwellings. That means house prices have spiralled out of control because interest rates have come down and banks have been more willing to lend – particularly if the loan is secured on property. Building more houses won’t do much to make houses more affordable to young people.
SO WHAT? Falling interest rates have been great for bank customers but terrible for their shareholders. You would think that all assets should have risen in price, not just houses. But Lloyd’s own dividend yield is currently 7%, roughly where it was 20 years ago when long term interest “risk free” Government bond yields used to discount future cashflows were at a much higher level than they are today. Many other equities are on similar dividend yields, despite the fact that future cashflows ought to be much more valuable, because the risk free discount rate is so low.
What is more, in almost all previous banking crises, what has caused problems is banks lending money secured on property (houses or other physical infrastructure eg railways, telecoms cable networks) and then discovering that their estimates of value and future cashflows were too optimistic and they can’t get their money back. But this isn’t the story of the recent past. Asset prices have gone up! Because interest rates have come down, that makes sense, but banks are STILL struggling to make a profit.
For instance: if I had published an equity research note in 2000 predicting that UK house prices would treble in the next decade, but Lloyds, HBOS, Northern Rock, Royal Bank would collapse and have to be nationalised…then the head of research would have called for the men in white coats, and they would have led me away in a straightjacket. They would have said you can’t have a banking crisis if the value of the collateral a bank is lending against keeps going up. But that’s what happened.
My own experience of banks in Germany, is that they will lend around 13x a businesses cashflow at incredibly low interest rates, if that future cashflow comes from a commercial property. But they will lend nothing against a business’s cashflow, if that future cashflow comes from a business that owns no property assets.
My rule of thumb, is that whatever or whoever German banks are lending to (Irish banks pre 2007, Greek Govt pre 2011, Donald Trump, credit derivatives sold by US investment banks) are going to be poor investments. Whatever German banks are refusing to lend against (Kreuzberg property in 2006, craft beer bars now) are probably going to turn out as decent investments.
I haven’t seen a mainstream economist or central banker talk about this. So I just thought I’d point it out, because no one else seems to have noticed.