It’s the too-big-to-fail banks that are likely to trigger the next crisis

Central bankers have been following an insane easy money policy to spur economic growth. They are loath to admit its failure. Neither growth nor jobs have resulted. Instead, companies have used the easy money to buy back their shares and declare higher dividends (not for capex, as hoped) and individuals have used it to repay costlier debt and to save more (not for consumption, as hoped). TBTF (too big to fail) banks continue to over-expose themselves.

Deutsche Bank (DB) has built up a derivative exposure which is, at gross level, over seven times Germany’s GDP. Excessive derivatives exposure had caused Lehman Brothers to collapse. Will Deutsche be the next Lehman?

DB is hugely undercapitalised, and is being hit by a $14b fine by the Department of Justice. Its market cap is $1.3 billion, about the same as Union Bank of India. It is trying to raise capital by selling off/securitising some assets.

True, net derivative exposure, in normal times would be 0.1 per cent of gross exposure. But in times of crisis, such as post-Lehman, the system freezes since no one trusts the balance sheet of a counterparty.

Chinese banks are also candidates for another global financial crisis, given the fact that debt to GDP ratio in China is an unsustainable 255 per cent. Outstanding loans given by banks total $28 trillion, more than those of US plus Japanese banks, combined.

Italy will face a crisis because it refuses to recognise non-performing loans. Banking authorities want to protect the bond-holders of bank debt, and so allow the non-recognition, whilst EU is asking them to clean up their balance sheets. If this problem is not resolved, its impact would be worse than Brexit.

Not to be left behind, we see a fraud in Wells Fargo, America’s largest TBTF bank by market cap. Fake accounts were opened, obviously with management permission. Nonetheless, it was over 5,300 tellers who were fired. The executive in charge, Carrie Tolstedt, retired with a $125-million settlement! This has led to outrage.

That is why the US Federal Reserve developed cold feet and moved back from raising interest rates. And that is why the markets rose, as the drinks are on the house! Somebody should gift Janet Yellen, Kuroda and Draghi some woollen socks.

But the market senses a storm ahead. Vix, the index of volatility, is down to 13.23, indicating complacency, and a sign of weakness ahead.

The Purchase Manager’s Index has fallen to 49.4 in August; any reading under 50 is a bad sign.

So, time for caution for investors. Once Yellen heats her feet and raises interest rates, something smelly will hit the fan!

(The writer is India Head, EuroMoney Conferences)

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