A few months ago I ran into a leading American investor who’d made a killing out of investing in (smaller) US banks. He’d made money – big profits – for at least the five years and was still enthusiastic about investing in the sector even at this late stage.

“And what about European banks – interested?” I aske, curiously.

He burst out laughing and said words involving stick, bargepole, and human excrement. “They’re bust, and the judgment day is coming”.

Those comments stuck in my mind as I read the continuing drumbeat of negative bond yield and interest rate stories. And they popped again when I recently read an excellent analysis by Tuomas Malinen, who runs research consultants GNS Economics.  I think it’s fair to say that Tuomas (who is Finnish) shares the same withering assessment of my American investor. The chart below tells you the obvious driver behind what he believes will be the impending carnage.

Figure 1. The size of the balance sheet of the ECB in million euros and the interest rate of main refinancing operations (MRO). Source: GnS Economics, ECB

According to Malinen “a large part of the European banking sector has probably been insolvent for the past 10 years, a conclusion that is also suggested by the group’s stock price performance for that same period. The sector simply never recovered from the 2008 crisis. …How will the ‘living dead’ European banks cope with the recession that is approaching fast? The only plausible answer is: not well. They are a ticking time-bomb.”

If you fancy reading a well-argued horror story read the full article HERE online – https://gnseconomics.com/2019/10/03/the-destruction-of-the-european-banking-sector/

I’m not sure I’d go quite so far as Malinen but I do think that the European banks are in a hole, one that central banks are making ever deeper by the day. Negative interest rates are simply not good news for both the banks and quite possibly the wider economy. The core concern is that if the big banks can make money from lending/saving they’ll simply react but cutting back the lending bit of the equation.

Analysts at big European bank Barclays have also been running the numbers to see how bank balance sheets will be impacted by negative interest rates. Their key concept is something called the reversal rate – the level of interest rates at which accommodative monetary policy becomes contractionary for the real economy. Once that point is reached, its clearly bad news for European banks.

The good news is that so far the aggressive monetary policy seems to have worked – according to Barclays “Euro area lending data show that banks continue to lend in greater volumes and at lower rates. This supports the calm response of policy-makers when discussing the side effects of negative rates and quantitative easing”.

But as rates go lower we fast approach that reversal rate which in their case doesn’t just come with interest costs but also the moment when banks can no longer grow lending by reducing other activities or costs.

Up till now, Barclays reckons that the banks’ substantial increase in lending has been manageable because other balance sheet activities have been cut back – notably market-making, repo and OTC derivatives.

“This approach to credit creation is doomed to slow once banks exhaust their capacity to shrink other activities unless there is an increase in loan demand that leads to higher margins on lending. At the limit, the low RoTE that banks generate threatens to keep credit growth constrained at relatively low levels in the euro area (<5%/y).”

Cue the reversal rate. But what can central banks do about this challenge?

“To re-establish bank profitability, regulators need to lower the cost of bank liabilities. One potential solution would be to allow banks to charge negative rates on household deposits, in part or full. But this would be controversial and not without risks for the banking system; we believe that regulators/law-makers would need to step in to make this approach broadly applicable. Other possible solutions include increased non-bank lending or greater wholesale funding of bank balance sheets. The most bank-negative outcome would be if policy-makers accept low credit growth as a “fact of life”, which could increase the risk of a low growth/inflation outcome for the euro area….If regulators do not act, the ECB may have to take controversial steps. Should banks hit a wall in lending, as balance-sheet constraints bite or demand weakens, the ECB could be forced to further relax TLTRO conditions or even consider extreme policy actions, such as adding bank securities to its asset purchase programmes.”