October 03, 2019

Europe’s Bank Woes Exact a High Price

This week the financial press carried a bizarre and fascinating tale of intrigue between the two big Swiss banks, UBS and Credit Suisse. The story circles around a spat between former colleagues, cocktail party fights, a tragic suicide and private investigators, and ends with Credit Suisse’s chief operating officer losing his job.

This contradicts the sedate, respectable and unadventurous image cultivated by Swiss bankers. Of course, personal factors are involved. Even so, there is pressure building on all European banks to maintain a successful business. And the Swiss intrigue may serve as a telltale example of how that pressure plays out. The simple reality is that Europe’s banks are struggling. European Central Bank Vice President Luis de Guindos discussed the low profitability of banks in a keynote speech last June. The data that stands out is that European banks’ return on equity is around 6 percent, while their cost of capital is around 8 to 10 percent. You don’t need to be a math or business whiz to see how that is unsustainable. 

The ECB maintains that its monetary policy is not the cause. Banks unable to make money on deposits in a negative interest rate environment are making it up on larger loan spreads, according to ECB officials. Guindos puts most of the blame on inefficiencies in the banks that are keeping operating costs too high.

Those circumstances may be true, but the real problems relate to a combination of factors, with negative rates being high among them. The original goal of forcing money into circulation by essentially penalizing savings has certainly not happened. 

In addition, recall that a few weeks ago we discussed the reversal interest rate, when a rate can be so low that it actually reverses its intended effect and depresses lending, hurting an economy. Part of that argument noted that the longer low rates continue, the less forgiving the economy gets and the higher the reversal interest rate gets. 

My View: This underscores the predicament that the ECB faces now. It can’t raise rates due to a weak economy and the longer rates stay put, the worse things get. A lot of folks are looking to fiscal policy – increased government spending, specifically – as a remedy. But that will add to the mountain of debt at negative interest. And the carousel continues to spin.

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