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Can Banks Survive a Financial Crisis?

A new study says many world banks cannot survive an economic downturn.

Playwright George Bernard Shaw wrote, “If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience.” Despite the destitution left behind in the wake of the financial crisis a decade ago, history is repeating itself. The government is fueling a housing bubble, subprime is fashionable again, and the central banks are enabling state interventions and debt binges through the printing presses. A lot has happened since 2008, but as the old adage goes, the more things change, the more they stay the same. And that is bad news for the global economy.

Banking on the Banks’ Demise

McKinsey & Company, a management consultancy firm that advises on major strategy overhauls, published a new report that warned one-third of global banks are unlikely to survive during the next financial crisis. McKinsey stated that profit margins are thinning, revenues are slowing, and loan growth is anemic. Overall, investor confidence in international financial institutions is sliding.

Banks face growing competition from fintech (financial technology) startups and juggernauts looking to consume market share in the banking and payments industry. So, it is not a surprise that researchers are concluding that banks need to revamp their business models to weather economic storm clouds.

What can reverse this downward trend? Study authors suggested an investment in artificial intelligence, cost-cutting, outsourcing, new services, and customer service improvements. Also, if possible, the financial industry needs to participate in mergers and acquisitions as part of the preparation for digital disruption.

This is a sound analysis on the part of McKinsey, but it failed to address several other factors.

Subprime: The Sequel

In July 2019, the Bank of England published a Financial Stability Report that highlighted banks, particularly US-based entities, are the biggest possessors of leveraged loans and collateralized loan obligations (CLOs). Of the entire $3.2 trillion worldwide leveraged loans and CLO market, banks control more than 55%, and the remaining are owned by asset managers, private equity, hedge funds, and business development companies.

This was an important report because leveraged loans and CLOs have come under the spotlight in the financial community as central banks across the globe cut interest rates. If the Federal Reserve continues to slash rates, for instance, then lower rates will increase demand for high-yield investment tools, which do include these products. But there is even more to the story.

In the early days, CLOs were mainly housing mortgages. Today, they have become integral to zombie companies – businesses that can only pay the interest on a debt and not the principal – because such entities borrow only to participate in share buybacks, pay dividends, and cover existing debts. While these may not seem like something to be concerned about in the boom phase of the business cycle, there could be trouble in Kansas as we transition into the bust phase. Experts are already sounding the alarm that leveraged firms will likely default on their obligations during the next downturn.

Moody’s finance company notes that the level of protection extended to leveraged loan buyers has slumped to an all-time low. It is estimated that 80% of these loans do not include written safeguards for creditors.

To make their pecuniary matters worse, banks are slipping back into the habit of subprime lending. In the aftermath of the economic collapse, financial institutions treated subprime like a leper. Years later, banks are pouring their resources into the business of lending billions to consumers with poor borrowing histories and bad credit. But, as Liberty Nation reported in December 2018, the finance industry is getting exposed to subprime by lending to non-bank organizations instead of lending directly to consumers, a practice otherwise known as backdoor lending.

What makes the subprime factor more concerning than the last one is how diverse it has become. For example, subprime auto lending accounts for a third of the entire $1 trillion market. In March 2018, Fitch Ratings data showed that borrowers are defaulting on their subprime auto loans at a higher rate than during the Great Recession as the delinquency rate reached a 22-year high of 5.8%.

It is not just housing anymore.

Bailouts 2.0?

In a move that will forever be a black eye to Wall Street, the federal government declared that certain institutions were too big to fail, resulting in multi-billion-dollar bailouts. This was an unprecedented move and one that incited moral hazard, an economic concept that involves a party amplifying its exposure to risk because another party will bear the costs of those risks.

Because Wall Street has been bailed out before, there is no reason to think that it would not be bailed out again. Instead of being fiscally responsible, the banks are rolling the dice on a series of gambles, from leveraged loans to subprime lending. It is a case of privatizing profits and socializing losses.

If you thought these outfits were too big to fail more than a decade ago, then you should grab a magnifying glass and a calculator and crunch their balance sheets now. Of course, US banks can fund these exorbitant endeavors by being close to the Federal Reserve spigot. With the central bank cutting rates and expanding the money supply, the Eccles Building is funneling newly printed dollars into the marketplace. The banking industry is usually the one to get its hands on the first batch from the printing press. Put simply, the Fed prints money, which gets to the big banks. Upon receipt, banks start engaging in risky behavior that could either lead to even greater rewards or send the company to the brink of closure.

Party Like It’s 2007

It is 2007 all over again. The big banks are highly leveraged, subprime is in vogue (again), and the Fed and other central banks are enabling reckless behavior. The house of cards can only be propped up for so long until weaknesses form in the infrastructure, and they are already beginning to show. The Great Recession will be a cakewalk compared to the devastation, destruction, and destitution the global economy will face in the next downturn – trade will be the least of our worries!

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Read more from Andrew Moran or comment on this article.

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