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$220b non-performing bank loans. How much will become bad debts?
May 21, 2020
In the last recession, Westpac had to be rescued by Kerry Packer and ANZ nearly had to be rescued. In recessions, bad debts tend to rise sharply. And now, it is likely that economic depression is ahead. This puts Australian banks at high risk of major losses and possible failure.
When a bank loan becomes a bad debt, if the loaned funds are not recoverable (eg if the borrower goes into bankruptcy), the loss of capital by the bank, is a loss on the profit and loss statement ..... and an income loss by the bank, causes a reduction of shareholder funds. Since banks are highly geared businesses, it can only require a modest proportion of bad debts to drive a bank into insolvency.
So let us look at the article in AFR 18/5/2020 "Why bankers hope they'll avoid a bad debt tsunami".
"There are 7.7 million Australian workers on some form of government welfare. Repayments have been frozen on 10 per cent of mortgages and 15 per cent of SME loans. Bankers have been left with about $220 billion in loans that aren't being serviced. Little wonder then that some analysts are querying whether the $5 billion that the big four banks have set aside to cover the losses they'll sustain from the economic collapse triggered by the pandemic will be sufficient. Now, bankers continue to emphasise that they won't know the extent of their problem loans for another month, when they start contacting the home owners and small business owners who opted to defer their loan repayments."
BB: And of course, at this point, the banks cannot know how big their bad debt book will be. There are far too many uncertainties at this point.
eg How long with this COVID-19 epidemic continue? No one can answer that yet. We do not even know if the vaccine, that might allow us to resume some form of "normal life", is even possible yet.
eg And how deep will this coming economic recession/depression be? Far too many unknowns yet to accurately estimate that at this point.
And yet, it does seem highly likely (see other blogs on this web site) that a deep economic depression is now likely. Therefore, it is probable that VERY tough economic times ahead for Australia - and therefore, it seems probable that very tough times are ahead for Australian banks.
So where should we look for some views of what might be ahead? A former central bank governor seems like a useful place to turn to, seeking a view on this.
Former governor of the Bank of England has warned us (02/06/2016) that periods of instability and failure are a feature of our form of banking system.
The point of the following article, is to provide a perspective from the recent past governor of the Bank of England, to respond to those who argue that Australia’s banking system cannot fail. Mervyn King’s answer is that our banking system is “designed to fail.” So it is only a question of when our banks next fail. Just remember that in the last Australian recession in the early 1990s:
Will there be another huge financial crisis? As Hamlet said of the fall of a sparrow: "If it be now, 'tis not to come. If it be not to come, it will be now. If it be not now, yet it will come – the readiness is all." So it is with banks. They are designed to fall. So fall they surely will.
A recent book explores not only this reality but also a radical and original solution. What makes attention to this suggestion even more justified is that its author was at the heart of the monetary establishment before and during the crisis. He is Lord Mervyn King, former governor of the Bank of England. His book is calledThe End of Alchemy.
The title is appropriate: alchemy lies at the heart of the financial system; moreover, banking was, like alchemy, a medieval idea, but one we have not as yet discarded. We must, argues Lord King, now do so.
As Lord King remarks, the alchemy is "the belief that money kept in banks can be taken out whenever depositors ask for it". This is a confidence trick in two senses: it works if, and only if, confidence is strong; and it is fraudulent. Financial institutions make promises that, in likely states of the world, they cannot keep. In good times, this is a lucrative business. In bad times, the authorities have to come to the rescue. It is little wonder, then, that financial institutions have become so large and pay so well.
Consider any large bank. It will have a wide range of long-term and risky assets on its books, mortgages and corporate loans prominent among them. It will finance these with deposits (supposedly redeemable on demand), short-term loans and longer-term loans. Perhaps 5 per cent will be financed by equity.
What happens if lenders decide banks might not be solvent? If they are depositors or short-term lenders, they can demand their money back immediately. Without aid from the central bank, the only institution able to create money without limit, banks will fail to meet that demand. Since a generalised collapse would be economically devastating, needed support is forthcoming. Over time, this reality has created a "Red Queen's race": governments try to make finance safer and finance exploits the support to make itself riskier.
Broadly speaking, two radical solutions are on offer. One is to force banks to fund themselves with far more equity. The other is to make banks match liquid liabilities with liquid and safe assets. The 100 per cent reserve requirements of the "Chicago plan", proposed during the Great Depression, is such a scheme. If liquid, safe liabilities finance liquid, safe assets – and risk-bearing, illiquid liabilities finance illiquid, unsafe assets – alchemy disappears. Finance would be safe. Unfortunately, the end of alchemy would also end much risk-taking in the system.
Tax on alchemy
Lord King offers a novel alternative. Central banks would still act as lenders of last resort. But they would no longer be forced to lend against virtually any asset, since that very possibility must create moral hazard. Instead, they would agree the terms on which they would lend against assets in a crisis, including relevant haircuts, in advance. The size of these haircuts would be a "tax on alchemy". They would be set at tough levels and could not be altered in a crisis. The central bank would have become a "pawnbroker for all seasons".
The value of liquid assets would then be known. They would consist of reserves at the central bank plus the agreed collateral value of any other assets. In the long run, argues Lord King, liquid assets, so defined, should match an institution's liquid liabilities, defined as loans of a year's maturity or less.
This scheme has several advantages. First, it recognises that only the central bank can create needed liquidity in a crisis. Second, it offers a path to a world without alchemy. Third, it offers an option between the status quo and the extreme of 100 per cent reserve banking. Fourth, it eliminates moral hazard, since the penalty on obtaining liquidity would be defined in advance. Fifth, it exploits today's circumstances, including the reserves created by quantitative easing and the infrastructure created by central banks to assess and manage collateral. Sixth, regulation could then be reduced to just two rules: a higher maximum leverage ratio (of at most 10 to one) and the rule that the pledgeable value of assets at the central bank must exceed the value of liquid liabilities.
In spring 2015, the value of the collateral of UK banks at the BoE was £314 billion ($629 billion) and of bank reserves was £317 billon ($635 billion). This makes total liquid assets of £631 billion ($1.3 trillion). That is to be compared with deposits of £1.82 trillion ($3.6 trillion). Over time, this gulf could be eliminated. The BoE should make existing reserves permanent. It could raise reserves by further permanent increases in the monetary base. Finally, it could agree the pledgeable value of more assets.
This is a radical and interesting set of proposals. If the proposed rule were in effect, the only people with an interest in "running" from a bank would be long-term lenders and shareholders. But if share prices did crash and long-term loans dried up, management would be under the right sort of pressure. It would also give time to resolve the financial position of institutions in difficulty. If equity were insufficient, then these losses would fall on longer-term creditors in a pre-defined order.
This scheme has drawbacks. Pledgeable values would have to vary with economic conditions, which could create a degree of stress. But it is a valiant attempt to discipline a financial system that makes promises it cannot keep. At the very least, the cost of making those promises would be made predictable and transparent. Alchemy would be less lucrative; banks would be better capitalised; and runs by short-term creditors should cease. These ideas deserve open-minded consideration.
9/May/2020 Mervyn King on the COVID-19 crisis. " 'Get a grip': Mervyn King warns of Covid-19 threat to UK economy"
Mervyn King, the Bank of England governor during the financial crisis, has warned that Britain’s economy will take longer than expected to recover from the coronavirus pandemic. Launching an attack on the government over its emergency loan guarantee scheme for businesses struggling during the crisis, Lord King said ministers needed to urgently “get a grip” on the situation to prevent lasting damage to the economy. In an interview published a day after the Bank’s current governor, Andrew Bailey, said the British economy could bounce back much faster than it did after the 2008 crash, he said: “It is silly to make precise numerical forecasts at this stage. What I will say is that there is too much confidence in a quick V-shaped recovery. It will take longer.”
I'm busy working on my blog posts. Watch this space!