ANATOMY OF A BANK LENDING CYCLE

ANATOMY OF A VERY EXPANSIONARY BANK LENDING CYCLE

There has been an extraordinary expansion of Canadian commercial bank balance sheets in the last 15 years post Great Financial Crisis (GFC), which has far outpaced the country's GDP growth. The Office of the Superintendent of Financial Institutions (OSFI), an independent agency of the Government of Canada, provides the following consolidated bank financial data that highlights this extraordinary post-GFC expansion:

·         Total assets have tripled from C$ 3.5trn to C$ 10.5trn

·         Household and Commercial Lending has quadrupled from C$ 1.3trn to C$ 5.4trn

·         Net Equity has increased from C$ 78bn to C$ 342bn (375%)

Canada is one of the 5 SNACS countries (*) which have all experienced a significant rise in private sector indebtedness during an extremely low interest rate environment post GFC. For example, the Australian APRA website shows a similar trend in the balance sheets of the 4 major banks that dominate the Australian economy:

·         Loans to nonfinancial businesses have tripled to A$ 688bn

·         Residential Loans to Householders have increased by 320% to A$ 1.1trn

·         Total residents’ loans and leases have increased by 286% to A$ 2.5trn

These huge loan expansions open up their respective economies to potentially serious risks if unaffordability becomes an issue through tighter monetary policy, negative real wages or a rise in unemployment. To highlight these risks, this research demonstrates the various stages of a debt cycle of excessive bank lending, drawing on the recent Spanish banking sector, which was one of many banking crises that have occurred in the last 30 years.

LOAN GROWTH AND EQUITY

In the 2000’s, like many other countries, the Spanish banking sector witnessed a huge increase in assets as low interest rates set by the ECB led to a rise in household lending to buy real estate. The Spanish banking industry was dominated by 5 banks - the chart shows the sum of their Spanish operations (taken from their individual balance sheets).

Figure 1. Spanish Bank Balance Sheets

In summary, between 2002 and 2010,

• Loans increased by €1trn (415%)

• Total Deposits increased by €833bn (380%)

• The Loans/Deposits ratio increased from 112% to 124%

• The shortfall gap between Loans and Deposits was met by a €345bn increase in bank issued debt.

• Net equity increased by €76bn (280%)

• Equity to Total Loans in 2010 seemed a very respectable 8.4%.

Something similar occurred  in Ireland (and of course in the US and UK), and unsurprisingly both countries experienced a consequential house price boom as their householders borrowed huge amounts of money to buy real estate.

Figure 2: Irish and Spanish Bank Prices (The Economist)

Because banks have to maintain a minimum equity capital ratio to weighted risk assets (i.e. loans), the increase in lending was accompanied by a substantial rise in equity in percentage terms. However in €uro NOMINAL terms, the equity increase was dwarfed by the increase in the loan book.

NON-PERFORMING LOANS (NPLs)

The ECB started hiking interest rates in Sep05, lifting them from 2% to 4% in Jun 07 - this was hardly a huge tightening of Monetary Policy given that Spanish interest rates were above 8% before the convergence of EU interest rates in 1998. But this small rate increase was enough to reduce the pace of loan growth and cause a significant rise in non-performing loans (below is consolidated from the financial report and accounts from the 5 banks):

Figure 3: Spanish Non Performing Loans and Provisions

If there has been a significant rise in asset values sustained by ever increasing debt, then there needs to be continued debt growth in order to maintain those asset prices. However, as soon as debt growth declines, then the demand for those assets (in this case residential real estate) also declines.

At this point, those householders who can no longer afford to maintain their properties start selling them, as do speculators who bought for the quick profit gains. This selling occurs as new construction continues, leading to an excess of inventories. This then leads to a price decline spiral - see Figure 2

The chart below shows how the growth in Spanish mortgages collapsed when the ECB started hiking rates, which then led to a low inflation environment.

Figure 4: Interest Rates, CPI and Spanish Mortgage Growth

The problem in Spain started once rates hit 4% (where they remained for 18 months). Bank credit declined and NPLs started rising, hitting a peak of €191.5bn, equivalent to 11.4% of Total Loans. This sum was MORE than total net Equity Capital of the 5 banks.

This demonstrates the fatal flaw in banking regulation that still exists today.

When there is a significant rise in loans, then only a relatively small amount of that new lending has to not perform to wipe out the equity capital of the entire banking system. Having collateral in the form of housing stock, even if Loan to Values are 60-90%, makes absolutely no difference – there was little bid for Spanish real estate and house prices collapsed (see Figure 2), leading to loans becoming undercollateralized (“negative equity”). This is what occurred in numerous real estate asset bubble banking crises over the last 30 years (Japan 90s, UK & Scandi 91/92, GFC and Peripheral countries (ex-Italy) etc.).

Not only is this fatal flaw of undercapitalisation in banking regulation backed by evidence from various banking crises, but the ex-Bank of England governor Mervyn King has also provided his views on the problem in his book "The End of Alchemy" (pages 257-259). After being complicit in allowing the British banking system to fall into the same trap, he has opined that the current regulations of capital to weighted risk assets is not robust enough. He believes that an equity to total assets and a true leverage ratio would be a better indication of a bank’s risk and calls for higher capital buffers.

Unsurprisingly his words have fallen on deaf ears as his successor was none other than Mark Carney, who led the Bank of Canada in the period when their own banking sector started ballooning their balance sheets……

As an aside, the situation is often made weaker when banks hold substantial amounts of Goodwill on their balance sheets. In Spain in 2010 this amounted to ~23% of capital, which falsely inflated their resilience - the same was the case in Ireland, UK, US, Italy etc. A quick glance at one of the large Canadian banks shows net equity of C$111bn and Goodwill of C$17.5bn (16% of equity) – that reduces the equity/loans ratio by 2 percentage points….

BANK RESCUE AND CONSEQUENCES

Following the rise of NPLs, Spanish banks had to raise fresh capital, obtained state support, the weaker ones were merged into larger ones and a significant amount of loan “evergreening” took place (Spanish Banks opened real Estate subsidiaries) and a whole set of accounting gimmicks were undertaken (especially in terms of reserve management). The combination of these actions, together with profits generated from the enormous Bonos carry trade, eventually got the industry back on its feet. However, as can be seen from the Figure 4, residential mortgage growth has been very weak ever since (NB the Bonos carry trade is not dissimilar to the Japanese carry trade undertaken in the 90s when banks levered up on receiving long dated fixed rate swaps).

The real estate market declined from 2007 to 2014 and still has not recovered to the lofty levels of 2007. Spanish real GDP remained below 1% between Dec08 and Dec14, often registering negative prints. Debt deflation took hold - Core CPI averaging 0.9%yoy in that period and Spanish Government Debt/GDP ballooned from € 416bn to € 1.35trn (39% to 131%).

Figure 5: Spanish Inflation

Figure 6: Spanish Government Debt as a percentage of GDP

BACK TO THE PRESENT DAY

Commercial Banks in some countries have seriously expanded their balance sheets as they have made sizeable loans to Household and Corporates. This has been accompanied by large increases in real estate prices. Compare the real price appreciation of Real Estate in New Zealand, Australia, Sweden and Canada with those in the US and UK

Figure 7: Real House Prices (The Economist)

A true definition of inflation is the amount of money required to buy a good or service over time. Whilst undoubtedly there has been a construction boom in all 4 countries, there has been an even larger increase in the money to buy those assets, resulting in the real estate price rises.

That money increase has been in the form of debt, as can be seen by the 15 year trends in Household leverage to GDP (left below), which for Australia, Canada and New Zealand has exceeded the levels seen in the US in the GFC. The reason why this is now an issue is that thanks to tighter monetary policy, credit growth is slowing and in the cases of NZD, SEK and CAD it has now collapsed (right below).

Figure 8: Household Debt/GDP Figure 9: Annual Household Credit Growth

The lessons from past periods of excess credit growth suggest that the length of time that a Central Bank maintains tight monetary policy is key for the economy and banking industry – if rates are held too high for too long, then this will not just be followed by a mild recession, but a deeper and longer lasting recession.

Central banks allowed these states of overindebtedness to occur because they were transfixed by low Consumer Price Inflation, ignoring much higher debt-fuelled Asset Price Inflation. Worryingly, but very understandably given their CPI targets and failure to predict the rise in inflation, recent Central Bank minutes have highlighted that inflation will take a long time to decline, and that they are prepared to keep policy tight (and even hike rates if need be), despite the already collapsed growth in private sector debt.

A recent Riksbank report is worth a read as it highlights some trends that were present in past periods that led to banking problems - you just need to know what to look for. For example, the chart below shows how “all in” the banking sector is on real estate. Not only is the lending to households overwhelmingly (>85%) linked to real estate (as is the case in most countries), buts so is their lending to businesses.

Figure 10: Swedish Banking Sector - Loan exposures

Some Central Banks have maintained high interest rates as lending growth has collapsed. The longer this tight monetary policy persists, the more mortgages (or maturing mortgage fixings) will set at higher rates and the longer that indebted consumers will feel under strain, keeping the growth in credit at low levels.

For economies with highly leveraged private sectors and bloated and undercapitalized banks, an extended period of unchanged rates (justified in the eyes of the inflation gazing Central Banks) will heighten the risk of rising Non-Performing Loans. Such economies need credit growth to keep the engine running otherwise unemployment can rise smartly from weak consumption and declining business activity.

If Central Banks remain on hold for too long and the first signs of this starts to happen, then equity markets (especially banking stocks) will decline much quicker and deeper than people expect.

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(*) SNACS = Sweden, New Zealand, Australia, Canada and South Korea

DATA SOURCES

All data provided is publicly available.

Bank Balance Sheet Data:

-          Bank’s own balance sheets on respective bank websites

-          Office of the Superintendent of Financial Institutions (OSFI)

-          Australian Prudential Regulation Authority (APRA)

-          Bank of Spain

Economic and Debt Data

-          Bloomberg

-          Bank of Spain for Debt and regional debt not disclosed as part of EDP

-          The Economist for data on House prices

Riksbank Minutes and November MonPol Report