Banking is in decline, but is it terminal?

The world’s banks are under siege. Cryptocurrencies threaten to undermine banking altogether. Banks’ lending activities are attracting ever less interest thanks to central bank policies, and now negative rates are on the cards. Governments are borrowing ever more money, expecting banks to buy their bonds. And Covid-19 has unleashed an economic crisis temporarily kept at bay by unreliable politicians. Are bank stocks in for their final bust? Or will our banking system evolve and survive?

Let’s explore those questions today. But first, a story…

Many years ago, I attended the Hamburg Harbour Festival with my mum. We got tickets on a schooner called the Ide Min. Sailing up and down the river amongst huge tall ships and many other smaller vessels was incredible.

The acting captain of the Ide Min, a Danish Viking of a man, invited me to steer. Which seemed unwise given nobody could see what was going on beyond the huge bow of the ship.

I shook my head at the invitation and pointed upwards at the rigging, saying I wanted to go up there instead. I was joking. But he said yes…

The next hour or so – I have no clue how long it actually was – is one of the most memorable of my life. They gave me a harness and that was it, off you go. With half of Hamburg and the whole crew watching, up I went.

The only iffy bit was getting through the hole in the crow’s nest floor. But once I was up, I discovered myself swaying amongst the rigging of other tall ships. A bunch of trainee Russian Navy sailors passed a few dozen metres away, a little higher than me, setting sails.

Meanwhile, the reason I’m telling you this story was playing out below…

A man approached my mum, asking about me and my climb. She explained I was working weekends as a flying trapeze artist, so the height wasn’t an issue. They got to talking and the man asked what I wanted to do after school. My mum mentioned I’d just received a university scholarship from the investment bank Goldman Sachs.

The man looked up at me climbing down the rigging and replied, “Oh, well, he can’t really fall any further then, can he?”

My mum thought this was hilarious.

I didn’t become a banker in the end. The scholarship’s internship was quite enough of that.

And I’m beginning to think avoiding the industry was a rather good move. The question is whether investors should do the same. Because banking has quite a way to fall just yet…

Is banking terminally ill?

It’s worth mentioning just how plausible a long-term decline in banking is. After all, it has happened in Japan and Europe.

A few months ago, the European bank stock index hit all-time lows. The Japanese Topix Bank Index is below where it was in 1983.

The point is, banking industries really do experience epic long-term declines. And the reasons why this happens are looking rather similar to the current news…

1. Low interest rates

Banks lend money at interest rates. Lower interest rates mean less profit for banks.

At least, that’s how the story goes. But it never made much sense to me…

Banks don’t just lend. They actually borrow too – that’s how they finance themselves. The profit margin is the difference between their cost of getting money and the interest they get on lending that money out. So low rates in and of themselves aren’t necessarily a reason for banks to make less money overall.

If it costs a bank 5%, but they lend at 7%, that’s the same 2% profit margin as borrowing at 1% and lending at 3%. Depending on how you measure it, the profit margin is actually higher.

Perhaps the explanation lies elsewhere…

2. Lower real interest rates

Inflation is a key part of the calculation for interest rates. If you borrow money at 4%, but inflation is at 6%, then it’s actually cheap to borrow money. The value of your debt is falling faster than the interest it costs you. Economists call this a negative “real” interest rate.

What banks are experiencing at the moment is inflation higher than interest rates. So, adjusted for inflation, their lending activities might not actually be making real money.

Central banks, in trying to bring about inflation and in trying to spur on the economy, are creating economic conditions that cost banks their profits.

And this could get dramatically worse in coming years if inflation picks up, but central banks don’t raise interest rates. Then real interest rates would fall, crushing banks’ true profits.

3. The value of collateral in a low-inflation world

Banks get their pound of flesh in the end. If you default on a loan, they can take your home, or your car, or whatever you’ve pledged as collateral for your loan.

But a key part of this pledge is the value of the asset. If, for example, house prices are rising, then the risk to the bank in making a loan is dramatically reduced. Worst case, if you don’t pay back the loan, the bank will recover its money by taking and selling your home. Which has gone up in value enough to cover the debt.

In such a world, with rising house prices, defaults don’t really worry bankers. People can usually just sell their home before they default on the debt. That, according to my incomplete PhD, was the true cause of the 2007 sub-prime crisis. Banks gambled that the value of house prices would cover up their dodgy lending.

But what if house prices aren’t going up? Which is what happened in 2006 in the US. Then, suddenly, the risk of lending doesn’t just depend on the value of the collateral (the house you pledge in a mortgage). It depends on the default probability of the borrower. A risk which was dismissed under rising house prices is back in the calculation.

This is why bank lending suddenly contracts when house prices fall. Banks recognise the risk of losing money on a loan default and being unable to recover it by taking possession of the house.

In a low inflation world, like Japan’s, house prices don’t go up. This means banks have to be more careful in their lending. At that means less debt and less profits for banks.

4. Covid-19 guarantees will unwind eventually

The pandemic supposedly required a government-imposed lockdown. And the government-imposed lockdown required extensive bailouts to prevent economic chaos.

But what happens when we unlock the economy?

How many of the banks’ loans to homeowners, landlords and businesses will go bust? We simply don’t know. But that shock is now baked into the banking system’s future. Whether it’s a gradual hit or a shock doesn’t matter. Banks could be in for a post-Covid surprise.

5. Cryptocurrencies undermine the need for banking itself

Banks don’t just borrow and lend. They are also our door to the global payment systems network.

But what if we didn’t need a global payment systems network any more? What if fintech companies, cryptocurrencies, distributed ledger technologies and blockchain simply take over instead?

What would the banking system look like if borrowing and lending really were its only real activities?

Well, it’d be a hell of a lot smaller.

6. Is another bailout viable?

One reason banks might seem like a good investment is that they are too important to let fail. Given the government stands behind the banks, what could possibly go wrong?

Well, I’m not so sure governments will be willing to fund another large-scale bailout in the next financial crisis. Because they might not be able to.

Debt-to-GDP ratios are out of control already thanks to Covid-19. The next time the banking system gets into trouble, a 2008-style bailout may not be so politically popular…

These are just some reasons why I’m worried about bank share prices in “the West”, where they haven’t yet suffered the decline seen in Japan and Europe.

Do you think owning bank stocks is not worth the risk?

Nick Hubble
Editor, Fortune & Freedom