Fending off potential financial market instability

The Annual Report of the Bank of Mauritius (BoM) for the year ended 30 June 2015 is cautiously reassuring about the state of health of our banking system.

Its Banking Supervision Department states that, at the overall level, commercial banks held capital amounting to 17.2% of their total risk assets at the end of June 2015, higher than the minimum requirement of 10%. This ratio of capital to risk assets was 17.3% at the end of June 2014. This figure relates to the aggregate level. It is reassuring nevertheless that banks collectively have a safe margin of capital to hedge against loans they’ve given should the loan quality deteriorate.

Banks’ bad loans increased from Rs24,641 million at the end of June 2014 to Rs33,505 million at the end of June 2015, or by as much as 36%. This is not reassuring. Either they were lying concealed from before or there has taken place a significant recent spurt in banks’ non-performing loans. The BoM’s Financial Stability unit states that the ratio of non-performing loans to total loans went up during this period from 3.9% to 4.9%, not as bad as in quite some other places.

The healthy capital adequacy ratio, even when seen against the backdrop of lately increasing amounts of non-performing loans, appears to indicate that there is a safety valve in the banking system as a whole to face minor deteriorations in the situation.

At the international level

It will be recalled that, beginning with China over fears of its economic slowdown at the start of this year, stock markets the world over have seen share prices tumbling. The wave that surged at that time has not reached the shore calmly. It has come down hardest on bank shares.

Since January 1st, American financial stocks have gone down by 19%; Japanese bank shares plunged 36%; Italians’ by 31% and Greek banks’ by 60%. The European banking index fell by 24% over this short period, plumbing by as much as it did when the Euro-zone was threatened with disintegration back in 2012.

In Italy, the share price of the world’s oldest commercial bank, Monte dei Paschi di Siena, a bank which has for long been under intensive care, has fallen by 56% so far this year. Société Générale and Deutsche Bank saw their share price tumble by 10% within hours last week. British bank, Barclays, and Swiss bank, Credit Suisse, were also taken in by the sweeping storm.

Whither bound?

It looks as if the global financial sector is still dogged by the loss of confidence it inspired when the international financial debacle took the stage in 2007. The least adverse wind which blows over it can bring back, it appears, strong apprehensions about its good health.

It may be recalled that financial institutions suddenly found themselves at the time without the capital to pay up for all the bad loans on their books. Had governments not bailed them out with taxpayers’ money, not only would they have collapsed with all the negative implications this has for depositors’ and investors’ money. Their fall could also have precipitated the downfall of various sectors of economic activity they were supporting with their loans.

Between then and now, progress has been made to beef up the financial institutions so that they can better withstand shocks than it was the case in 2007. Banks in particular have had to raise significant amounts of additional capital from shareholders and bondholders under what are called Basel III rules. Regulations have been made tougher. Euro-zone banks alone have raised more than $280 billion of additional equity after the financial crisis of 2007.

The European Central Bank, which has taken over the charge for supervising European banks since 2014, has required banks not only to put in additional equity. It has also required them to adopt a “bail-in” system whereby it is not taxpayers who will bear the brunt of bank failure, as it happened last time, but senior bondholders and bank depositors as well if the bank fell short of capital due to bad loans having been given.

The situation appears to be less perturbed in America, compared with Europe, because they acted more swiftly to do the repairs after the 2007 crisis. Despite this, American lenders’ shares are already down by 19% so far this year. In Europe, banks have plumped up their core equity from 9% in 2009 to 12.5% in 2015.  Troubled banks in the eyes of the current storm have quickly cut themselves down to size or have suspended dividend payment to look well-behaved.

Uncertainty still stalks on the stage

There are three major reasons why serenity is not quickly being restored to the financial markets worldwide.

First, the world economy is still groping for strength. The Chinese slowdown, accompanied by unsteady and negative growth in different other economies, is not really confidence-building. Normally, banks do well when the economies are growing; they perform miserably when that is not the case. Investors know this and they are being careful by opting out of bank shares.

Second, plunging commodity prices do not augur well for companies’ (clients of banks) future profits. Weaker corporates with mounting debts will imply more bad loans which the banks may have to pick up, worsening their profitability. Investors should then expect lower returns from banks. They may even get bad surprises if, confronted with the stress, banks were to reveal more bad loans than they actually show in their books to paint a current rosier picture of their financial health.  The IMF estimates that non-performing loans and other debt in Europe was already around Euro 1 trillion at the end of 2014.

Third, wide-ranging political uncertainty across the world makes it more difficult to contemplate how cohesively the world will respond to yet another debt crisis after that of 2007, if it came about. How far will politicians dare impose the bitter pill on voters if the so-called “bail-ins” of financial institutions had to kick in, involving loss of depositors’ money, especially in those countries whose banking systems are the most prone to serious disaster, for example, Italy with bad loans 18% of its total bank loans?

Conclusion

We in Mauritius are not insulated from the risks which have found expression in the first part of this year with investors walking out of financial companies’ stocks in several parts of the world. Were a renewed bout of market uncertainty to shake once again the foundations of the global economy, there is no doubt we’ll take up part of the knock along with others. Any big write-down of bank debts will take away the calm with which countries should navigate the rough seas unleashed by the loss-of-confidence factor. If the surgery has to be done, it would be preferable to extirpate the malady without killing the patient.

* Published in print edition on 19 February 2016