Can the next financial crisis be avoided?

High-level seminar of the European Political Strategy Centre on the European Deposit Insurance Scheme (EDIS). From left to right, Mejra Festić, Vice-Governor of the Central Bank of Slovenia, Thierry Dissaux, Chairman of the Board of the Guarantee Fund for Deposit and Resolution, Dirk Cupei, Head of the Department “Financial market stability” at the Association of German Banks, Alex Kuczynski, Coordinator of the EU Committee of the European Forum of Deposit Insurers (EFDI), Giuseppe Boccuzzi, Director General of the Italian Interbank Deposit Protection Fund, and Joseph Delhaye, Chairman of the Guarantee Deposit Association Luxembourg. (Date: 03/12/2015, Location: Brussels – EC / Berlaymont, © European Union , 2015/Source: EC – Audiovisual Service/Photo: Etienne Ansotte).

The descent of prices in the world capital markets continued almost unhindered this past week and only last Friday financial, oil and commodity values gained some limited grounds. Altogether however, the major stock markets have erased trillions off their capitalization since last June, when the dark clouds gathered above the Chinese mega-cities of Shanghai and Shenzhen. Presently, the downfall continues being particularly costly in the financial and the oil – commodities markets.

As it appears, the selloff of Chinese stocks was just the beginning. Now, it’s the major western banks which head the fall in the capital markets. The reason is that they have heavily invested other people’s money in highly risky assets. Such placements yield strong returns in the short-term, but are exposed to the chilly winds blowing from whatever direction in the world financial markets. And those winds are now felt by all, including the dreadful geopolitical risks in regions like the Middle East and the Sea of China.

Heading to a new crisis?

For example, the mighty Deutsche Bank sits on a pile of risks amounting to around €50 trillion in the derivatives markets and another €10tn in government debt. As for the American banks, they are heavily exposed to corporate and developing country debt and of course they have an, impossible to estimate, exposure to all kinds of derivatives.

Now, we learn to our dismay that all the major western banks are also heavily exposed to the oil and other commodities markets. Quite naturally, when those markets plummet, the banks’ losses in derivatives and other linked products may be multiple. No one can estimate how much those losses can amount to. That’s why the regular investors, who manage pension and other very long-term funds are alarmed and are now unloading banking stocks en mass.

‘My death will cause your death’

Of course, this is a double cutting edge action and even those standard savers are forced to a large extent to support the tricky games of the banks and stop uploading the lenders’ stocks. This interconnectedness of the fates of savers – investors with those of bankers is one of the sticking new features of our brave new world. The bankers’ motto is nowadays similar to Sampson’s last words, “O God…Let me die with the Philistines!”, meaning in free translation ‘my death will cause also your death’.

As things stand now, the ‘too big to fail’ banks are indirectly asking the monetary authorities to keep feeding them with more zero cost money. Presently, the task to supply the banks with additional newly printed cash has passed to the European Central Bank and the Bank of Japan, but nothing compares with the Fed sizes and generosity. On top of that, the lenders are extremely negative over the possibility that the American central bank may start offering negative interest rates for the deposits the lenders place with it. Janet Yellen, the Fed President, when asked by the American lawmakers if the Fed would look into negative interest rates, answered “I wouldn’t take those off the table”.

The ‘system’ of the banks

During the past six years the Fed has ‘supplied’ the banks with $4.5tn. From 16 December 2008 until 16 December 2015 the Fed charged for all that money anything between 0.0% to 0.25%. As from last December it charges anything between 0.25% – 0.50%. Obviously this abundant ‘money for nothin’ policy was the famous Washington treatment to repel the reverberations of the 2008 financial Armageddon.

However, this ‘money for nothing’ strategy cannot go on forever for obvious reasons. The first and most important one is that money must cost something noticeable. The universe of ‘money for nothin’ is a fantasy which cannot last long. The second and more pressing problem is that, if a new crisis comes about, the Fed will be almost totally out of ammunition to deal with it, because it would be a totally impossible reaction to draw the monetary accommodation (quantitative easing) line beyond the current float of $4.5tn.

To straighten this anomaly, last December the Fed decided as mentioned above to start charging the banks with 0.25% – 0.50% for the $4.5bn they have got. On top of that, the monetary policy decision makers said they will proceed to four more interest rates rises during 2016, presumably of the same magnitude. This would have brought those interest rates to 1.25% to 1.50% by December 2016.

Now, Yellen says that apart from all that, the Fed can charge negative interest rates for the money the banks deposit with it. At this point, it must be clarified that the banks at times ‘park’ with the Fed their excess liquidity expecting a positive return. Now this easy profit making possibility may disappear and even entail some cost.

Reducing Fed’s exposure

With all those policy changes, the Fed expects that its outstanding credit line to banks of $4.5tn would be reduced to lower levels. Predictably, the banks would return a good part of the money they got for free, because now they are paying something for it, albeit negligible. On the same line of action, the Fed left to be understood that it wouldn’t refinance all the maturing debt.

Obviously the markets, led by the banks, are now reacting quite negatively to those new monetary policy lines. Naturally, if one is accustomed to free treatments, one doesn’t like at all to start paying for the consumption. So the banks triggered the selloff in the capital markets that plagued almost all and every stock from the beginning of this year.

New environment

Up to December 2015 the western financial system, headed by the big banks, had stomached the Chinese crisis but seemingly it couldn’t or it didn’t’ want to digest the new changes of the Fed’s monetary policy at the same time. The new quantities of free money provided by the European Central Bank and the Bank of Japan do not seem enough to replace the Fed’s bonanza.

So, there is a strong possibility that the major western lenders, as they are currently structuring their business, are unwilling or incapable to operate in the new monetary environment of a restored normality, as far as the value of money is concerned.

They refuse normality

That’s why the banks vehemently oppose any attempt by the Fed to normalize the trade. At the same time though, the Fed cannot reverse its policies, just a few weeks after it introduced them. The impasse is then real, despite the fact that the money markets ‘predict’ a full policy reversal, with no further interest rates increases.

Irrespective of the fact that this may be the result of the banks’ unwillingness or inability to comply, the outcome will be the same; the next and more devastating financial catastrophe may be around the corner. Unfortunately for us all, the governments on both sides of the Atlantic Ocean have changed nothing in the regulatory environment of the financial industry and the banks have manage to retain a size that reaches colossal dimensions.

As a result, the domino effect from a banking fallout would reach the smallest corner of the real economy. Without fast growth in the developing world the Atlantic banking industry will suffer. In reality, there will be no place to hide under this new Armageddon, which will be bolstered by the geopolitical hazards.