The biggest problem for banks: they aren’t very good at making money

Another grim day for markets yesterday.

Most risky stuff sold off (with the notable exception of gold miners). Most “safe haven” stuff jumped (gold, the yen – a “safe haven” currency, and developed-world government bonds – with the notable exception of “peripheral” eurozone debt).

Oil. Resources. The strong dollar. The negative interest rates. The potential for a US recession – it’s all getting too much for poor investors.

Now it’s the banks that are freaking everyone out…

It’s not easy making money when you’re a banker

The global banking sector bore the brunt of yesterday’s big sell-off. Credit default swaps (CDS – remember them?) on various banks, Deutsche Bank in particular, “spiked to three-and-a-half-year highs”, notes the Financial Times.

A CDS offers a way to insure against a bank going bust – if it doesn’t pay out on its bonds, the CDS will pay out. So when things are looking wobbly in the sector, a CDS represents an asset that goes up when the banks go down. It works as a hedge, or as a good way to bet on more turmoil in the banks.

Meanwhile, the cost of Italian, Spanish and Portuguese debt headed higher, while various German bonds “set new record negative lows”. In other words, it’ll cost you more to enjoy the safety of a German bond that it ever has before.

Wunderbar!

Anyway – what’s got everyone worried this time? There are a few things. And they mostly boil down to central banks.

Firstly, let’s talk about negative interest rates. Negative interest rates are a bit of a problem for the banking sector.

At their most basic level, banks make money by borrowing in the short term, and lending over the longer term. So they make profits based on the difference (the “spread’, to use the jargon) between short-term borrowing rates and long-term ones.

So rising interest rates – as promised by the US Federal Reserve – were something for the banks to look forward to. The promise of higher future rates would increase the gap between today’s rates, and the rates ten years from now (ie the “yield curve” would steepen).

That’s not on the cards now. The Bank of Japan has taken interest rates negative. Europe’s already done it. And now all the talk in the US is shifting towards when the Fed will trim rates again, not when we’ll see another rise.

So that’s a problem for banks’ profit margins.

Secondly, there’s the prospect of recession, implied by current panicky central bank actions. Whether we’re heading for one or not (it’s certainly more than possible) a recession implies higher bad debt levels, which again is bad news for banks.

Thirdly – and perhaps most pertinently, particularly in Europe – there’s the vexing question of who pays next time we have to bail these damn things out?

The trouble with the banking sector

You see, European banks have been in trouble for a long time, and the process of cleaning up their balance sheets is far less advanced than in the US or even the UK, as James Ferguson of MacroStrategy Partnership regularly points out.

None of this is particularly new. As The Wall Street Journal puts it: “Banks don’t face an acute crisis as in 2008. It is something that in some ways looks worse: a chronic profitability crisis that makes it impossible for banks to build up barely-adequate capital bases.”

So your basic problem here is that the banks still need to do a lot of restructuring work. But if they are doing it against a backdrop of minuscule rate spreads and a potential recession – well, that’s going to take its toll.

And if they can’t keep topping up their capital via profits, then they might end up needing to stop paying dividends, or coupons on junior debt, or they might need to issue equity. Or, as the Wall Street Journal notes, they might have to “make riskier loans that pay more but have a higher chance of default”.

Hence the fear. Sure, it’s hard to see a bank going bust in a world where central banks have already made it clear that they will keep banks liquid. Whether you’ll make any money by investing in the things is quite another matter. And the last thing the world needs is the monetary transmission mechanism being gummed up again into the bargain.

So what’s doing well in this environment? Gold, of course. Hope you’re still hanging on to yours. It’ll provide some small consolation for the falls in the rest of your portfolio. But more to the point, it’s worthwhile insurance against things really going pear-shaped.

Merryn and I discussed gold, the joys of squinting at your portfolio through your fingers in horror, and the madness of central bankers in the most recent MoneyWeek podcast – you can listen to it here.