Humility and the willingness to unlearn the lessons of the past
Lesson #7
The final lesson is the importance of humility and a willingness to unlearn the lessons of the past, especially in relation to banking and macroeconomics. It is, after all, only six years since the Bank of England debunked the widely taught and held view that banks act simply as intermediaries, lending out deposits that savers place with them.
In the current context of large-scale fiscal responses to the pandemic, its will be important to see how other (so-called) lessons from the past are treated e.g. governments should budget like households, governments spend taxpayers money, deficits are evidence of over-spending/crowding out of the private sector, Chancellors have moral duties to balance the books etc.
The shape and duration of any recovery and investment returns in 2021 will depend, for example, on whether the notion that fiscal expansion is indispensable to sustain demand is fully understood or not (#4). Will 2020-21 be a watershed moment in macro understanding/policy?
In this context, I am ending this series of summary posts with a link to a recent article published by David Andolfatto of the Federal Reserve Bank of St Louis on 4 December 2020. This important article may foreshadow a shift in macro policy understanding. In line with my preferred financial sector balances approach (#2), Andolfatto questions the “government as a household” analogy and also notes that, to the extent that government debt is held domestically, it constitutes wealth for the private sector. From here, and more significantly, he argues that:
“…it seems more accurate to view the national debt less as a form of debt and more as a form of money in circulation…The idea of having to pay back money already in circulation makes little sense, in this context. Of course, not having to worry about paying back the national debt does not mean there is nothing to be concerned about. But if the national debt is a form of money, wherein lies the concern?”
“Does the National Debt Matter?” Federal Reserve Bank of St. Louis, December 2020
Wherein indeed? Delicious food-for-thought for the Festive Season and for 2021…
2020 is not a re-run of 2008 – periods of monetary expansion can and do have different drivers and implications (Source: ECB; CMMP analysis)
Lesson # 6
The penultimate lesson(s) from the money sector is that periods of monetary expansion differ in terms of their drivers and implications and that there is no stable relationship between reserves, broad monetary conditions and inflation.
Broad money in the euro area (and the UK) may be growing at the same rates as 1Q2008 but current trends are not a repeat of 2008 dynamics.
Previous CMMP analysis compared the components and counterparts of both phases. The message in the pre-GFC period was one of (over-) confidence and excess credit demand. In contrast, the current message is one elevated uncertainty and subdued credit demand.
Today’s monetary expansion reflects fiscal and monetary easing in response to weak private sector demand and rising savings (with added uncertainty regarding the extent to which rising savings are forced or precautionary). The message from the money sector supports rather than contradicts the ECB’s modest inflation expectations out to 2023.
Similar messages, but is the UK more geared to recovery?
The key chart
What is the expansion in broad money in the UK and EA telling us? (Source: ECB; Bank of England; CMMP analysis)
Lesson #5
The UK and EA money sectors have been sending very similar messages during the pandemic, albeit it with more volatile YoY trends in the UK. Broad money is growing at the fastest rate since April 2008 in both regions with narrow money’s contribution to total money also reaching historic highs.
The overriding message here is that uncertainty reigns with HHs and NFCs maintaining a preference for holding highly, liquid assets despite earning negative/very low real returns. From a counterparts perspective, above trend NFC credit and resilient mortgage demand have been offsetting weak consumer credit. But again, the dominate message is one of subdued credit demand – the gap between money supply and private sector credit demand continues to hit new highs.
“Uncertainty” and “subdued credit demand” are four key words missing from the inflation hawks’ current narrative!
Looking forward, the key unknown is the extent to which increased savings are forced or precautionary. The OBR may be too optimistic in the assumed extent of recovery in HH consumption, but there is evidence here to suggest that the UK is likely to demonstrate a higher ST gearing to a return to normality than the EA.
Debunking myths and identifying key drivers of future returns
The key chart
So far, so good – but is the wider notion that fiscal expansion is indispensable fully understood? (Source: Eurostat, CMMP analysis)
Lesson #4
In addition to helping challenge UK official forecasts (lesson #3), financial sector balances (lesson #2) have also allowed us to debunk three myths from the euro area and identify the key factors that will determine the shape and duration of any recovery and investment returns in 2021.
Back in April 2020, I challenged the arguments that: (1) painful structural reforms post-2000 were the main driver of Germany’s recovery and resurgent competitiveness; (2) existing fiscal frameworks (including the Stability and Growth Pact) were still relevant; and (3) “this crisis [was] primarily the hour of national economic policy.”
Focusing here on (2), in response to COVID-19, EA households increased their savings sharply and corporates stopped investing. The ECB called correctly for fiscal responses, “first and foremost” and the EU and European governments responded appropriately with a shift to more proactive and common fiscal policies.
Policy makers have acknowledged that private sector investment is unlikely to fill the gap left by COVID-19.
So far, so good. The wider question (see also lesson #7) is whether the notion that fiscal expansion is indispensable to sustain demand is fully understood.
Relative performance of leading European banks (SX7E) versus the wider SXXE European index (Source: CMMP analysis)
Lesson #1
I started 2020 by arguing that the true value in analysing developments in the financial sector lies less in considering investments in developed market banks and more in understanding the wider implications of the relationship between the banking sector and the wider economy for corporate strategy, investment decisions and asset allocation. Banks have underperformed again (c20% YTD in Europe) but the messages from the money sector have been as important as ever.
Second, monetary developments have continued to provide reliable leading indicators of economic activity (that link directly into asset allocation models), key insights into the behaviour of households and corporates over time and between regions, and warnings of hidden risks in emerging economies. Third, the mechanical link between money supply and inflation has been challenged and replaced by an explanation of what will be required for LT secular trends (eg, growth vs value) to be reversed in a sustainable fashion.
And all from the simple observation that, “everyone has a balance sheet” (see Lesson #2).
Private sector financial surpluses and general government financial deficits since 2008 (Source: Eurostat, CMMP analysis)
The key message
Looking into 2021, the shape and duration of any economic recovery and the outlook for investment returns/asset allocation in the euro area (EA) depend critically on whether policy makers have learned from the mistakes of the past.
The region remained trapped by persistent, excess savings and out-dated policy rules at the start of 2020. A major policy reboot was already long overdue.
As COVID-19 hit, households (HHs) increased their savings sharply and corporates (NFCs) stopped investing. The private sector surplus returned to GFC levels. In response, the ECB called (correctly) for fiscal responses, “first and foremost” and the EU and European governments responded appropriately with a shift to more proactive and common fiscal policies.
With broad money growing at the fastest rate since 2008, debate over future inflation and its implication for duration trades is growing. Today’s monetary trends are very different, however, and the message from the money sector remains one of heightened uncertainty and subdued credit demand in direct contrast to 2008.
Private sector investment alone is unlikely to fill the gap left by COVID-19. Investors betting on a reversal of existing secular trends must be confident, therefore, that the notion that fiscal expansion is indispensable to sustain demand is fully understood.
The EA has a unique opportunity to make greater use of fiscal policy to achieve its goals – will they seize it or waste it?
The charts that matter
In February 2020, I suggested that the EA was trapped by persistent, excess savings and out-dated policy rules and argued that a major policy reboot was long overdue. This was before the full economic and social impacts of the pandemic were understood. The EA private sector ran average financial surpluses/net savings of 4.4% GDP in the decade between 1Q10 and 1Q20. General government ran average financial deficits/net borrowings on 2.7% GDP over the same period, resulting in average net savings for the EA of 1.7% GDP (see key chart above). These trends placed downward pressure on growth and inflation over the period.
Trends in EA, UK and US private sector debt ratios (% GDP) since 2000 (Source: BIS, CMMP analysis)
The messages from the money sector at the time were clear. First, when the private sector is running a financial surplus in spite of negative/very low policy rates, this is a strong indication that the economy is still suffering from a debt overhang. As can be seen from the chart above, private sector deleveraging in the EA was delayed and more limited after the GFC than in both the UK and the US. Data released by the BIS this week, shows that the EA private sector debt ratio hit a new high of 174% of GDP in 2Q20 compared with ratios of 165% and 160% in the UK and US respectively. Second, fiscal space, like debt sustainability, is at its core a FLOW not a STOCK concept.
Trends in HH and NFC financial surpluses (+) and deficits (-) since 2008 (Source: Eurostat; CMMP analysis)
As COVID-19 hit, HHs increased their savings sharply and NFCs stopped investing. HH net savings, which had trended between 2-3% of GDP in the post-GFC period jumped to 5% in 2Q20. The NFC sector, which had resumed investing in 4Q18, also returned to net savings equivalent to 0.2% of GDP (see graph above). In aggregate, the net financial surplus/net savings of the EA private sector increased to 6% of GDP. (Note that basic accounting principles indicate that surpluses run by the private sector must equal deficits run by general government and/or the RoW -see graph below).
Basic national accounting principles in practice – trends in PS, government and RoW financial surpluses (+) and deficits (-) since 2008 (Source: Eurostat; CMMP analysis)
In response, the ECB called (correctly) for fiscal responses, “first and foremost” and the EU and European governments responded appropriately with a shift to more proactive and common fiscal policies. In brief, general government deficits of 3.7% GDP and a ROW deficit of 2.1% offset the private sector surplus in the 2Q20 (see chart above).
Growth rates (%YoY) in EA broad money (Source: ECB; CMMP analysis)
With broad money growth accelerating, debate over future inflation and its implication for duration trades is growing. In October 2020, broad money grew 10.5% YoY. This is the fastest rate of growth recorded since April 2008 (see graph above).
Growth in M3 (%YoY) and contribution from M1 to M3 growth (ppt) since 2000 (Source: ECB; CMMP analysis)
Today’s monetary trends are very different, however, and the message from the money sector remains one of heightened uncertainty and subdued credit demand in direct contrast to 2008. From a components perspective, narrow money (M1) contributed 9.4ppt to October’ 10.5% growth as HHs, and to a lesser extent NFCs, maintained their preference for holding highly liquid overnight deposits, despite negative real returns (see chart above).
Monthly HH deposit flows for the EA (Source: ECB; CMMP analysis)
Monthly deposit flows provide a useful proxy for private sector uncertainty levels. In the HH sector, monthly flows are lower than in the March-April 2020 when uncertainty was at its peak, but October’s flow of €43bn was still 1.3x the average flow of €33bn recorded in 2019 (see chart above).
The widening gap between YoY growth rates in the supply of money and the demand for credit (Source: ECB; CMMP analysis)
From a counterparts perspective, private sector credit contributed 5.2ppt to broad money growth in October. The gap between money supply and private sector credit demand hit a new high of 5.9ppt, another clear indicator that the region is still suffering from a debt overhang (see chart above). In passing, it is worth noting the important role of QE, especially large-scale government bond purchases during the crises, in current monetary growth. Credit to general government contributed 7.3ppt to October’s 10.5% growth in M3 (see chart below).
Growth in M3 from a counterparts perspective (Source: ECB; CMMP analysis)
Conclusion
In a speech made on 12 October 2020, Isabel Schabel, a Member of the ECB’s Executive Board, argued that, “at times of significant uncertainty, private investment may not fill the gap left by the pandemic in spite of very favourable financing conditions. In these situations, monetary policy alone cannot unfold its full potential. Fiscal expansion is then indispensable in order to sustain demand and mitigate the long-term cost of the crisis.” CMMP analysis supports this view.
Investors betting on a reversal of existing secular trends (eg duration trades) must be confident, therefore, that the notion that fiscal expansion is indispensable to sustain demand is fully understood.
Outside the narrow focus of financial markets, the EA has a unique opportunity to make greater use of fiscal policy to achieve its goals – will they seize it or waste it?
Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.
Uncertainty reigns and consumption remains subdued
The key chart
The UK and EA money sectors sent a clear message this week (Source: Bank of England; ECB; CMMP analysis)
The key message
The UK and euro area (EA) money sectors sent a clear message to investors this week – don’t bet on the consumer.
Uncertainty reigns among European households. Monthly flows into deposits in the UK and EA remain 1.5-2.0x the average seen in 2019, despite negative real returns.
Yes, household lending has recovered from recent lows, driven by resilient (and rising) mortgage demand. Consumer credit demand, however, remains negative/weak. UK HHs repaid £0.6bn of consumer credit in September after additional borrowing in July (£1.1bn) and August (£0.3bn). The annual growth rate fell to -4.6%, a new low since the data series began in 1994. EA HHs borrowed €1bn for consumer credit in September, down from €3bn in August and €5bn in July, but the 0.1% YoY growth rate was the slowest since consumer credit recovered back in May 2015.
High uncertainty and slowing consumer spending were in place even before the introduction of the latest round of restrictions across Europe. No wonder that Madame Lagarde was so emphatic in warning investors to expect something more dramatic in December.
A simple message in six charts
Monthly UK household deposit flows since January 2019 (Source: Bank of England; CMMP analysis)Monthly EA household deposit flows since January 2019 (Source: ECB; CMMP analysis)YoY growth rates in UK and EA mortgage and consumer credit (Source: Bank of England; ECB; CMMP analysis)Monthly UK household credit flows since January 2020 (Source: Bank of England; CMMP analysis)Monthly EA household credit flows since January 2020 (Source: ECB; CMMP analysis)Trends in EA and UK inflation versus target since 2010 (Source: Bank of England; ECB; CMMP analysis)
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately
What messages can be derived from the components and counterparts of current money growth and how do they compare with past cycles? (Source: ECB; CMMP analysis)
The key message
Broad money (M3) in the euro area (EA) is growing at its fastest rate since early 2008. However, CMMP analysis of the components and counterparts of this growth suggests that the associated “messages from the money sector” and their implications are very different.
The message in the pre-GFC period was one of (over-) confidence and excess credit demand. In contrast, the current message is one of heightened uncertainty and subdued credit demand. Today’s money growth reflects fiscal and monetary easing in response to weak private sector demand and rising savings (with added uncertainty regarding the extent to which rising savings are forced or precautionary).
The implications for inflation and policy options are clear. Inflationary pressures are likely to remain weak during the current cycle. Madame Lagarde may well signal more monetary support before the end of 2020 at this week’s ECB meeting, but the over-riding message from the EA money sector is that the route to economic recovery and higher inflation remains “fiscal, first and foremost.”
Seven charts that matter
Broad money (M3) in the euro area (EA) is growing at the fastest rate since early 2008. M3 grew 10.4% YoY in September, up from 9.5% in August. This is the fastest rate of YoY growth since April 2008 when M3 grew 10.6% YoY. However, CMMP analysis of the components and counterparts of these two growth phases suggests that the associated “messages from the money sector” are very different. Current trends are not a repeat of 2008 dynamics.
Different drivers and implications of monetary expansion – 2008 versus 2020 (Source: ECB; CMMP analysis)
Note that the components and counterparts of M3 provide different perspectives and explanations of changes in broad money. Monetary aggregates are derived from the consolidated monetary financial institutions (MFI) balance sheet and comprise monetary liabilities of MFIs and central government vis-à-vis non-MFI euro area residents.
The Eurosystem defines narrow (M1), intermediate (M2) and broad (M3) aggregates. They differ with respect the degree on “moneyness” or liquidity of the instruments included. M1, for example, comprises only currency in circulation and balances that can be converted into currency or used for cashless payments. Relative high holdings of M1 indicate a relatively high preference for liquidity and can be used as an inverse proxy for the level of private sector confidence.
The consolidated MFI balance sheet also provides the basis for analysing the counterpart of M3. All items other than M3 on the consolidated balance sheet can be rearranged to explain changes in broad money. The relationship between M3 and its counterparts rests on a simple accounting identity. What this means is that we have two identities that can be used to provide different perspectives on changes in broad money:
Components: Broad money equals M1 plus M2-M1 plus M3-M2
Counterparts: Broad money equals credit to EA residents plus net external assets minus longer term financial liabilities plus other counterparts (net)
What was the message from the money sector in the pre-GFC period? (Source: ECB; CMMP analysis)
The message in the pre-GFC period was one of (over-) confidence and excess credit demand. From a components perspective, for example, M1 was growing only 2.7% YoY in April 2008 and contributing just 1.2ppt to the overall 10.6% growth in total money. At this point M1 accounted for 43% of the outstanding stock of money. From a counterparts perspective, private sector credit was growing at 11.2% and contributing 17.6ppt to the growth in total money (offset by negative contributions from net external assets and LT financial liabilities). Credit to general government was contributing just 0.1ppt to broad money growth.
What is the message from the money sector now? (Source: ECB; CMMP analysis)
In contrast, the current message is one of heightened uncertainty and subdued credit demand. M1 grew 13.8% YoY in September 2020, up from 13.2% in August and contributed 9.4ppt to the overall 10.4% growth in broad money (versus 9.0ppt in August). M1 now accounts for 70% of the outstanding stock of money. The private sector is holding higher levels of the most liquid assets despite negative real returns on those instruments. This suggests high levels of uncertainty that have been exacerbated by the Covid-19 pandemic. (Note in passing that monthly flows showed a divergence between rising and above 2019-average household deposit flows and falling and below 2019-average NFC flows in September).
Uncertainty reigns – very different drivers of money growth (Source: ECB; CMMP analysis)
Private sector credit grew 4.6% YoY in September, unchanged from August. As before, relatively robust demand for NFC credit (7.1%) and resilient (and rising) mortgage demand (4.5%) continue to offset relative weakness in consumer credit (0.1%). However, private sector credit contributed only 5.2ppt to the overall 10.4% growth in broad money.
A key point here is that, in typical cycles, monetary aggregates and their counterparts move together. Money supply indicates how much money is available for use by the private sector. Private sector credit indicates how much the private sector is borrowing. The current relationship between money and credit cycles is far from typical, however. Indeed the gap between M3 and PSC is at a historic high reflecting the fact that the euro area is only emerging very gradually from a period of debt overhang.
Counterparts to M3 – the alternative view of what is driving money growth (Source: ECB; CMMP analysis)
Today’s money growth reflects fiscal and monetary easing in response to weak private sector demand and rising savings (with added uncertainty regarding the extent to which rising savings are forced or precautionary). Credit to general government and credit to the private sector contributed 6.8ppt and 5.2ppt respectively to the 10.4% growth in broad money (see graph above). This is in direct contrast to the pre-GFC period when money expansion was driven primarily by strong, or excess, private sector credit demand (see graph below).
Contrasting contributions of private sector credit and messages for the outlook for aggregate demand (Source: ECB; CMMP analysis)
Conclusion – don’t confuse the messages
The implications for inflation and policy options are clear. Inflationary pressures are likely to remain weak during the current cycle. Madame Lagarde may well signal more monetary support before the end of 2020 at this week’s ECB meeting, but the over-riding message from the EA money sector is that the route to economic recovery and higher inflation remains “fiscal, first and foremost.”
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
What now for bank capital distributions? Absolute and relative performance of SX7E index YTD (Source: Macrobond; CMMP analysis)
The key message
The current 3Q20 results season is refocusing the attention of investors, banks and regulators on the “exceptional and temporary” restrictions imposed on bank capital distributions during the COVID-19 pandemic.
The gradual recovery in banks’ dividend payouts up to that point had been a rare positive in an otherwise negative investment outlook for the sector. Their suspension added to the list of on-going negatives including “low profitability, high costs, the lack of sustainable business models at certain banks and insufficient investment in new technologies,” (ECB, 2020) that help to explain why banks have been the worst performing sector YTD.
The exceptional status of these restrictions reflects the fact that they applied to all banks irrespective of whether pre-determined capital limits had been breached or not. Their temporary status was a recognition of the perceived and real risks associated with such a “one-size-fits-all policy.”
Looking forward, higher expected losses (ELs) and risk-weighted assets (RWAs) resulting from the economic downturn and increase in non-performing loans will lead to a deterioration in capital ratios. However, estimates by my colleagues at zeb consulting suggest that the average CET1 ratio of the largest 50 banks will remain on a sufficient level. More importantly, their analysis highlights significant differences among the sample banks. They find no statistically significant patterns regarding specific business models or country/regional exposure.
Further vigilance is required but the case for maintaining blanket restrictions on capital distributions has weakened. However, just because regulators should return to judging the merits of capital distributions on a case-by-case basis does not mean that they will. Sympathy towards banks and their shareholders remains subordinate to other priorities.
Six charts that matter
The current 3Q20 results season is refocusing the attention of investors, banks and regulators on the “exceptional and temporary” restrictions imposed on bank capital distributions during the COVID-19 pandemic.
And then they were gone – the recovery in bank dividends was a rare positive for EA banks (Source: Macrobond; CMMP analysis)
The gradual recovery in banks’ dividend payouts up to that point had been a rare positive in an otherwise negative investment outlook for the sector. Across advanced economies, banks’ dividend yields had recovered from the low levels that accompanied the rebuilding of capital after the GFC.
Euro area (EA) banks increased their shareholders’ yields via dividends but also tended to raise capital by issuing new shares. In contrast, the recovery in yields for US banks was more modest, as US banks have returned more cash through share buybacks instead. ECB analysis suggests that US and Nordic banks were the most generous in terms of shareholder remuneration recently, ahead of their UK, Swiss and EA peers (see graph below).
EA banks increased shareholder yields via dividends but also tended to issue new shares (Source: ECB; CMMP analysis)
Their suspension added to the list of on-going negatives including “low profitability, high costs, the lack of sustainable business models at certain banks and insufficient investment in new technologies,” (ECB, 2020) that help to explain why banks have been the worst performing sector YTD. In previous posts, I have (1) explained that the macro building blocks that are required for a sustained improvement in banks’ profitability and share price performance have been missing, (2) highlighted that weak pre-provision profitability left European banks poorly positioned to absorb the impact of the COVID-19 pandemic, and (3) questioned the conviction of previous sector rallies. Despite a 2% recovery over the past month, the SX7E index has fallen 42% YTD and underperformed the wider SXXE index by 34%.
Another miserable year for bank investors (Source: Macrobond; CMMP analysis)
The 60% underperformance of EA banks over the past five years supports a central theme in CMMP analysis. The true value in analysing developments in the financial sector lies less in considering investments in banks and more in the understanding the wider implications of the relationship between the banking sector and the wider economy for corporate strategy, investment decisions and asset allocation.
Why bother analysing banks/developments in the financial sector? (Source: Macrobond; CMMP analysis)
The exceptional status of these restrictions reflects the fact that they applied to all banks irrespective of whether pre-determined capital limits had been breached or not. It is important to note that the implementation of post-GFC standards had improved the capitalisation of global banks and that the introduction of capital buffers also helped them to withstand stressed situations such as the current pandemic. When these buffers are drawn down to pre-determined levels, Basel standards place automatic limits on dividends, share buybacks and bonus payments. However, given the scale of the potential losses that might arise from the pandemic, supervisors moved to halt dividends and buybacks even if pre-identified capital limits had not been breached.
In the case of EA banks, Yves Mersch, a member of the Executive Board of the ECB and Vice Chair of its Supervisory Board, explained last month that “while prudent capital planning is the order of the day, the current economic uncertainty means that banks are simply unable to forecast their medium-term capital needs accurately. Such an unorthodox move was therefore justified by our ultimate goal to counteract procyclical developments and support banks’ capacity to absorb losses during the crisis without compromising their ability to continue lending to the real economy.”
Their temporary status was a recognition of the perceived and real risks associated with such a “one-size-fits-all policy.” Mersch also acknowledged that, “under normal conditions, profitable and healthy banks should not be prevented from remunerating their shareholders. Restricting dividends can increase banks’ funding costs, have an impact on their access to capital markets and make them less competitive than their international peers.”
Expected losses to increase signficantly for Europe’s 50 largest banks (Source: zeb consulting)
Looking forward, higher expected losses (ELs) and risk-weighted assets (RWAs) resulting from the economic downturn and increase in non-performing loans will lead to a deterioration in capital ratios. Estimates from my colleagues at zeb consulting suggest that ELs could rise to between EUR 543-632bn in 2021 and EUR 611-833bn in 2022. Combined with a rise in RWAs, this would result in a drop in average CET1 ratios to between 11.4% and 12.3% in 2021 and 11.4% and 12.6% in 2022. In other words, the average CET1 ratio of the largest 50 banks in Europe is expected to remain sufficient despite higher ELs and RWAs.
Capital positions expected to remain sufficient (Source: zeb consulting)
Their analysis highlights significant differences among the sample banks. In several cases, banks are expected to consume their pre-Covid-19 capital cushions and will be forced to use the capital buffers release by regulators. In the “zeb base case”, eight of the top 50 European banks fall into this category. This number increases to 18 in their more “severe scenario”. However, none of the banks will end up with CET1 ratios below the reduced post-Covid-19 requirements.
More importantly in the context of the current debate, they find no statistically significant patterns regarding specific business models or country/regional exposure.
Conclusion
Further vigilance is required but the case for maintaining blanket restrictions on capital distributions has weakened. Yes, European banks remain dependent on government support for private and corporate customers and regulatory easing regarding capital ratios and banks, regulators and governments also need to continue to work together to prevent future credit or liquidity crunches. ECB representatives are also correct to highlight the real challenges faced by banks in forecasting medium-term capital needs accurately and the argument that they and the IMF put forward in terms of the benefits of flexibility is valid (eg, additional capital preserved could be distributed to shareholders should it prove unnecessary).
Nonetheless, the significant differences that exist between European banks and the lack of significant patterns at the business model, country or regional exposure levels suggests that the case for a blanket approach to restrictions of banks capital distributions is much weaker now that it was at the start of the pandemic. However, just because regulators should return to judging the merits of capital distributions on a case-by-case basis does not mean that they will. Sympathy towards banks and their shareholders is subordinated below other objectives and I conclude with the words of Andrea Enria, the Chair of the ECB’s Supervisory Board from a recent interview with Handlesblatt:
The ban on dividends is an exceptional measure. We do not intend to make it a regular supervisory tool. It was introduced when governments, the ECB and ECB Banking Supervision announced a major support package to deal with the fallout of the pandemic. The ECB has calculated that the full use of government guarantee schemes might reduce banks’ loan losses by between 15 to 20 per cent in the euro area. The package was intended to allow banks to grant loans to households and companies, not to compensate shareholders. The pandemic led to factory and school closures, and some of us were locked down for months. Why should dividends, of all things, be the only sacrosanct element in our societies?
Andrea Enria, Interview with Handlesblatt (12 October 2020)
Please note that the summary comments and charts above are abstracts from more detailed CMMP and zeb consulting analysis that is available separately.
Resilient demand masks tough times for UK mortgage providers
The key chart
Resilient mortgage demand masks tough times for UK mortgage providers (% YoY) (Source: Bank of England; CMMP analysis)
The key message
The relative stability/resilience of mortgage markets in the UK (and in the euro area) has been a consistent theme in the “messages from the money sector” during the COVID-19 pandemic.
UK mortgages grew 2.9% YoY in August, unchanged from July, and monthly flows have been steadily increasing from their April 2020 lows. This recovery has also been the main driver in the rebound in overall household borrowing, with mortgages accounting for £3.1bn in August’s £3.4bn increase in total lending to individuals. Looking forward, the number of mortgage approvals for house purchases also increased sharply in August to 84,700, the highest number since October 2007.
So far, so good – but there is always a “but”…
Current mortgage demand is very subdued in relation to past cycles despite the low cost of borrowing. One factor here is that, despite the deleveraging seen since 1Q10, the UK household debt-to-HDP ratio remains at 85%, the threshold level above with the BIS believes that debt becomes a drag on future growth. Unsurprisingly, the CAGR in HH debt (primarily mortgages) has trended between only +/- 1% nominal GDP growth since early 2016 – not much of a “growth story” here.
More concerning for mortgage providers, the effective rates on new and outstanding mortgages have fallen 28bp and 32bp respectively over the past 12 months to new lows of 2.14% and 1.72% respectively. The gap between the rate on outstanding and new mortgages was 38bp in August, indicating further downward pressure on net interest margins and income.
With subdued growth and further NIM compression ahead, mortgage providers will need to embrace digitalisation to deliver effective market segmentation/client knowledge, alternative revenue sources, further efficiency gains and more effective liquidity and risk management.
Seven charts that matter
The relative stability/resilience of mortgage markets in the UK (and euro area) has been a consistent theme in the “messages from the money sector” during the Covid-19 pandemic. Outstanding mortgage balances grew 2.9% YoY in August, unchanged from July but slightly below the 3.1% growth recorded in June. In contrast, the growth in consumer credit hit a historic low (-3.9% YoY) while corporate lending grew 9.7% YoY (see key chart above).
Monthly flows have recovered steadily since their April 2020 lows (Source: Bank of England; CMMP analysis)
The recovery in monthly HH borrowing flows since April’s lows (see chart above) has been the key driver in the recovery in overall household lending (see chart below). In August, for example, mortgages accounted for £3.1bn out of a total £3.4bn monthly flow.
Mortgages are driving the recovery in household lending (Source: Bank of England; CMMP analysis)Approvals suggest positive momentum (Source: Bank of England; CMMP analysis)
Looking forward, the number of mortgage approvals for house purchases also increased sharply in August to 84,700, the highest number since October 2007. This partially offsets the March-June weakness – there have been 418,000 approvals YTD, compared with 524,000 in the same period in 2019.
So far, so good – but there is always a “but”…
Current demand is very subdued in relation to past cycles in nominal and real terms (Source: Bank of England; CMMP analysis)
Current mortgage demand is very subdued in relation to past cycles (see chart above), despite the low cost of borrowing. One factor here is that, despite the deleveraging seen since 1Q10, the UK household debt-to-HDP ratio remains at 85%, the threshold level above with the BIS believes that debt becomes a drag on future growth (see chart below).
HH debt ratios remain elevated at the BIS threshold level (Source: BIS; CMMP analysis)
Unsurprisingly, the CAGR in HH debt (primarily mortgages) has trended +/- 1% nominal GDP growth since early 2016. The chart below comes from CMMP Relative Growth Factor (RGF) analysis, which considers the rate of growth in debt in relation to GDP on a three-year compound growth basis with the level of debt expressed as a percentage of GDP. This graph illustrates the UK HH RGF on a rolling basis. There is little to get excited about in this chart.
An unexciting “relative growth” story – rolling 3-year CAGR in HH debt versus rolling 3-year CAGR in nominal GDP (Source: BIS; CMMP analysis)
More concerning for mortgage providers, the effective rates on new and outstanding mortgages have fallen 28bp and 32bp respectively over the past 12 months to new low of 2.14% and 1.72% respectively. The gap between the rate on outstanding and new mortgages was 38bp in August, indicating further downward pressure on net interest margins and income.
The challenge of delivering top-line growth (Source: Bank of England; CMMP analysis)
Conclusion
With subdued growth and further NIM compression ahead, mortgage providers will need to embrace digitalisation to deliver effective market segmentation/client knowledge, alternative revenue sources, further efficiency gains and more effective liquidity and risk management.
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
