We’re at the start of a banking civil war. It will destroy the traditional way of banking. It will also yield very real opportunities for income investors willing to think outside the box.
Occasionally I receive emails from readers who say our letters are too long. They generally state that if I can’t say something in three sentences it’s not worth saying. If you’re one of them, I dedicate the opening paragraph of today’s piece to you. It’s the short version of the idea I want to share with you.
I think it’s worth elaborating on, because it’s important for two reasons: a) it explains what could be happening to the banks right now, and b) it leads to a very real opportunity for you to bank bigger income. Roughly 4%-6%, or around 20 times the current Bank of England base rate.
When banks fight banks
The interests of the world’s central banks and commercial banks have been aligned since the financial crisis. Central banks looked after their commercial counterparts by making it easy for them to rebuild their balance sheets post Lehman by keeping interest rates low and reflating the financial system with lots of QE. All good for banks, if not for savers.
But that has started to change. The more “out there” monetary policies – like negative interest rates – aren’t good for commercial banks. They squeeze margins and make it difficult to make a profit. And that’s significant. It signals a parting of the ways: it puts central banks and commercial banks in opposition to one another.
Two case studies: Japan, and Europe. The two places where we’ve seen interest rates go deeply negative. In both cases, that’s caused various degrees of uproar. The Germans have directly complained that the European Central Bank’s (ECB) policies are hurting commercial banks’ margins.
In fact the Bundesbank said negative rates cost German banks €248m last year. As German finance minister Wolfgang Schäuble put it in May: “There is a growing understanding that excessive liquidity has become more a cause than a solution to the problem”.
“Growing understanding” is one way of putting it. Another is that lots of people always knew that excessive liquidity would create problems, it’s just that recently now those problems haven’t affected banks margins.
It was a sign
But still, it was an unusually blunt assessment from a figure of authority. It was a sign. German banks are struggling. And that’s translating into lower stock prices: the Euro Bank Stoxx is down 21% on the year.
Last week, Draghi was forced to respond: “Those who blame ECB policy for the mixed performance of certain German financial firms have been very vocal.
But what has been forgotten is that many banks have been able to more than offset declining interest revenues with higher lending volumes, improved loan performance and lower interest expenses, all of which are beneficial to both the banks and their customers.”
In other words: stop complaining and get on with it. The system comes first. And we’re prepared to push the banks to the brink to save it.
The elephant in the room, of course, are those “certain German financial firms”. That means Deutsche Bank. Whether Deutsche Bank will or won’t need a bailout is beyond both the scope of this email and my own understanding of the banks balance sheet. So let’s park that. But Deutsche Bank seems to be in trouble for three reasons: the fine US regulators are trying to impose on it, its “systemic importance” and derivatives book, or the fact that its margins have been squeezed by negative rates. It’s quite possibly all three.
The same thing is happening in Japan. Earlier in the year, banks claimed they wanted to leave the group of 21 institutions that deal in government bonds. The only reason you’d give up a seat at that table is if there’s no money left in it.
RIP “traditional” banking
To be clear about what this means: central banks and commercial banks are fighting on opposite sides now. The central banks will do anything to save the system, even sacrifice their mates down the road. And through a combination of monetary and regulatory policy, that’s exactly what they’re doing.
This was one of the themes that came out of David C Stevenson’s presentation at yesterday’s conference. I call it a banking civil war. David called it nothing less than the end of the traditional banking model altogether. He believes the industry as we know it now is fundamentally going to change and what is now one industry will become two: “casino” banks operating in the financial markets, and “old fashioned” banks operating like utilities, offering savings accounts and mortgages and paying dividends.
That may sound like a more benign environment than it actually would be. Because as I discussed with both David and Tim Price backstage at the conference (look out for our conversations as extras on the DVD), both of them made the point that in a world where old fashioned utility style banks return there’s a strong chance they’d be nationalised. That might be in a crisis. Or it might be the ultimate act of centralization in the financial system and involve central banks simply hijacking the commercial banks altogether, becoming the sole creators and allocators of credit in the economy.
That’s an idea for another day. Today I promised you a big picture idea and an opportunity. Where’s the opportunity?!
That came in the second part of David’s presentation…
An opportunity for ambitious income hunters
As David explained yesterday, the death of the existing banking system – and the strain it is already under – means traditional models of financing things are in retreat. But in a (nominally) free market capitalist system, the retreat of one model means the advance of others as innovators strive to fill the void.
For David that means the “shadow” banking system. That might have negative connotations for some, but all it really means in this context is “something that isn’t a bank”. If you want income – big income – in today’s world you have to understand what the shadow banking system is and how it works.
Ultimately it’s about lending. Just lending. Connecting people with surplus capital they want to put to work to people and organisations that need it to operate. That might be small and medium sized businesses, infrastructure projects, marketplace lending, FinTech… there’s a huge universe of alternative investment income opportunities out there.
Many of them aren’t regulated in the way the traditional financial system is. But that doesn’t mean that cautiously ambitious investors (not a contradiction in this context) can’t earn between 4% and 6% from them. A word of warning: don’t get carried away in this space. As David said yesterday, anything above 7.5% is likely to be highly risky (it’s got a 7.5% yield for a reason), and anything in double digits you can “run a mile”.
David’s one of the most knowledgeable people around when it comes to understanding how alternative income opportunities work. He explained in detail how he analyses the market yesterday. And of course, David works with us regularly to share his research (look out for more from David in coming weeks – we have a couple of projects bubbling away behind the scenes that’ll interest you).
Category: Central Banks