THE PROBLEMS IN THE BANKING SECTOR ARE ONLY HALF WAY OVER

According to the IMF the problems in the banking sector are far from over.  In their latest Global Financial Stability Report they find that the economy is improving, however, the risks to the banking sector remain.  They also conclude that any hiccup in the real economy would reverberate thru the banking sector and further intensify the weakness in the broader economy:

“The immediate outlook for the financial system has improved markedly since the April 2009
Global Financial Stability Report (GFSR) and extreme tail risks have abated. Financial markets have rebounded, emerging market risks have eased, banks have raised capital, and wholesale funding markets have reopened. Even so, credit channels are still impaired and the economic recovery is likely to be slow.

A key question addressed is whether the financial system can provide sufficient credit to
sustain an economic recovery. Recently, bank balance sheets have benefited from capital-raising efforts and positive earnings. Nonetheless, there are still serious concerns that credit deterioration will continue to put pressure on banks’ balance sheets. Our analysis suggests that U.S. banks are more than halfway through the loss cycle to 2010, whereas in Europe loss recognition is less advanced, reflecting differences in the economic cycle.”

The IMF estimates that banks have taken less than HALF of their total writedowns to date.  While commercial banks have already written down $1.3T the IMF estimates that banks have another $1.5T to writedown.  Of these writedowns, the U.S. is slightly further along than their Asian and UK counterparts.  This is similar to what McKinsey recently reported.

Much like Japan in the 90’s, the banks have been given the green light to earn their way out of this crisis.  With $1.5T in writedowns coming down the pipe it’s unlikely that operating earnings will suffice in offsetting the losses.  Banks are also facing a staggering $1.5T in maturing debt over the next 2 years.

“While stronger bank earnings are supporting capital levels, they are not expected to fully
offset writedowns over the next 18 months. Moreover, steady-state earnings are likely to be lower in the post-crisis environment. Stronger action to address impaired assets will help bolster bank earning capability and support lending. The tightening of bank regulation under way is expected to reduce net revenues and require more costly self-insurance through higher levels of capital and liquidity.”

The McKinsey report came to the same conclusion:

The challenge for many adequately capitalized banks is that they will find it difficult to generate enough income to cover loan-loss provisions over the next two years. Moreover, it is unclear how long net interest margins will hold up. Since 2006, net interest margins have actually increased for the stress-tested banks, despite rising nonaccruals (that is, when a loan defaults and a loan provision is made, it no longer accrues interest). For these banks, net interest margin has actually increased from 2.1 percent to 3.0 percent, which represents $70 billion of income annually. Much of this increase is due to rapid declines in funding costs thanks to the US Federal Reserve, which has lowered the rates banks pay faster than the interest on their loan and securities books. As more loans go on nonaccrual and as loans roll over, net interest margin may come under pressure, even if the Federal Reserve keeps rates low.

This likely means banks are going to continue to be a drag on any potential recovery as they struggle with their own capital problems as opposed to servicing the debt needs of their customers.

The IMF concludes that the economy is far from complete stability and any decline in economic activity could cause a ripple effect in the banking sector which could cause further deterioration in any recovery:

“the economic forecast for the remainder of 2009 and 2010 is still gloomy and banks are not immune to a deterioration in the economic environment.”

While we’re certainly seeing some positive trends in the banking sector and the broader economy it would be foolish to conclude that the secular deleveraging problems have been resolved.  Of course, the banking sector, being in bed with the government and the Fed, is unlikely to be allowed to wither.  Instead, it’s far more  likely that the banks will continue to benefit as the taxpayer loses, i.e., bailouts and taxpayer subsidized programs aren’t even close to being finished with.  What does this mean for investors? One heck of a mess for future generations.

Both notes are attached in their entirety below:

IMFGFSR –

IMF Staff Position Note:

spn0924 –