NEWS,17.07.2013

'Low rates build risk for fragile banks'

A determination by Europe's most powerful central bankers to keep interest rates low might save the continent's fragile banking system from short-term pain but undermines long-term profitability and encourages excessive risk-taking.
The Bank of England's new governor Mark Carney raised eyebrows on July 4 when he said market expectations of higher interest rates were "not warranted", a policy departure for a central bank that traditionally plays its cards close to its chest until monthly rate decisions are taken.
Hours later, the European Central Bank's president Mario Draghi echoed the same guidance for eurozone rates, saying monetary policy should remain "accommodative".
The commitment to lower interest rates means Europe's banks, still fragile after the 2007-2009 crisis and facing stress tests in mid 2014 that could trigger fresh capital demands, have less cause to fear an interest rate shock that would dramatically change their funding and lending costs after four years of record low rates.
That has been identified as a major risk by authorities including the Bank of England, the Dutch National Bank and Switzerland's Finma, since it could trigger higher loan defaults, a hit to margins over a transition period and lower equity values for banks.
But once rates have stabilised at higher levels, banks earnings should improve, and they are less tempted to pursue riskier lending and investment.
"We are trapped between a rock and a hard place," said Gert Wehinger, a senior economist with the OECD's financial directorate. "The more we have extremely low interest rates, the more we have risks accumulating ... If you lift them now, you can trigger something even worse, which means recessions and banks defaulting."
A painful adjustment
Most major banks provide some disclosure on what would happen to their 'net interest income', or lending margin, if rates rose. In eight of Europe's biggest 10 banks, those disclosures show margins rise as rates rise. At HSBC, annual net interest income would rise by $1.4bn if rates rose by 0.25% a quarter for four quarters.
But that rosy picture belies a more complex truth. The banks' figures show what would happen if all short-term and long-term interest rates moved by the same amount, typically a 1% increase, but that rarely happens.
Central bank action affects short-term rates more than long-term rates, which are buffeted by a wider range of influences, such as supply and demand and long-term rate expectations.
Banks typically earn money at long-term rates, on lending such as mortgages, but borrow for shorter terms, so they prefer a rising yield curve over time. If short term-rates rise and long-term rates don't, the bank is squeezed.
Even if long-term rates rise, they can't necessarily be applied to all the bank's long-term loans - 20-year fixed-rate mortgages are popular in many European markets - while customers will quickly expect higher interest on their deposits.
"The question there is, will banks be able to refinance on the long run these very low long-term mortgage rates," said Professor Martin Hellmich, of the Frankfurt School of Finance & Management. "That is one thing where you have substantial risk."
Loans take hit as rates rise
The more down-to-earth risk banks face from higher interest rates is higher defaults, once borrowing costs eventually rise.
"Low interest rates are tempting many people to buy their own house or private apartment despite the sharp rise in prices," said Patrick Raaflaub, the head of Switzerland's regulator Finma said at an event on March 26.
"But will these new buyers be able to cope with a higher interest burden if interest rates rise?"
Such fears were behind the BoE's June decision to ask banks for more information on their interest rate risk by September. Holland's DNB asked for something similar earlier in the year, "with special emphasis on mortgages".
Even if borrowers don't default, fixed rate loans are still worth less to a bank in a rising interest rate environment.
The income stream of loan repayments, taking into account the bank's own borrowing costs, is known as net present value, and is a key input into the 'real' value of a bank.
In its 2012 annual report, Dutch bancassurer ING said a 1% rise in interest rates would reduce its net present value by €2.14bn. Even a hit that large is not immediately recognised by banks.
"Changes in the book value of a loan only have to be recognised if the borrower's creditworthiness has deteriorated," said Christoph Memmel, an economist with Germany's Bundesbank.
"Present value losses caused by increases in the risk-free (central bank) interest rate have no immediate consequences for a bank's profit and loss."
Regulators aren't blind to the risk, and banks do have to hold some capital for it under part of the capital framework known as Pillar 2, which stresses their 'banking books' against a 2% rise or fall in rates. But the picture is incomplete, and investors have little sight of the real risks.
Capital consequences
The capital hit is more apparent on banks' trading books - the 'available for sale' (AFS) securities they hold which have to be regularly revalued, or 'marked to market'. These take an immediate hit if interest rates rise, as a bond paying 4 percent is immediately less valuable if new issues pay more.
In a June 19 note, KBW analysed how the equity of 36 European banks would be hit by a 1% fall in the value of their AFS debt securities, an analysis that depends on the relative size of AFS holdings, not the portfolios' attributes.
It found that Portuguese bank BPI would be worst hit, with shareholders' equity falling by almost 6% for every 1% fall in the value of its AFS debt.
"Unsurprisingly, the banks in the periphery, with lower equity base and higher ALM/carry trade portfolios, are most leveraged, with negative marks," the analysts said.
The ALM/carry trade portfolios hold higher-yielding bonds that banks bought with cheap money from the ECB.
Among the bigger banks, France's Credit Agricole and Belgium's KBC would suffer falls of about 2.5% in equity for a 1% fall in the value of their AFS instruments. Falls would be lowest at Credit Suisse, at just over 0.1%, and Lloyds, less than 1%, KBW said.
KBW said investment banks were less exposed to AFS losses than many investors perceive because they have slimmed down their portfolios so much. The 'Value at Risk'(VaR) linked to interest rates has fallen by two thirds across Europe's four biggest investment banks, KBW said.
Some investment banks would benefit from higher interest rates for some business areas, it added. Banks' pension deficits would also look better in a higher interest rate environment.
Pulling an overall picture from the many moving parts can be difficult, but history suggests the transition to higher rates is a painful one. "Banks (shares) have underperformed in the four tightening periods over the last two decades, and by 9 percent on average," KBW said.
Once higher rates are bedded in, most bankers acknowledge it is better for profitability; several have told their investors about the drag of low interest rates on margins.
Policymakers also believe higher interest rates lead to more sustainable lending and investment. At a London conference on June 26, ECB executive board member Benoit Coeure detailed how low interest rates could promote bank risk-taking.
The crisis-tackling policies introduced by the ECB were designed to enable banks to continue lending into the real economy "by taking new risks", he noted.
"The concern is, however, that persistent liquidity sows the seeds for market turmoil."

European car sales sink to 20-yr low

European car sales slumped to their lowest six-months total in 20 years in the first half of 2013, with a 6.3% drop in June suggesting no let up for an industry battered by overcapacity and weak demand.
European automakers have been suffering for months from the effects of record unemployment and government austerity measures in the euro zone, with some such as Peugeot seeking to close factories and lay off workers to counter heavy losses.
Italy's Fiat saw the biggest drop in sales among major manufacturers last month, suffering a 13.6% slide, followed by a 10.9% fall at France's Peugeot, while Ford bucked the trend with a 6.9% rise.
"Even if there is a recovery in the second half of the year, it's hard to see how it could be strong enough to offset the bad results we've registered so far this year," said Quynh-Nhu Huynh, economics and statistics director at the Association of European Carmakers (ACEA), which compiled the figures.
Norbert Reithofer, chief executive of Germany's BMW, said in a newspaper interview on Tuesday he did not expect a rebound in western European markets until at least the middle of next year.
ACEA said car registrations in European Union countries plus those in the European Free Trade Association (EFTA) fell 6.7% in the first half of the year to 6 436 743, the lowest six monthly total since 1993.
Sales in June were the lowest for that month since 1996.
Nonetheless, some analysts were encouraged that sales fell at a slower pace than in many previous months.
"The market has bottomed out, for sure," said Pierluigi Bellini, head of sales forecasts for EMEA (Europe, Middle East and Africa) at IHS Automotive. "We can't talk about a recovery this year, but we see smaller monthly declines going forward."
The German market, which had resisted much of last year's slump, shrank 4.7% in June, while sales in France and Italy fell 8.4% and 5.5% respectively as unemployment and austerity measures curb consumer spending.
Ferdinando Uliano, national secretary of the Italian metalworkers' union FIM-CISL, said high taxes and insurance costs were stifling demand and called on the government to act.
"What is the government waiting for to enact measures to support investment in this key sector?" Uliano said in a statement.
Sales in Britain, in contrast, remained robust, notching up a 16th straight month of gains with a 13.4% increase.
Among luxury carmakers, Mercedes posted a 2% gain, powered by new models, while the BMW brand fell 7.7% and Volkswagen's Audi dropped 8.9%.

Bangladesh tightens labour law

Bangladesh approved a labour law earlier this week to boost worker rights, including the freedom to form trade unions, after a factory building collapse in April killed 1 132 garment workers and sparked debate over labour safety and rights.
The legislation puts in place provisions including a central fund to improve living standards of workers, a requirement for 5% of annual profits to be deposited in employee welfare funds and an assurance that union members will not be transferred to another factory of the same owner after labour unrest.
"The aim was to ensure workers' rights are strengthened and we have done that," Khandaker Mosharraf Hossain, chairperson of the parliamentary sub-committee on labour reforms told.
"I am hoping this will assuage global fears around this issue as well," Hossain said.
The legislation is seen as a crucial step towards curbing rising cases of exploitation in a country with 4 million garment factory workers. But activists said it failed to address several concerns and blamed the government for enacting the law in a hurry to please foreigners.
Bangladesh was under pressure to adopt a better labour law after the European Union, which gives preferential access to the country's garment industry, threatened punitive measures if it did not improve worker safety standards.
Tax concessions offered by Western countries and low wages have helped turn Bangladesh's garment sector into the country's largest employment generator with annual exports worth $21bn. 60% of exports go to Europe.
In late June, US President Barack Obama cut off US trade benefits for Bangladesh in a mostly symbolic response to conditions in its garment sector, given that clothing is not eligible for US duty cuts.
"They have made progress but the government rushed with it," said Rashed Khan Menon, president of the Workers Party of Bangladesh and a member of Parliament.
"They should have spent more time to deliberate on the issue of compensation for the injured and dead, maternity benefits and rights of domestic workers," he said.
The government is in talks with labour groups and factory owners on a new minimum wage for the garment sector. Its current $38-per-month minimum pay is half what Cambodian garment workers earn.
Bangladesh last increased its minimum garment-worker pay in late 2010, almost doubling the lowest pay. This time, wages are unlikely to go much higher as factory owners, who oppose the raise, say they cannot afford higher salaries as Western retailers are used to buying cheap clothing.
The April 24 collapse of the Rana Plaza complex, built on swampy ground outside Dhaka with several illegal floors, ranked among the world's worst industrial accidents. A fire at another garment factory last year killed 112 people.