ECB President Cautions Interest Rate Hike, But Banks Are Ill-Prepared
With ultra-low-to-non-existent interest rates in the western world, banks are experiencing something of a borrowing ball. As a result, one European politician is becoming concerned about the reliance of financial institutions on cheap debt.
"Emergency treatment and strong medicines are sometimes necessary. But, if their use is prolonged, they can lead to dependence and even addiction ... Eventually, the administration of painkillers must be stopped if patients are to get back on their own two feet," European Central Bank (ECB) president Jean-Claude Trichet told an industry rag recently.
Trichet added that if signs of price inflation begin to creep into the Eurozone economy, policymakers there will be forced to ramp up interest rates.
Indeed, as a result of the Federal Reserve's zero interest rate monetary policy, something of a backwards logic is in play among financial institutions these days:
You see, as bizarre as it may sound, the market is actually rooting for bad news to extend the Fed's zero interest rate policy (ZIRP). And if it manages to send the dollar even lower -- that's something of an added bonus.The Problem With LeverageThat is the twisted logic the U.S. dollar carry trade has now given us. Because when it costs you virtually nothing to borrow in dollars, you can plough them into other assets in a game with little risk.
These issues go to the heart of a concept every non-financial executive has come to loathe since the beginning of the economic fall-out: leverage. The problem that policymakers in the U.S. now face is that by bailing out the largest domestic institutions as they did 18 months ago, they effectively leveraged those organizations to the hilt.
In other words, a share of Citigroup (C), Bank of America (BAC), Wells Fargo (WFC) or any other TARP recipient is not the same thing as it was before the financial crisis began, since it now represents a claim on the earnings and assets of the bank, plus billions in cheap government-sponsored debt. Ironically, when it was coupled with low interest rates, this scenario produced a financial system just as reliant on leverage as in the days of heavy credit derivatives trading.
That's part of the reason that hedge fund manager John Paulson favors the growth prospects of Citigroup and Bank of America over those of Goldman Sachs (GS) right now: the former two are much, much more geared with debt (which should in theory help them to expand artificially faster).
Certainly, U.S. policymakers seem ready to start the reverse process of deleveraging, by incrementally increasing lending rates. Earlier in the week, the Federal Reserve announced that it is re-introducing its capital adequacy checks for banks such as Goldman Sachs, JP Morgan (JPM) and Morgan Stanley (MS).
However, the problem the Federal Reserve faces with lifting interest rates right now is that essentially, the practice could end up causing exactly the same problems as homeowners who defaulted on their mortgages in 2007 did. In other words, too high an interest rate policy too soon will cripple the big banks' earnings growth, since cheap, government-organized debt is central to financial institutions' ability to grow and prosper right now. If you like, low interest rates to banks this year are what collateralized debt obligations were to banks in 2006.
ECB's Trichet is hinting at a worrying development: the closer you look at the banking system as a whole these days, the less difference and the more in common you find with the past era of excess.