TECHNICAL SCOOP

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Charts created using Omega TradeStation 2000i.  Chart data supplied by Dial Data

The banking system is supposed to be the backbone of the economy is it not. Ok maybe not. Many tout small business as the backbone of the economy. That is most likely a myth as well. Big business helps create numerous small businesses so that would make big business the backbone of the economy. It is the financial and banking system that greases the economy. So one would think that the bank stocks would be amongst the strongest sectors on the NYSE. But the chart above of the PHLX KBW Bank Index appears to suggest that is not the case. The KBW Bank Index remains well below its highs of 2008. Over the past couple of years the KBW Bank Index appears to be caught in a sideways trading pattern as the internal indicators weaken. This suggests that the index could be poised for a fall.*

Note: The PHLX KBW Bank Index is a modified cap-weighted index of 24 exchange listed national and money center banks and some leading regional banking institutions.

Financial crises are nothing new. They have been occurring for centuries. And the cry before the onset of every banking crisis is the same – this time is different. “This Time is Different” is the title of a book written by economists Carmen M. Reinhart and Kenneth S. Rogoff in 2011. Reinhart and Rogoff’s book covers 66 countries across eight centuries. They could have gone back even further. The Roman Empire fell primarily because of a series of banking and currency crisis that resulted in constant debasement of the currency of the day.

History is replete with currency debasement and debt collapses that have resulted in financial panics over the centuries. Since the financial crisis of 2008 over $57 trillion of new debt has been added globally according to studies by McKinsey and Co. The global debt to GDP ratio has gone from 269% at the end of 2007 to 286% in mid-2014. The ratio is most likely higher today. A number of advanced countries including Canada have seen their total debt to GDP ratios increase by 40% or more in the same period. Advanced countries with a gross government debt to GDP ratio over 100% include Japan (over 200%), Greece, Italy, Portugal, Ireland, and the USA. Two countries potentially stand at the potential edge of a Sovereign default – Greece and Ukraine. A Greek collapse in and of itself is not large and Ukraine would be smaller. If a default occurs the real danger is contagion to other countries including Italy, Spain and Portugal.

The world has leveraged up considerably since the financial crisis of 2008. Governments have led the way with $25 trillion of the additional $57 trillion of debt. Deleveraging would have required deep fiscal adjustments or large increases in GDP. Much of the debt growth was because of bailouts of the financial system and stimulus programs. Households have not been immune to adding debt. Household debt to income ratios have become quite high especially in advanced economies such as Canada, Australia, Denmark, Sweden and Netherlands. While the US’s household debt to income ratio has improved since the financial crisis it is primarily because of a sharp drop in mortgage debt outstanding. Credit card debt has continued to grow sharply.

It was announced this week that the Chinese economy shows further signs of slowing. China’s debt has more than quadrupled since the financial crisis of 2008. China’s debt is up more than $21 trillion in that time frame. Where the danger lies in China is its unregulated shadow banking system, its real estate market, and local governments that have borrowed heavily to finance expansion. The Chinese government, however, does have the capacity to bail out any potentially collapsing sectors.

The same might not be said of the advanced economies where many of them including the Euro zone, the US and Canada have enacted bail-in legislation in the event of another banking collapse on the scale of what happened in 2008. Governments, particularly in the Euro zone and the US do not have the capacity to provide bailouts again. Bailouts become the debt of the taxpayer. Bail-ins on the other hand means that depositors and bond holders pay. The bail-in regime has yet to be severely tested except in the case of Cyprus. But its time may be coming if another financial crisis erupts.

Trying to pinpoint where a financial crisis might erupt is difficult. The 2008 financial crisis was triggered by a collapse in the sub-prime mortgage market and the subsequent fall out of the collapse of the structured products and derivatives associated with the sub-prime market. The US mortgage market has shrunk primarily because of tightened rules, more stringent credit application and a lack of qualified borrowers. Maybe it is not a surprise that the sub-prime mortgage market has effectively been replaced by student loans, car loans and a myriad of other banking products that have allowed overall credit to expand in the US even as the mortgage market shrunk.

 Source: www.stlouisfed.org

Then there is the estimated $9 trillion of debt denominated in US$ This comes as a result of a binge of borrowing in foreign countries much of it from foreign corporations and sovereigns taking advantage of low US interest rates. Except now with the high US$ relative to other currencies this debt has become vulnerable. If the US were to raise interest rates even by a quarter of a percent it could move some percentage of this debt into a default position.

Finally few talk about the estimated $278 trillion of derivatives held by just six large US financial institutions – JP Morgan Chase, Citibank, Bank of America, Goldman Sachs, Morgan Stanley and Wells Fargo. The total percentage credit exposure to capital is estimated according to the Office of the Controller of the Currency to be 193%. Total credit exposure to capital is estimated at about $850 billion. Naturally not all of it could collapse during a financial crisis. The bulk of it is interest rate related so a quarter of percentage point rise in interest rates following years of low interest rates could have a negative effect on the banks.

The banks are lagging for good reasons. Stringent new capital requirements set by the Bank for International Settlements (BIS) has forced many banking institutions especially in Europe and Asia to shore up their capital. As well banks are regularly subjected to stress tests to see if they have enough capital to withstand a financial collapse on the scale of what happened in 2008. The regulatory environment remains weak as the banking institutions have fought oversight.

Initial stress tests following the 2008 financial collapse revealed that numerous US and European banks in particular were severely under-capitalized. While the situation has improved it is still not ideal. In 2014 Bank of America passed only provisionally and had numerous deficiencies. As well Goldman Sachs, JP Morgan Chase and Morgan Stanley had to alter plans in order to pass. Many criticize the stress tests as being too easy. As well, the banks have fought against bringing back Glass Steagall that would once again separate banking operations from securities trading. Following the 2008 financial collapse large securities firms such as Goldman Sachs and Morgan Stanley turned themselves into bank holding companies so as to be eligible for FDIC insurance in the event of another collapse.

The regulatory environment for banks is far more stringent in Canada. Parliament has exclusive regulatory authority over banking in Canada. Banks in Canada come under the Office of the Superintendent of Financial Institutions (OSFI). Canada also has a Financial Consumer Agency and as in the US an insurance corporation CDIC. Canada has stronger capital requirements that already met or exceeded the BIS regulatory requirements. Canada has been rated the world’s soundest banking system seven years in a row.

The 2008 financial collapse caused fewer problems for Canada’s banks although they did suffer losses. Since the 2008 collapse unlike the US banks the TSX Financials Index did regain the highs of 2007. However, for the past year the index is showing signs of rolling over. No new highs have been seen since November 2014. Internal indicators have been weakening since November 2013.  A breakdown under 240 could suggest a decline to 200.

Charts created using Omega TradeStation 2000i.  Chart data supplied by Dial Data

The US banking sector is demonstrating considerable weakness as it has failed to keep up with the broader market. Like the broader market, the banking sector has been showing signs of distribution against the backdrop of extreme complacency. There are numerous global debt risks that could result in another major debt collapse and banking crisis as was seen in 2008. The junk bond to US Treasuries spread has been rising, a sign that credit conditions are weakening. A crisis often starts with a trigger. Some have been identified above. But the trigger could come from elsewhere such as the deteriorating global geopolitical situation where a mistake or an accident could trigger a global confrontation between the major powers. It is hardly the time to be complacent.

Copyright 2015 All rights reserved David Chapman

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 -- Published: Thursday, 16 April 2015 | E-Mail  | Print  | Source: GoldSeek.com

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