Why the Banking System Will Not Collapse

[Toro]

Many banks are going under but the banking system is repairing itself, albeit slowly.

The panic is overwhelming. The negativity is unrelenting. I think an entry point in specific banks is not far away.

Two interesting articles about why the financial system is not the Great Depression, or even Japan.

Indeed provided you can maintain access to funding the opportunities in banking are the best that they have ever been in my life. The margins are massive. Many people want (even need) to borrow money – and if you have money to lend you can select on the absolutely best credits. Your risk is much lower than it was on the average loan in the boom. The implied return on equity is much higher.

Happy days.

Of course they are happy days only if can maintain your funding (far from being a given) and you do not have losses so big from the boom that you will be wiped out (also far from being a given).

But in the past most banks that have got into trouble have been recapitalised by pre-tax, pre-provision earnings. And at the moment pre-tax, pre-provision earnings are going up.

For the record this is very different to Japan. In Japan bank spreads collapsed to 30bps. They did this because of the vast excess deposit bases at zero interest rates. But I cannot find another banking crisis in which bank spreads have fallen.

Bronte Capital: A series of quarterly numbers

Banking is a unique industry. Unlike virtually any other industry on earth, banks deal in a product that never goes out of style - money. As long as a bank maintains adequate technology and human capital to compete in the marketplace, long-term profitability is virtually assured, because demand is assured. As long as a bank can generate positive cash flows, and as long as the NPV of these cash flows exceeds the NPV of the losses from the defaulted assets, then the present intrinsic value of that bank’s common equity is positive. A bank can therefore have a very negative net worth and still have a highly positive net present value.

What about the impact of the toxic assets on the balance sheet? Many may worry that allowing banks to carry negative book value (in HTM value terms) will create a “zombie bank” situation, such as that which existed in Japan. But the Japanese analogy isn’t apt. In Japan, the government forced banks to continue to lend to unprofitable companies, effectively preventing Japanese banks from being able to dig themselves out, since they were forced to throw good money after bad.

This isn’t what’s happening to the US, nor should we expect it to happen. The US isn’t forcing banks to make new lows to borrowers
in default.

So is allowing the banks to operate with negative equity
in HTM terms a free lunch? No. Carrying the non-earning toxic assets on their balance sheets will cause US banks to earn a lower return on assets over the next few years; this reduces the NPV of their common equity.

There should be no free lunch for the common equity shareholders
of banks, nor need there be. That’s the point. In the example provided, bank equity holders are paying for the full value of their losses. However, they’re doing so over a number of years. There’s no need for dilutive equity offerings, and absolutely no need for government subsidies that socialize the banks’ losses. As long as banks are allowed to value their assets at acquisition cost and gradually charge them off over a period of, say, 15-20 years (similar to depreciation), the banks can continue to operate normally by collecting deposits and extending new credits to credit-worthy customers.

Op-Ed: Are US Banks Worthless? - Minyanville