Major European banks threaten the financial stability of the United States

Donald Trump's victory in the race for the White House and the subsequent stock market rise have relegated to the background the publication of a worrisome report, not just for the financial stability of the United States as well, but for that of the world.

The 2016 Financial Stability Report of the Office of Financial Research, (financialresearch.gov), an independent structure of the Department of Treasury shows that the very low interest rates of the last few years have caused investors to turn to increasingly risky investments and the accelerated increase of debts, the advance of which has significantly exceeded the economic growth.

The OFR was set up after the coming into force of the Dodd-Frank law (author's note: the Law for the reforming of Wall Street and protecting consumers), and its activity focuses on evaluating and monitoring the threats to the financial stability of the United States.

Aside from identifying "trendy" threats to the financial American system, such as cyberattacks, the report points out that "macroeconomic risks to the financial stability of the USA originate from global factors", as "companies have a high degree of interconnectedness, and key activities are concentrated with a low number of major players".

The situation is similar for financial institutions, and that is where the report identifies the major exposure to Europe of American banks of global systemic importance a risk factor.

The amount of that exposure is about 2 trillion dollars, of which half is off-balance sheet. Major American banks have also sold credit derivatives with a notional value of 800 billion dollars, whose core assets are in the European financial system.

These exposures now have to withstand "an increase in risks at the level of some European banks, which present substantial interconnections". Furthermore, the report also notes that "financial stability and the economic growth of the United States could be affected even further in the event of other threats to the European cohesion".

The OFR report also presents a comparison between major American and European banks in terms of their leverage ratio.

Thus, out of the major European banks, only Royal Bank of Scotland and Credit Agricole have a leverage ratio greater than 5%, the minimum threshold required by the regulatory institutions of the US and Switzerland, and HSBC has a leverage ratio of 5%. According to the Basel III Capital Agreement, the minimum leverage ratio for banks of systemic importance is 3%.

The aforementioned department of the US treasury seems to be concerned by the underestimation of risk weights used to determine the capital adequacy ratio among European banks, which allows them to report a good capitalization ratio. The phenomenon is reflected in the major differences that exist between the total assets and the total risk-weighted assets.

Aside from banks, insurance companies in the US also have significant exposures to Europe, represented by reinsurance contracts and financial derivatives. For the top ten American insurance companies, the OFR estimates an exposure of 32 billion dollars to European companies.

Threats to the financial stability of the US do not only come from European banks, however. There are many sources of domestic instability sources, of which the most significant is the accelerated increase of the non-government credit.

"Loans granted to non-financial US companies in the US continues to increase faster than the GDP", the stability report of the OFR states, having reached 45% of the GDP, a higher level than in 2007 and close to the historic high of 46%, of 2009.

The economic growth staying behind the increase in credit shows that the marginal return of the new debts has decreased significantly, perhaps even into negative territory, and the actions of the central banks to stimulate lending, can no longer be justified.

Another concerning trend, tightly tied to the advance in lending, is the rapid growth of commercial real-estate prices, as the OFR estimates that the amount of loans using commercial real estate as collateral is approximately 3.6 trillion dollars.

The OFR report also emphasizes that "American firms have increased their leverage ratio over the last few years, by issuing bonds and stock buybacks", a phenomenon which leads to an increase in credit risk, risk which is present in the portfolios of banks, insurance companies, mutual funds and pension funds.

In this context, the biggest threat to the financial stability is the hike of interest rates, amid the major increase in the leverage ratio over the last six years, and the authors of the report recommend the application of stress tests to corporate bondholders, which would include the scenario of "severe payment inabilities".

In his latest monthly analysis, Bill Gross, fund manager at investment firm Janus Capital, writes that an increase in the yield of American 10-year government bonds above 2.6% will represent the most important moment of 2017, because it will lead to a long-term decrease of the value of government bonds. "2.6% is the key element for the interest rates and maybe even for stock prices in 2017", says Gross.

Another important name on the financial market, Jeffrey Gundlach, the executive CEO of investment firm DoubleLine Capital, disagrees with Bill Gross's opinion, and says that the final threshold beyond which a significant decline of the market for government bonds would occur is a 3% yield on government bonds with a 10-year maturity. In Gundlach's opinion, "these bonds reaching a 6% return by 2020 should not be considered a radical forecast".

The yield of 10-year US government bonds has increased in the last six months, from approximately 1.5%, to almost 2.6%, and in the beginning of the year it has oscillated around 2.35%.

The return of long-term government bonds represents a benchmark not just for the bonds of companies issued domestically, but also for the borrowing costs on other developed or emerging markets.

A study presented on the blog of the Bank of England (bankunderground.co.uk) states that 2016 was the year of the biggest speculative bubble on the bond market, based on data from the last 800 years. The author, Paul Schmelzing, of the Harvard University, thinks that the historical experience indicates the nearing of the moment when the trend will reverse, as a result of inflationary pressures, and investors will suffer bigger losses than in 1994, when a "bond massacre" occurred.

How big? Hard to estimate, but two factors can provide a starting point. According to a report by McKinsey Global Institute of February 2015, the global debt was 246% of the global GDP in Q4 2000. In a recent report from the Institute for International Finance (IIF) it is shown that the total global debts se have exceeded 325% of the world's GDP in 2016, amid the accelerated increase of government debts. In the first nine months of 2016, the global debt has increased 11 trillion dollars, to 217 trillion.

If in 1994 it was a "massacre", what is the word that can depict the scale of the collapse of the bond market, when the return of 10-year American bonds increased to 6% by 2020, up from 2.4% currently? And what more can the central banks do?