Bank Capital Ratio Strength Offset By Non-Performing Loans

The Bank of International Settlements released its 84th Annual Report covering 2013/2014. The quality of bank balance sheets were brought into question.  During the Great Recession, bank capital ratios became a headline phrase. The banks have committed to general rules since then and when it comes to boosting capital rations there has been progress above the minimum amount implied in Basel III phase-in arrangements.  However, that strength in the capital structure has been offset by what Bloomberg reported Sunday morning as the continuous growth in non-performing loans since 2010 in places likes Spain and Italy.  The reason it's offset is because low rates banks have been able to mask those losses and increase capital ratios through net income generation.  Speaking to this very idea, the BIS report says "The capacity of capital to absorb future losses is severely undermined by recognized losses on legacy assets" and this impacts the flow of money because "unrecognized losses distort banks' incentives, diverting resources toward keeping troubled borrowers afloat and away from new projects".    This concept is echoed by the recognition that corporate equity returns have been driven by P/E multiples and not organic earnings.

Touching on the observation of low volatility, the BIS pinned Forward Guidance as the influence.  Referencing data displayed on the center panel in the figure below, the BIS says "The responsiveness of interest rate volatility in the euro area and the United Kingdom to US rate volatility fell considerably after the ECB and the Bank of England adopted forward guidance in summer 2013".  Readers will also recall the US Fed discussing removing their forward guidance, which they began releasing in August 2011.  Until central bank forward guidance is no longer a major influence, it would appear that volatility is remain removed for the markets.

Until we can pass through the next 2 quarters of data US economic updates, there is still room for expansion even as the underlying fundamentals do not support a robust and sound recovery, in the US or globally.  Wiggle room still exists for expansion as noted by Goldman Sachs GS in an April note before markets will have to face more certainty about when the Fed will remove the punchbowl of low rates.