Bail in risks….

Banks earn a spread on the money they lend versus the money they borrow.  The historically low relative return for cash based investments has been based on bank regulation, risk management and government backed deposit based guarantees. 

But with bail ins now becoming a de facto solution for dealing with bank liquidity/solvency issues, should not returns on cash based investments rise, and what should be the reference benchmark?  Additionally, how does this impact the bonus culture for deposit taking banks?

The only way historical risk/return relationships for deposit based investment can be retained is if banks increase their regulatory capital and reduce their leverage.  In other words, they need to lend less and take fewer risks, precisely the opposite of what QE and other similar measures are trying to do.

To create higher rates of return on cash, to compensate for the greater risks, banks marginal return on capital will fall as funding costs rise – rates are unlikely to rise at present for a number of reasons, and if they do, risk premiums on assets across the board would need to adjust.  This could all impact the dynamics of a financial recovery in the current relative debt heavy scenario.

Whichever way you swing the axe, the economic impact is likely to be more or less the same!  And of course, bank stocks are going to be impacted because returns to shareholders will fall.  But if the cost of capital is to rise so must the risks to capital, meaning that risky asset valuations will either need to accept lower returns or adjust their risk premiums via relative price movements.

Leave a Reply