Banks from countries that are still enjoying financial booms may be weaker than they appear as reliable warning indicators are flashing red, said the Bank for International Settlements (BIS).
BIS, known as the central banks' bank, said it was mainly concerned about financial institutions that are exposed to emerging markets, such as China, where economic growth is being fueled by unstable leverage based on a benign credit outlook and a potential for strong earnings.
But BIS’ concern is not limited to emerging markets but extends to banks in some advanced economies, such as Switzerland and the Nordic countries where high market valuations “may be reflecting fast credit growth and frothy property prices,” BIS said in its latest annual report.
Although several indicators, including non-performing-loan ratios (NPL), are signaling an upbeat message about banks in emerging Asia and Latin America, BIS cautioned that “such indicators failed to signal vulnerabilities in the past.”
Because of their backward-looking nature, NPL ratios did not rise in advanced economies until 2008 when the financial crises was already under way, just as credit ratings and market valuations failed to warn of the imminent financial distress.
“In contrast, measures of credit expansion and the speed of property price inflation, which have been reliable earning warning indicators, are flashing red lights about a number of emerging market economies at the current juncture,” said BIS.
BIS has developed an early warning indicator for domestic banking crises that is based on the a credit-to-GDP gap - the difference of credit to GDP ratio from its long-run trend - along with a property price gap, or the deviation of property prices from their long-run trend.
The credit-to-GDP gap is above 10 percentage points for Asia in general, along with Brazil, China, India, Switzerland and Turkey. The indicator for the property price gap also shows a high level for Asia and Switzerland, with the indicator flashing red for Brazil and China in the event that interest rates rise by 2.50 percentage points.
“The historical record shows that credit-to-GDP gaps … above 10 percentage points have usually been followed by serious banking strains within three years,” said BIS.
The credit-to-GDP gap is used by the Basel Committee on Banking Supervision as a starting point for discussions about countercyclical capital buffers, now applied in Switzerland and Norway.
Capitalisation ratios – a measure of market value divided by book value of liabilities – have also been declining for emerging market banks and non-financial corporates (NFCs). Not only are NFCs the main source of credit risk to banks in emerging markets, but they have also recently joined the credit intermediation chain.
The decline in Chinese banks’ price to book ratios in the last five years is one sign of investors’ growing skepticism, with the explicit and implicit links between regulated and shadow banks contributing to this skepticism, BIS said.
Non-bank credit to these private non-financial corporates has exploded in recent years, with its share of China’s total credit rising to 25 percent by the end of last year from 10 percent in mid-2008.
Corporate deposits in many other emerging markets, such as Chile, Indonesia, Malaysia and Peru are also above 20 percent of the total assets of these countries’ banking systems and if those firms lose access to debt markets they could withdraw their deposits, leaving banks with funding problems.
A number of defaults and near-defaults among China’s shadow banks contributed to a drastic reduction in the country’s credit supply in the first quarter of this year, with strains expected to have repercussions on banks because they acted as issuers and distributors of shadow banking products.
In addition to these risks, BIS said banks will also have to deal with the phasing out of monetary accommodation in advanced economies and appealed to authorities to not be lulled into a false sense of security but to reassess some of the macroprudential tools that have previously been used in emerging markets.
In addition to the risks from high credit, BIS said the shift in bank lending to market-based debt financing by non-financial corporates has changed the nature of risks.
On the positive side, many borrowers have taken advantage of favourable conditions to lock in long term funding. Less than one-tenth of the roughly $1.1 trillion outstanding in international debt securities by borrowers from emerging markets, matures in each of the coming years.
“But the benevolent impact of longer maturities could be offset by fickle market liquidity,” said BIS, noting that market funding is notoriously procyclical and easily available when conditions are good but dries up at the first hint of problems.
Another risk facing emerging markets is that a growing portion of investors now have short-term horizons which tends to amplify shocks when global conditions deteriorate.
This is illustrated by the shift away from traditional open or closed-end funds to exchange traded funds (ETFs) that can be traded on exchanges and used by investors to convert illiquid securities into liquid instruments.
ETFs now account for around 20 percent of all net assets of dedicated emerging market bonds and equity funds, up from around 2 percent a decade ago.