The Trouble With Banks Is Contained, for Now

Three asset classes -- energy, high-yield corporate bonds and emerging-market currencies -- became unhinged last year amid abnormal asset price volatility. Now the banking segment seems to be getting a lot closer to following the same route. Should this occur -- thankfully, that's still a big if at this stage -- the consequences for the real economy and global financial markets would be much more consequential.

An unhinged asset class is one that loses most of its fundamental anchors, causing any small bit of news to provoke outsize movements in asset prices. The longer this persists, the greater the damage to a shrinking investor base, leading to even greater volatility. In the process, even the stronger names within the asset class are contaminated, increasing the risk of additional rounds of spillbacks and dislocations.

This is what has happened last year to energy (and particularly oil),junk bonds issued by companies rated below investment grade and foreign exchange markets in the emerging world.

Each class experienced eye-popping price overshoots and contagion. And each has yet to regain its footing.

Today, the banking sector is experiencing unusual price volatility, both up and down. These swings have taken place around a declining multiday trend with three self-reinforcing factors exerting an influence:

• Lower interest rates, including negative ones in Europe and Japan, along with flattening yield curves are reducing the ability of banks to generate steady earnings from their basic financial intermediation function.

• Persistently low economic growth, together with the sharp decline in commodity prices, are placing pressure on the credit quality of banks' loan portfolios.

• Periodic reminders from regulators that, after highly controversial past bailouts, investors no longer have the backing of governments, which is making both equity and bond holders more anxious and their capital more flighty.

These three contributing factors are far more in evidence in Europe, and banking institutions there have been hit a lot harder. In addition, despite progress brought about through the determined insistence of the European Central Bank, European banks have lagged their U.S. peers in bolstering their capital cushions, improving their assets and convincing markets of their willingness to be sufficiently transparent in conveying information.

Last week, a handful of banks -- including in France, Germany and Switzerland -- saw their stock prices fall to multidecade lows. This forced some bank executives to reassure markets of their institutions' robustness, and required a government official to back those reassurances.  And, in at least one case, an institution intervened to support bond prices via buybacks.

Although banks generally have a more robust anchoring than the three other asset classes, increased volatility should be monitored carefully over the next few weeks (even though we are nowhere close to the type of banking dislocations that crippled the global economy in 2008-09). 

Should the banking sector become unhinged, the flow of funds to companies and households  would slow, and international trade financing would be more expensive and less accessible. It also would further restrict the already limited appetite of broker-dealers to alter their balance-sheet inventory to accommodate investors seeking to reposition their portfolios.

The trouble with banks, though notable, has been containable so far. But should it evolve into a much sharper downturn, there could be serious consequences for a slowing global economy and for financial markets that have generally had a lousy start to the year. Those are risks that the global economy and markets can ill afford at the moment.