Introduction
The overwhelming view of financial sector and media is that banks have made strong recoveries from the problems of 2007-9. Earnings are resilient, share prices strongly up in 2024, and 2025 should be another good year. But closer analysis shows that this view is optimistic. Large financial institutions have balance sheets where relatively few assets are traded and where subjective valuations play a major role in determining balance sheet values. Should these subjective valuations prove wrong – as they did in the last crisis – then apparently safe profit levels will be revealed to be losses. Regulators have recently enhanced their focus shift from capital adequacy to liquidity and are attempting to convince the world that they can supervise liquidity. All they can do is create and pump liquidity. This Newsletter exposes the dangerous and increasing role of collateralized funding, which in fact strips bank depositors from higher quality assets on which, pre-2009, they used to rely.
Commercial Experts’ Views
European banks have never been stronger since the 2008 crisis, according to the financial media and the banks themselves. Goldman Sachs put out a note in September 2024 that share prices were up by 25%1, and by the end of the year bank shares were up by 32% in calendar year 2024, their performances demonstrating resilience amid falling interest rates, earnings remaining strong. 2024 was the best year for banks since 2010.
European Union banks, especially those focussed on fee income and wealth management services, stayed profitable. Eurozone banks, benefitting from large capital buffers and lower non-performing loan ratios, were even stronger. Those suffering lowering loan growth “offset” this problem by effective risk management.
At a more detailed level, accountancy firm Ernst and Young (EY) noted that 2025 will prove challenging for banks with pressures to use technology more effectively with customers’ demands for personalised offerings and service such as round the clock support2. Also, noting that staff want to work from home three days a week, the availability of global talent pools, and modifications to ESG (Environment, Sustainability and Governance), EY notes that banks will have difficulty maintaining individual cultures.
Nonetheless the mood of optimism abounds; in the light of new US tariffs not one European bank has downgraded its future profitability guidance. Artificial Intelligence (AI) is hailed as a continuing source of cost reductions, even though there is copious evidence that there is an upper threshold to viability, and there are constant reminders of the absence of crises and stability of credit quality.
But is this the view of the European Central Bank (ECB)?
ECB Views
In its May 2025 Financial Stability Review3, the ECB indeed notes that US tariff announcements have caused sensitivity in the banking market but also observes how well banks have responded owing to strong equity valuations and credit spreads.
The Report does however note that the debt service capabilities of euro area companies declined in 2024, owing to slow growth, resulting “stagnant net income” and increased interest expense4. The position is similar in the US and BBB rated corporate spreads have already risen this year:
The Report then comments on the rise in the price of gold and observes that 60% of gold is bought by central banks and investors primarily as a hedge against “policy uncertainty” but cautions that large financial institutions might suffer losses.
The Report then turns to bank non-performing loan levels and ratios in a section entitled:
“Asset quality deterioration has remained contained, but credit risk and provisioning needs are likely to increase”5
Here the Report explains that the commercial real estate market has never recovered from the COVID era work from home culture, and that SME (small medium enterprise) lending is not in great shape. The gist of this section is that the outlook for corporate debt is at least mildly concerning. Regarding non-performing loans, we have previously commented on how the accounting rules and practices were subtly changed to enable banks to reclassify many NPLs as “performing”.
We are then told that open ended funds invested in corporate bonds have seen outflows, and if these increase there could be pressures to sell assets. Here the Report touches on structural liquidity mismatches, official language for borrowing money on a short-term basis but investing or lending long term. The March 2023 collapse of Silicon Valley Bank was substantially due to such mismatches.
“As a result, liquid asset holdings are frequently insufficient to cover a severe yet plausible redemption shock.”6
The overall tone of the Report is that the outlook for banks’ profitability is somewhat cooler than the media and markets imply.
Real World Inputs – Collateral Transformation
What the ECB’s Report fails to mention are the immense levels of central bank support 7 from which the banking system has benefitted since the 2007-09 crises. All these benefits incline first to banks, providing a permanent source of liquidity which enables them to maintain the appearance of solvency. Indeed, had these measures such as quantitative easing been in place prior to the crises, there is considerable doubt as to whether the crises would have occurred at all in Europe. For example, many banks lost their shirts on US sub-prime loan portfolios; in today’s world such portfolios could be sold to the national central bank at par.
But this is only one aspect of fiscal largesse, with multiple policies being enacted at sovereign level with the primary aim of supporting banks. House prices are a major area of risk for banks given the ECB’s concerns about many other asset classes above.
In the UK, no longer a part of the EU but increasingly close to rejoining, since 2021 banks have had the opportunity to “buy” a guarantee on the riskiest parts of mortgage loans from 80% Loan to Value (LTV) to 95% LTV. Naturally this law was criticised when enacted in 2021 as simply propping up the prices of starter homes, which in effect bolster banks’ asset portfolios. But this criticism generally appeared only in technical financial sections of the press. It was noteworthy that, by 2021, over a decade of bank friendly policies seemed to have ingrained publics and politicians everywhere into the need to do anything to avert the “disaster” of a future systemic banking collapse. Many European countries have similar policies, or restrictions on repossessions (Spain).
But perhaps collateral transformation is the greatest threat to the health of the banking system. In a detailed report8, John Butler analyses the emergence of collateral transformation and its sister term “shadow banking system”. He argues that the reason that top US bank economists, most of them trained at the Fed, failed to predict the 2007 crisis was their lack of understanding of this important and largely unregulated source of liquidity. John argued that securities repo and other forms of collateralized lending had destabilized the financial system from 2006, but his counterpart US economist disagreed, perhaps failing to understand the term “collateralized transformation”.
Conclusion – Regulations are the Problem
Just as bank regulators today argue that their mistakes of the 2000s were to regulate bank capital and not liquidity, since 2013 the Bank for International Settlements has emphasised the importance of regulating “collateralized funding markets” i.e. liquidity.
In their reports the BIS warn of the post crisis practice of banks funding each other secured on collateral, which it notes will further expose customers. If banks mortgage to each other their highest quality assets then depositors and customers are being effectively subordinated in the capital structure, with few assets left to rely on.
The increased focus of regulators on liquidity and collateral transformation does not protect the system at all, rather it encourages all banks to behave in the same way and in effect grow the systemic risk. In short, by expanding their role into liquidity the regulators have in effect shut out markets from performing their natural function of allocating savings and liquidity efficiently.
1 STOXX Europe 600 banks index European bank stocks are forecast to rally even more | Goldman Sachs
3 Financial Stability Review, May 2025
4 Ibid clause 1.3
5 Ibid clause 3.2
6 Ibid clause 4.2
7 EU shadow borrowing increases | Lyddon Consulting
8 Backdraft in the banking system – by John Butler
