Why the Market Freakout About Bank Stocks is Well Warranted

It’s ugly out there.

The proximate cause of this week’s market wobbles was a sharp selloff in bank stocks in Europe on Monday. That appeared to be triggered by the recognition that energy related dud loans could imposes losses of an additional $100 billion on already wobbly banks. And that’s before you get to the fact that many banks already had corporate loans they had not written down sufficiently and those books can only be getting worse given low growth and borderline deflation in Europe. And on top of that, European banks lent to other commodities players, not just energy concerns, and many were active in lending in emerging markets (Deutsche Bank, the most undercapitalized of the megabanks, is almost certainly exposed to all these trades, and its stock has been swooning accordingly).

But as bad as this bad loan story is, and the foregoing is already pretty ugly, the underlying structural and regulatory picture is is vastly worse. Central banks have painted the financial system in such a tight corner that it’s not clear how they get them out. And even if there were no big dud loan overhang, banks would bleed to death under current circumstances.

First, the current low interest rate environment has been squeezing banks’ bread and butter source of earnings, like risk-free income on float and other sources of net interest margin (“NIM”), as Izabella Kaminska has reported at FT Alphaville. From a post last week:

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