Banking on Stress

So where is the next banking crisis going to hit?

The bursting of the housing bubble in the US wiped out about $300 billion in bank capital here. That led to the demise of WaMu, Wachovia, Merrill, Lehman, and Bear. It followed a classic boom/bust pattern: innovation leading to price gains, followed by leveraged momentum investing, followed by a bust and financial crisis. After the shake-out and bailouts of 2008, the stress tests of 2009 restored faith in our banking system.

In the aftermath, governments around the world borrowed and spent to prop up demand. In Europe, the banks lent to countries on the periphery, and when the market questioned the sustainability of that sovereign borrowing, phase two of the financial crisis kicked in and the Europeans needed a stress test of their own to restore faith in their system.

Now that the results are in and it looks like most European banks are okay, where is the crisis headed? My money is on Asia. News out of China indicates that Chinese banks lent about $1 trillion to provincial governments during the crisis. But only a fraction of the projects financed are paying for themselves. And $250 billion face serious default risks.

If Chinese banks see these kinds of losses, they also may face solvency issues, reigning in lending and growth. Could a stress test there help? Maybe. But the stress tests restored confidence because they were transparent about assumptions, risks, and results. When I think of China, transparency is not the first word that comes to mind.

Douglas R. Tengdin, CFA
Chief Investment Officer
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