Spiraling share prices and annual losses bad enough? Banks may not get their FX borrowings back either

Investor concern over the collapsing share prices of some of the largest banks and FX interbank dealers recently has been extremely high, and indeed not without justifiable reason.

Banks mired in balance sheets which are in the red for the first time since pre-financial crisis 2008 adorn Canary Wharf’s waterfront, and investors, prime brokerages and liquidity takers are concerned about the cash position of these giants.

The actual corporate performance is not the only cause for concern, however, as today it has emerged that there is a further liability which could manifest itself.

Many banks have lent money in currencies that borrowers will find it difficult to pay back, therefore the FX liability is very high indeed.

This particular situation illustrates the way that capital flows operate in a financially integrated world and how they contribute to both booms and busts.

The Bank for International Settlements (BIS) has collected data that confirms that the total amount of dollar and euro lending to non-bank borrowers outside the US and the euro area grew 57% during the past six years to $12.7 trillion.

One of the main contributing factors toward this was that both the US Federal Reserve and the European Central Bank held interest rates extremely low for a long period of time to support their own economies. This caused many banks to seek higher returns elsewhere, and also made borrowing in their currencies very attractive all around the world.

This matter may well have been a sleeping peril had the US governent not considered raising interest rates recently.

The increase in interest rates plus a conservative view toward the financial position within many emerging markets have both caused the dollar to rise against many currencies, major and otherwise.

The extension of credit on a large scale to entities (and even countries) that may not have the means to settle it has historically been the cause of severe financial problems on a national, and even global scale, however the FX liability in today’s environment highlights a potentially harsh exposure.

In addition to the dollar’s increase, the euro has surprisingly increased against some currencies, too, mostly in emerging markets.

Due to these rises, borrowers in countries such as Brazil and Turkey, whose currencies have weakened, will find that the cost of paying back all that debt has increased considerably.

On a per-country basis, the local currency value of dollar and euro debts to banks has grown substantially as a percentage of gross domestic product over the past two years just due to exchange rate fluctuations, never mind other economic factors.

Should banks begin to take measures to mitigate exposure to this, they may reduce leverage on the amount that banks can borrow or lend to eachother in equity and in doing so curtail the amount that those borrowing would be able to obtain and therefore would not find themselves in a position where they cannot pay what they owe.

Meanwhile, the elephant in the room advances.

Photograph: “Money to Burn” by Victor_Dubreuil, oil on canvas, 1893