Western households have binged on low-interest debt. Banks need to be ready for when it all goes south, writes Brian Caplen.

To succeed at their jobs, bank CEOs must be optimistic about the future. They must believe that the economy is set to grow, businesses and households will prosper and the majority of borrowers will repay their loans. Without optimism, their chances of expanding the business and increasing returns to shareholders are severely constrained.

But the best bank CEOs also keep a close eye on when credit conditions are set to unravel, and they do not allow their optimism to outweigh prudence in balance sheet management.

They would be defying gravity if they did not prepare for some hard knocks from the current credit binge. In the UK, incomes adjusted for inflation are falling and savings rates are at the lowest level on record – just 1.7% of disposable incomes.

At the same time, consumers have been taking advantage of record low interest rates to go on a credit binge serious enough for the UK’s Prudential Regulation Authority (PRA) to warn firms against a loosening of underwriting standards and further reductions in pricing. The Bank of England’s financial stability director, Alex Brazier, said in a recent speech: “Lending standards can go from responsible to reckless very quickly.”

One area of concern is car loans. The trend for cars to be obtained under personal contract purchase plans, with an option to hand back the vehicle at the end of the contract, makes lenders vulnerable to a downturn in the used-car market, according to the PRA. In the US, auto prices have dropped 10% and overdue car loans are on the rise.

According to the Federal Reserve Bank of New York, US household debt reached $12,730bn in the first quarter of 2017, surpassing the $12,680bn peak at the start of the 2008 financial crisis.

Some analysts point out that despite the rise in the aggregate figure, the US household debt to GDP level is below its recent peak of 95.5% in 2008. But a change in the composition of the debt should still make them sit up and take notice. The growth in credit card, auto and student loans as opposed to mortgage debt makes lenders more vulnerable to non-payment.

The reality is that quantitative easing and on-going rock bottom interest rates have had a huge distortionary impact on consumer behaviour. It is hard to see how this will not end badly.

 Bank CEOs who ignore the dangers are not performing their duties properly. Better to sit this one out than do a Chuck Prince. The former Citi CEO famously said before the financial crisis: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Unfortunately for Chuck the music stopped very shortly after he made those comments. 

Brian Caplen is the editor of The BankerFollow him on Twitter @BrianCaplen

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