Global Banks Face Recession Risk After Record Profits

Global banks posted their highest profits and returns on equity (ROE) in over a decade during 2022-23, even as the World Bank estimates high double-digit recession probabilities for most countries [2]. This period of strong performance follows a challenging 15 years since the 2008-09 global financial crisis (GFC), which exposed significant vulnerabilities in the sector [2].

Post-GFC Recovery and Lingering Vulnerabilities

The financial services sector, which includes banking, investment, and insurance, is crucial for economic stability by facilitating capital flow and liquidity [1]. While banks have shown strong profitability recently, some institutions, like Credit Suisse, required mergers, and others, such as Deutsche Bank, trade at a low price-to-book (P/B) ratio of 0.4, indicating potential overstatement of loan portfolios and high-risk exposures [2]. This low P/B ratio also suggests low expectations for generating returns on capital [2].

Central banks, traditionally providers of emergency liquidity, have significantly expanded their balance sheets since the GFC. The US Federal Reserve's balance sheet has increased eight-fold since 2008, and the European Central Bank's has quadrupled, reducing their capacity for future interventions [2]. The banking industry, a foundational component of financial services, primarily generates revenue from the spread between interest rates charged on loans and rates paid to depositors [1].

Preparing for Economic Shifts

The current calm in markets may be temporary, with potential "tidal shifts" from geopolitical events, real-estate collapses like China's Evergrande Group, macroeconomic shocks, liquidity crises, or contagious credit defaults [2]. The financial services sector's strength is vital for economic growth, as a failing system can lead to recession, tightened lending, rising unemployment, and reduced consumer spending [1].

To prepare for potential downturns, experts suggest a five-point checklist for banks: investing in businesses with strong returns on capital, selectively adopting new technologies like generative AI (GenAI) for efficiency, optimizing operating and governance models, embracing climate-risk mitigation, and conditioning business units for inflationary scenarios and prolonged recessions by creating liquidity buffers [2].

What to watch

• Global Recession Indicators: Monitor World Bank updates on recession probabilities and macroeconomic data releases for major economies [2].
• Central Bank Policy: Observe any shifts in monetary policy from the US Federal Reserve and European Central Bank, particularly regarding balance sheet reduction or interest rate changes [2].
• Bank Valuations: Track the price-to-book ratios of major global banks, especially those with low current valuations, as an indicator of investor confidence in their asset quality and future returns [2].

The recent period of high bank profits contrasts with underlying economic vulnerabilities and reduced capacity for central bank intervention, raising questions about the sector's resilience to future shocks.