The European banking sector: a gloomy picture in early 2016?

European stocks have experienced a difficult start of the year (Soughley and Zega). George Soros draws parallels with 2008 while The Economist wonders if we are seeing a repeat of the financial crisis. For Russo, the rout in the Stoxx Europe 600 is driven by concerns about bad loans at banks adding to worries about an oil rout and China’s economy. Doom-sayer Nouriel Roubini predicts the Global Economy’s New Abnormal, caused by a variety of factors like concerns about China, worries about the US economy, geopolitical uncertainties and plummeting commodity prices, especially oil—magnified by grim medium-term trends.

The fall in bank equity prices reflect investors’ worry about the health of the region’s banks and slowing global growth, according to Masoni and Prakash, a reminder of the 2008 crisis (The Economist).

What are the factors hurting European bank shares? (i) Sluggish economic growth tend to generate bad loans; (ii) Specific worries, e.g., issues about Deutsche Bank’s ability to pay coupons on its $5 billion in convertible bonds; (iii) Greek banks hit by renewed worries about the country’s bailout agreement (BBC). Finally, the prospect of a long period of negative interest rates in the euro zone may weigh on bank profits, as they are unwilling to pass them on to their customers. This can be a recipe for a perfect storm (Moss). The Economist points out other fundamental problems in the European banking sector: too many European banks are not profitable and investors are scared by the new European approach to bail in creditors if large losses occur.

Banking risks, as illustrated by Frances Coppola, may have risen as a result of new capital requirements. Erik Nielsen (Unicredit) reminds indeed that policy makers launched a series of capital requirements and regulation, resulting in huge costs to banking operations. Compounded with the effects of monetary policy (flat curves and negative rates, which eliminates earnings from maturity transformation). For Nielsen, the recent sharp fall in banking equity prices is driven by three distinct events: (i) market participants (generally – and somewhat excessively - worry about Italian NPLs) have expressed disappointment about the deal between the Italian government and the European Commission (see last week’s blogspot); (ii) confusion and disappointment about Portugal’s handling of the securities in the Novo Banco affair; (iii) January was littered with single-name events and stories of banking difficulties. Jernej Omahen, at Goldman Sachs, is more nuanced, noted that ample liquidity and more capital on banks’ balance sheets reduce the risk of a crisis re-run (see research), though he notes that reasonable earning are offset by negative sentiment (GS).

In the short term, confidence management has played an important role—from announcement of debt buy-backs (DW, FT and FAZ) to Wolfgang Schauble brushing worries aside.

Paul Davies (WSJ) investigates the reasons behind the fall in banking stocks—partly due to crashing energy prices or emerging markets (but those are not new factors), but mostly a chronic profitability crisis that makes it impossible for banks to build up barely adequate capital bases—a problem that cannot be solved by the ECB. Even more so, monetary policy may be contributing: very low interest rates hurt the profits banks make on loans, especially as long-term and short-term rates converge, and negative rates forcing banks to pay to leave funds on deposit at a central bank, all this contributing to an actual tightening of credit. This makes dealing with bad loans harder to deal with. Earnings are necessary for banks to continue to add capital, leaving them with two options: make riskier loans for higher returns (but higher chance of default) or raise capital.

What do financial market experts say about European banks? Macdonald argues that important restructuring efforts and higher capital levels are necessary. Stubbs (JP Morgan) is concerned about important uncertainties in the Italian banking sector, especially credit quality, as Italian banks combine all uncertainties (Wheeler). Deutsche Bank has exemplified those concerns—with interventions to limit the panick (announcement of a debt buyback) at an opportune time (Eurointelligence and Mack).

A generalized crisis (of confidence) in the European banking sector. For Eurointelligence, market concerns are generalized and not concentrated on Deutsche Bank, with several large financial institutions (Credit Suisse) registering bigger losses over the past year. For Vidal-Folch, this crisis requires new global, political and economic, leadership and greater international monetary coordination (Ghizzoni). The current crisis does not only concern banks but is due to interactions between banks and sovereigns, with substantial investors’ discrimination (Eurointelligence).

The specific case of the Italian banking sector? The high share of bad loans makes the Italian banking sector particularly vulnerable: 16.7 percent of Italian bank loans are non-performing against a European average of 5.6 percent (Pastakia) while higher sovereign spreads (Micklethwait) compound the issue. For Shapiro, this could lead to a very serious crisis. The recent agreement to resolve the NPL problem in Italy received mixed reviews (see our previous blogspot).