“The current European banking troubles, with significant declines in market values and 1 trillion Euro of bad loans, sure doesn’t fit the liberal U.S. narrative, that greedy and reckless bankers and lax regulation caused the crisis, does it? It does fit the libertarian/conservative narrative though, that well-intended government policies and central bankers distorted free and fair markets and disrupted rational decision-making by borrowers, lenders, and others.”, Mike Perry, former Chairman and CEO, IndyMac Bank
Paul J. Davies, February 8, 2016, The Wall Street Journal
Why European Bank Stocks Are Getting Hammered
A big profitability problem risks making European banks’ other, known issues worse
Shares of European banks, including Italy’s UniCredit, dropped on Monday. PHOTO: ASSOCIATED PRESS
By Paul J. Davies
When stocks and bonds sell off together, it usually signals serious problems. That is what European banks are suffering.
Shares in European financial firms took a beating on Monday, and then some. Stock in German national champion Deutsche Bank dropped 9.5%. That brings its year-to-date loss to nearly 40% while its valuation has fallen to around just 30% of book value. Banks such as Barclays, BNP Paribas and UniCredit all were down more than 5%, faring far worse than broader European markets.
Why are things so bad for Europe’s banks? General fears about bad debts related to crashing energy prices or emerging markets don’t cut it as an explanation for the 20% drop in bank shares this year. Those factors have been around for a while.
In truth, banks don’t face an acute crisis as in 2008. It is something that in some ways looks worse: a chronic profitability crisis that makes it impossible for banks to build up barely-adequate capital bases. And central banks may be powerless to stop it.
The eurozone’s top banking regulator gets it. This arm of the European Central Bank has said profitability is the key systemic financial risk in 2016. But ECB President Mario Draghi can’t help. When asked about bank stability at his last interest-rate news conference, he said protecting bank profits wasn’t his job.
Very low interest rates hurt the profits banks make on loans, especially when investors believe loose monetary policy is here to stay. Long-term rates at which banks lend then fall to be little more than short-term ones at which banks borrow. That spread has shrunk in the U.S. and Europe over the past month.
In Europe, negative deposit rates may have another, perverse effect: banks could start charging more for loans, moving against the direction of central bank policy. Negative rates force banks to pay to leave funds on deposit at a central bank, but they don’t want to pass this cost on to depositors for fear of scaring them away.
Switzerland has already got rising mortgage costs, while last week in Denmark, which also has negative rates, Nykredit said it would begin lifting rates on all its mortgages in what Morgan Stanley believes is likely to kick off a wave of repricing.
The result is ultraloose monetary policy that actually leads to a tightening of credit: exactly what Europe doesn’t need as it battles to restore growth.
Worse still, if economic recovery falters this would make Europe’s roughly €1 trillion stock of bad loans harder to deal with and more likely to cause fresh losses.
Add to this the restructuring and resizing of retail and investment banking businesses that still needs to take place (particularly in Germany and Italy, but also in France) and there is another wave of costs to be taken.
Most eurozone banks have enough capital—just. But many also need to continue to add to capital through earnings to hit higher targets coming in 2019 and to improve the quality of their capital.
Without the green shoots of an economic recovery, banks won’t hit these targets. Meanwhile if they fall close to their minimum capital needs, regulators will stop them paying not only stock dividends, but also coupons on junior bonds that count as capital.
This is why bank debt is getting hit, too. The cost of insuring junior bank bonds against default has doubled this year, while that cost for other high-yield debt has only risen 50%.
Banks have two options to beat this set of circumstances. One is to make riskier loans that should pay more but have a higher chance of default; the other is to launch another round of capital raising.
Investors don’t like either option.