The Risks Facing European Banks

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Last week, European Central Bank (ECB) President Mario Draghi, responding to market concerns that had battered the shares and bonds of Eurozone banks, insisted that “We have to acknowledge that the regulatory overhaul since the start of the crisis has laid the foundations for durably increasing the resilience not only of individual institutions but also of the financial system as a whole.” No doubt that overhaul has been a positive development. But we are not completely reassured that the actions taken with respect to either timing or dimension have been sufficient to keep the currently visible strains from worsening into a serious crisis that could cripple the eurozone recovery.

A major concern is the legacy of nonperforming loans, estimated at some 900bn euros, still on the balance sheets of European banks, with Italian banks accounting for a third of these bad loans. Since the financial crisis in 2008 the Europeans have lagged far behind the US in addressing this problem, with reforms promised but little achieved. The Italian government is now faced with the need for urgent action to clean up bank loan books in a way that is acceptable to both the Italian public and European Union authorities (that is, the cleanup cannot involve state aid or subsidy prohibited by EU rules). The Italians are moving forward with a plan, accepted by the EU, to issue guarantees that should help banks sell loans to third parties such as hedge funds. This measure may help in some cases but probably will not head off some further Italian bank failures.

European banks are not operating in economies that are favorable for easing the nonperforming loan problem. Economic growth in Europe is projected to remain sluggish, particularly in the core euro area, with investment remaining weak. Slower global growth, as reflected in the latest OECD Interim Economic Outlook, means lower demand for European exports. The OECD notes that, “In several euro area countries, high private sector leverage and high levels of nonperforming loans hamper the credit channel of monetary policy transmission.”

Read: OECD's William White: In Terms of Debt, the Situation Is Way Worse than 2007

There are serious concerns about the effects of ECB monetary policy on bank profitability. Draghi said in January that the best way to help banks’ profitability is “to make sure the overall economy returns to growth, to sustainable growth, with price stability.” That should be the primary objective of monetary policy. Yet it must be recognized that the flattening of the yield curve is bad for the profitability of European banks. The move to negative rates, which looks likely to intensify, with the ECB expected to cut the deposit rate an additional 10–20 bps next month, could become particularly difficult for European banks. The further down negative rates go and the longer they remain there, the greater the share of the euro area asset base that earns nothing. Retail banking, where the opportunities for fee income are the most limited, would be hurt the most. Should rates decline to the point where banks start passing the costs on to retail customers, massive withdrawals could well result. The ECB must be aware of this risk.

The new European watchdog for the eurozone’s largest banks, the Single Supervisory Mechanism, warned last week that overall risks for these banks have “not decreased compared to 2014.” It is not surprising that the biggest risk cited by the supervisor is adapting business models to a new environment of low interest rates. The supervisor ordered the banks to boost their capital levels by 0.5 percentage points on average. Core Tier 1 capital ratios must be raised to 9.9% on average this year from 9.6% last year. The banks are also to set aside an additional 0.2% of capital against systemic risk. The report noted that the capital of five banks falls short of the current requirements while some other banks have sufficient capital to meet or exceed the new requirements. No banks were named. It is important to note that the 130 banks falling under this supervision account for about 85% of all eurozone banking assets.

Meeting these new capital requirements will not be easy in the current markets. The MSCI Europe Financials Index has swooned more than 15% since the beginning of the year. European bank shares have been hit by waning confidence in bank profitability and especially by the perceived increased riskiness of Southern European banks, which are likely the banks most in need of raising their capital ratios. The greatest problems appear to be in the market for bank bonds.

Read also: Russell Napier Forecasts Negative Rates in the US as Deflationary Pressures Spread

The recent sharp losses in the market for Europe’s riskiest bank bonds, contingent convertible (“coco”) bonds, sent a warning to investors that they are exposed to increased risk. These high-yielding bonds, which count toward Tier 1 capital, convert to equity or are written down when a bank’s capital falls below a certain level. The concern that hit markets was the realization that interest payments can be skipped under certain circumstances, following an announcement by the ECB concerning the capital level at which coupons are likely to be halted.

The turmoil in European bank debt brings us to another European Union development: the European Bank Recovery and Resolution Directive, now in full force, which sets out a required common bail-in mechanism for a failing bank. The guiding principle behind “bail-in” is that investors rather than taxpayers should bear the costs of a bank resolution. Governments, however, are very reluctant to apply these standards to individual buyers for political reasons and because of the risk that bondholders that are also depositors may lose confidence in their banks and withdraw deposits. This reluctance implies that there could be a tendency to impose greater losses on institutional investors than on individual buyers, a concern that certainly undermines market confidence. This is a great concern for Southern Europe institutional investors. We understand that there will be some room for national authorities to have a say on how the bank resolution rules are applied. However, any changes in the normal pecking order must be approved by the eurozone’s resolution authority.

Check out: Move Over Greece, It's Italy's Turn - George Friedman Sounds the Alarm on European Banking Crisis

A further concern for the eurozone banking system is the German proposal to limit each bank’s holdings of sovereign debt from a single country. This proposal reflects a valid concern of central banks, including the ECB, that there are serious risks when a bank holds large amounts of its country’s sovereign debt. Note that currently eurozone banks do not have to put capital against their sovereign debt exposures, which are treated as risk-free. However, applying hard limits or “caps” on these holdings would deal a heavy blow to the income of some banks, including those in Italy and Spain. They would need to sell significant volumes of their countries’ sovereign debt holdings, which they would likely replace with relatively lower-yielding sovereign debt of other countries. The hard limits would also depress the sovereign bond markets in the countries where the caps lead to sovereign debt sales. It is not surprising that Italian Prime Minister Renzi says his country would “veto any attempt to put a ceiling on the amount of government debt in banks’ portfolios.” This fight also threatens agreement on a common eurozone deposit insurance scheme. With all the problems facing the Italian banking system, it seems likely that any such caps would be phased in gradually, possibly as “soft caps” that, rather than imposing strict limits, would require banks to set aside progressively more capital against increasing sovereign bond holdings.

In sum, the move to a banking union based on an integrated European banking system is proving to be a difficult one. We applaud the objective and agree the system will be more resilient and efficient if and when that union is achieved.

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About Bill Witherell