For Europe’s banks, a lack of cap­i­tal—and so­lu­tions

▶ Lenders are strug­gling to build up the cap­i­tal they need ▶ “We’ve stayed ever since the fi­nan­cial cri­sis”

Bloomberg Businessweek (North America) - - Contents - -Yal­man Onaran and Ni­cholas Com­fort

Euro­pean banks are hav­ing a hard time mak­ing money. The 12 largest lenders earned 18¢ on av­er­age for ev­ery $100 in as­sets last year, while their six big­gest U.S. ri­vals made 92¢. Three Euro­pean gi­ants— Credit Suisse, Deutsche Bank, and Royal Bank of Scot­land— each racked up bil­lions of dol­lars in losses in 2015. RBS has lost money ev­ery year since the 2008 cri­sis.

The predica­ment has put the mar­kets on edge. Euro­pean bank stocks are down an av­er­age of 18 per­cent this year as of March 1, com­pared with a loss of 7.4 per­cent for the Stoxx Europe 600 in­dex. More dis­con­cert­ing is the jump in the cost of fi­nan­cial con­tracts that pro­tect bond­hold­ers if a bank de­faults. In­sur­ance on the se­nior bonds of Deutsche Bank, for ex­am­ple, has more than dou­bled in price this year.

Which prompts some ques­tions: Is the fall in Europe’s bank stocks the re­sult of in­vestors wak­ing up to the re­al­ity that, in a post-cri­sis world, bank­ing will be a slower-grow­ing, lower-earn­ing busi­ness? (Not nec­es­sar­ily a bad thing.) Or is it a sign that the banks are weak enough to pose a risk again to Europe’s econ­omy and fi­nan­cial sta­bil­ity? The an­swers ap­pear to be yes and yes.

Banks need to bol­ster their cap­i­tal po­si­tion to get safer, but the dearth of prof­its is mak­ing that more dif­fi­cult. “We’ve stayed away from Euro­pean banks ever since the fi­nan­cial cri­sis,” says Lucy Macdon­ald, chief in­vest­ment of­fi­cer for eq­ui­ties at Al­lianz Global In­vestors. “And un­til they re­ally get to grips with their cap­i­tal po­si­tion and bal­ance sheets, then there is no real need to be there as an equity in­vestor.”

Cap­i­tal, in a nut­shell, is what stands be­tween a bank merely los­ing money and go­ing in­sol­vent. It’s mainly share­hold­ers’ equity, the money raised by ei­ther is­su­ing stock or re­tain­ing prof­its. Share­hold­ers don’t have to be paid back when busi­ness goes bad, whereas de­pos­i­tors and bond­hold­ers de­mand it. The more a bank’s busi­ness has been funded with equity, or cap­i­tal, the safer it is from go­ing bust. Banks on both sides of the At­lantic have been forced by reg­u­la­tors to beef up cap­i­tal since the 2008 cri­sis. (Be­fore, many had as lit­tle as 2 per­cent of as­sets fi­nanced by equity.) In part be­cause Amer­i­can reg­u­la­tors have taken a stricter line, U.S. banks have been quicker than the Euro­peans to get on top of the prob­lem.

By one mea­sure, the cap­i­tal of the top U.S. banks av­er­ages 6.6 per­cent of to­tal as­sets, com­pared with 4.5 per­cent for the big­gest Euro­pean banks. (Banks of­ten cite cap­i­tal of 10 per­cent or more, af­ter weight­ing some as­sets dif­fer­ently based on risk. Cal­cu­lat­ing cap­i­tal ra­tios us­ing to­tal as­sets re­lies less on banks’ own risk es­ti­mates.) Two of France’s largest banks, BNP Paribas and So­ciété Générale, have cap­i­tal of only 4 per­cent of to­tal as­sets. Deutsche Bank sits at the bot­tom of the list of Europe’s large banks, with 3.5 per­cent; its shares are off about 22 per­cent in 2016 so far.

“Banks that the mar­ket deems to

have less cap­i­tal than oth­ers will have trou­ble in terms of their stock prices,” says Nikhil Srini­vasan, chief in­vest­ment of­fi­cer of Ital­ian in­surer As­si­cu­razioni Gen­er­ali.

Deutsche Bank of­fered last month to buy back some bonds, and it found few tak­ers. That shows an “in­vestor pref­er­ence to re­tain ex­po­sure” to it, the bank said in a Feb. 29 state­ment.

Some in­vestors say the mar­kets have over­re­acted this year. Banks have, af­ter all, im­proved their cap­i­tal lev­els since the cri­sis, says Martin Wil­helm, founder of money man­ager IFK, which holds Deutsche Bank bonds. “It’s a bad start, but banks can turn things around this year just like a soc­cer team can climb the league ta­bles,” he says.

It cer­tainly will be eas­ier to build cap­i­tal if busi­ness im­proves, just by hang­ing on to the earn­ings in­stead of pay­ing div­i­dends. But there are head­winds, start­ing with bad loans. Europe’s lenders lost about $600 bil­lion in the U.S. sub­prime de­ba­cle, then piled up more bad debt when con­sumers and com­pa­nies fell be­hind dur­ing long re­ces­sions in sev­eral coun­tries.

The In­ter­na­tional Mon­e­tary Fund es­ti­mates there’s $1 tril­lion of bad debt on Euro­pean banks’ bal­ance sheets. For Ital­ian banks, bad loans con­sti­tute al­most 20 per­cent of to­tal loans out­stand­ing, mean­ing they’re not mak­ing any money on a big chunk of as­sets. And with in­ter­est rates at rock-bot­tom lows, it’s hard for banks across Europe to earn much on the good loans, ei­ther. Ire­land and Spain are the only two euro zone mem­bers that forced their banks to clean up. The banks had to sell dud loans to as­set man­age­ment com­pa­nies set up by the govern­ment at deep dis­counts. The cleanups cost the gov­ern­ments a lot of money, but now the banks can fi­nance eco­nomic growth. Un­der new Euro­pean Union rules, gov­ern­ments can’t fi­nance such a cleanup un­less they first force some bank cred­i­tors to take losses. That’s called a “bail in,” as op­posed to the bailouts funded only by tax­pay­ers.

Politi­cians in some coun­tries “are re­sist­ing a cleanup be­cause bail­ing in cred­i­tors will touch cor­po­rate de­posits or wealthy savers,” says Har­ald Benink, a fi­nance pro­fes­sor at Til­burg Univer­sity in the Nether­lands and chair­man of the Euro­pean Shadow Fi­nan­cial Reg­u­la­tory Com­mit­tee, a watch­dog group.

Lousy fi­nan­cial mar­kets have come along to make things worse. In­vestors are fret­ting over banks’ po­ten­tial ex­po­sure to fall­ing com­mod­ity prices and volatile emerg­ing mar­kets. Bar­clays said its in­vest­ment bank divi­sion had its first quar­terly loss in at least two years, as trad­ing rev­enue slumped.

Growth isn’t easy to find in more con­ven­tional bank­ing lines, ei­ther. Deutsche Bank bought a retail bank in 2010 to bet­ter com­pete against Ger­many’s 409 sav­ings banks and 1,047 co­op­er­a­tive banks. Af­ter years of ek­ing out prof­its, the ac­quired unit is on the chop­ping block. The cut­throat lo­cal mar­ket is fur­ther com­pli­cated by the ex­is­tence of Lan­des­banks, par­tially owned by Ger­man states. Europe lacks the depth of U.S. cap­i­tal mar­kets. Com­pa­nies are less likely to is­sue stocks or bonds, and so de­pend more on bank lend­ing

for fi­nanc­ing. Weak banks can ! quickly be­come a drag on the econ­omy. “The banks just don’t seem equipped to be able to cope with it,” says Ste­wart Richard­son, chief in­vest­ment of­fi­cer of Lon­don-based RMG Wealth Man­age­ment. “We need bank lend­ing to the pri­vate sec­tor to con­tinue to grow, and the risk is ac­tu­ally that it be­gins to fall.”

The bot­tom line A legacy of bad debts and weak cap­i­tal lev­els has left Europe’s banks poorly po­si­tioned for 2016’s tur­bu­lent mar­kets.

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