Europe’s banking rout

Following Monday’s rout in European banking stocks, there is one thing that we can say for certain: the proximal cause of the sell-off had nothing to do with China. With Chinese markets closed for the lunar new year holiday, beleaguered investors in Europe had been hoping for a little breathing space this week. In the event, the sell-off in European bank shares only intensified, with the Euro Stoxx banks index sliding -6.4% on Monday, Deutsche Bank down -9.5%, a clutch of Italian banks down between -10% and - 12%, and Greece’s Eurobank Ergasias down an eye-watering -29%. So what is really going on?

Blaming this year’s weakness in European bank shares on heightened risk in China always seemed something of a stretch. The current slowdown in China’s economic growth has been five years and more in the making; it cannot have surprised anybody. What’s more, the direct exposure of European banks to China is only small, and their indirect exposure via China-dependent emerging markets is relatively modest. According to the European Central Bank, at the end of 1H15, loans to emerging Asia stood at just 1.5% of major European banks’ loan books. Exposure to Latin America was higher, at 4%, but non-performing loan ratios were relatively contained.

A second explanation advanced for the sell-off — the flattening of the US dollar yield curve as expectations have diminished for interest rate rises over the course of this year — also appears exaggerated. A flatter US yield curve might help to explain the weakness in US banks shares, but it hardly accounts for the underperformance of European banks. The true explanations must lie closer to home.

· Bank profitability is suffering. As the ECB has pushed short term interest rates deeper into negative territory, net interest margins have been squeezed. On top of that, new regulations introduced since the financial crisis mean that pre-crisis business models are now less profitable. Banks today are required to maintain much higher liquidity ratios and to hold more capital against formerly lucrative activities such as fixed income trading. In response, many banks have been slow to cut costs and explore new business lines. And where European banks have pursued new income streams, for example by emphasizing asset and wealth management services, recent market volatility, coupled with the slump in oil prices, has prompted heavy withdrawals, especially from Middle Eastern clients.

· Investor sentiment towards European bank assets has been damaged by new regulations prioritizing bail-ins over state aid for troubled banks. Matters have not been helped by widespread confusion over the legal basis by which some investors in the bonds of Portugal’s Novo Banco were bailedin under a late December decision from the Bank of Portugal. However, as the chart below shows, long before that decision Target 2 balances at the ECB suggested that northern European banks were more comfortable paying -0.30% to the ECB than lend to Spanish and Italian banks at a positive rate of return. It seems that attempts by the European authorities to mitigate the potential costs of bank failures are hindering rather than helping further integration within the banking union.

· There remains the possibility of nasty surprises. With the oil price down 44% over the last 12 months, and the broader commodity complex down 31%, there is an appreciable probability that one or major European banks are sitting on commodity derivative losses that have yet to break surface. What’s more, with the enthusiasm of regulators for pursuing past misdemeanors apparently undiminished, it is possible that a number of banks could find themselves shouldering unexpectedly high litigation costs over the next couple of years. In recent days, such fears have raised doubts that Deutsche Bank will be able to meet upcoming coupon payments on its outstanding contingent convertible — or CoCo — bonds. Although the Frankfurt-based giant strenuously denied it faces any problem, in the current market environment, Deutsche’s denial did nothing to bolster sentiment in its debt.

Couple these concerns with the unaddressed NPL crisis in the Italian banking sector and renewed doubts that Greece will be able to meet the terms of its latest bail-out, and the upshot is a veritable hurricane for European bank shares.

Of course, there are those investors out there who argue — with considerable credibility — that there are no fatal time bombs hidden on the balance sheets of Europe’s big banks, that their capital positions remain solid, and that the current sell-off is a momentum-driven panic that presents “the buying opportunity of a lifetime”. They may turn out to be right. But for the time being at least the wind is blowing against their position.