Europe’s bank­ing rout

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

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.

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