No relief for European banks
On Monday, a consortium of Italy’s healthier banks and financial institutions agreed to put up EUR 5.7 bln to finance a private sector bailout fund for the country’s weaker banks. The deal, which was cobbled together by Italy’s Finance Ministry, is clearly intended to circumvent European Union rules limiting state aid to the banking sector. Details remain sketchy, however it is difficult to see how the agreement can restore confidence in Italy’s banks, which collectively are sitting on non-performing loans worth some EUR 350 bln, or 18% of their customer loan books. At best, the deal can do little to overcome the twin headwinds of EU regulations requiring the bail-in of bank creditors, and a flattened yield curve, which together have hampered the ability of European banks to strengthen their capital positions. At worst, yesterday’s agreement could amount to a conduit through which contagion is spread from Italy’s weaker banks to its stronger institutions. Either way, the powerful headwinds opposing the counter-trend rally in European equities of the last two months are likely to remain in force.
Since mid-February the MSCI EMU large and mid-cap index has rallied a welcome 10%. However, as the chart shows, the broader downward trend which has prevailed since the European Central Bank initiated its program of quantitative easing last March remains in place. This downtrend is especially discouraging, considering the additional boost that low oil prices should have lent to both economies and markets on top of the ECB’s ultra-loose monetary policy.
A closer look at the sectoral dynamics of European equity performance suggests why these favourable factors have failed to gain more traction. Since last April, the overall -20% decline of eurozone equities has been led by the single currency area’s bank stocks, with the MSCI EMU bank index now down by some -37%.
Part of the problem for Europe’s banks is how ECB policy has flattened the yield curve. Before the crisis, when official action led to a flatter yield curve it was generally because the central bank was responding to robust expectations of future growth by raising short term rates. In such a strong growth environment, banks had an incentive to compensate for the flattening of the curve by taking on riskier, and therefore hopefully more rewarding, long-dated assets.
Now, however, the curve has flattened because central bank asset purchases in an environment of pronounced economic weakness have depressed yields at the long end. The result is not simply that banks earn less on long term loans relative to their short term funding. It is also that the extra returns available from taking on riskier assets have fallen, even though the risk has increased because of the weakness of the underlying economy. The upshot is that bank margins have been compressed, making it more difficult for them to rebuild their capital positions from earnings.
By allowing banks to fund themselves at potentially negative rates, the ECB’s new round of Targeted Longer Term Refinancing Operations is intended to offset the erosion of bank net interest margins inflicted by negative central bank deposit rates. However, at most the new TLTROs will only partially relieve the pain.
If banks cannot rebuild their capital positions organically, neither is it easy for them to raise fresh capital from the market. New EU rules insisting that bondholders in troubled banks must be bailed in before governments can step up with state aid do not make bank bonds, or shares, an attractive proposition for many investors. And with banks facing difficulty building up their capital positions, they are hardly rushing to lend into the subdued economies of Southern Europe. As a result, Monday’s deal will do little to overcome Europe’s formidable headwinds.