No re­lief for Euro­pean banks

Financial Mirror (Cyprus) - - FRONT PAGE - By Nick Andrews

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.

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