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”

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.