European Banks and Regulators are Ignoring the Warning Signs

Jonathan Rochford

Narrow Road Capital

If you want to search for weaknesses that could lead to another financial crisis, banks are a very good place to start. The last financial crisis saw banks around the world needing government bailouts to cover their solvency and liquidity deficiencies. Whilst banks in the US and Australia have substantially raised their capital levels, many European banks have failed to use the last decade to materially de-risk. The most obvious outworking of this is that European banks continue to receive taxpayer funded bailouts, with Germany’s NordLB and Italy’s Banca Popolare di Bari both receiving lifelines this month.

At a high level, strengthening weak banks isn’t an overly complicated process. They need to hold more capital and they need to clear their balance sheets of bad loans. These two issues are intertwined in that a bank with an excess of non-performing loans (NPLs) will struggle to raise additional equity capital from shareholders until the NPL ratio is reduced. This is where regulators come in, they are meant to stop this situation from occurring and take swift action when it does. If shareholders won’t contribute additional capital, the regulator needs to compel action. This could be via a forced merger, through a bail-in of subordinated capital and senior unsecured debt, or via a government takeover.

These actions are all a standard part of the playbook for the US banking regulator, the FDIC. They were all utilised after the onset of the financial crisis, often deployed at short notice (see FDIC Friday). The aim of rapid action is to maintain consumer and financial market confidence that the banking system will continue to function, thus reducing the severity of an accompanying recession.

Unlike the Americans, the Europeans generally prefer to delay action and hope the issue magically resolves itself. A quick review of the price to book ratios for European banks shows this approach isn’t working out. There’s a bunch of zombie banks that remain stuck at the bottom of the list with insufficient profitability to lift their ratios organically or to attract additional shareholder capital at anything other than a horrendous discount. Deutsche Bank is the poster child for this group, its last decent profit was in 2011 with several massive losses since then.

Deutsche Bank typifies the problems of many European banks in that it has failed to clear problem assets even though it has been through several waves of restructuring. The proposed merger with Commerzbank could have provided an avenue to reset its capital levels and reduce its costs. However, it would have required both parties to reassess the value of their assets, which could have resulted in asset write-downs. It is another missed opportunity by the two banks and their regulators.

Negative interest rates are also part of the problem, in that banks are struggling to earn a decent spread between their deposit and lending rates. Most European banks have voluntarily chosen not to pass on negative interest rates. This resolve is gradually breaking down as a growing group of banks in Germany and Denmark let all but the smallest depositors share the pain of errant central bank policy.

Now that savers are being directly punished for their prudence, central bankers and politicians should expect a far greater level of criticism of negative interest rates. It should not be forgotten that whilst banks have few friends and no votes, savers have many votes they can use to extract change. Sweden’s decision to lift its overnight interest rate back to zero this week might be a turning point.

One final issue that lurks particularly amongst European banks is their gaming of capital ratios. European banks have become masters of finding assets that require little risk capital but can generate a decent margin. Government debt from Italy is one example, with pressure now being put on the ECB to allow for unlimited purchases of Greek government debt. This would substantially increase the already significant “doom loop” risk. This risk arises from the potential for a default on government debt to bankrupt the banks, and the converse situation where failing banks look for a taxpayer bailout and bankrupt the country.

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Jonathan Rochford
Portfolio Manager
Narrow Road Capital

Narrow Road Capital is a credit manager with a track record of higher returns and lower fees on Australian credit investments. Clients include institutions, not for profits and family offices.

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