Europe’s bank stability is in question, say country risk experts

Tough new European Union “bail-in” regulations taking effect since January aimed at shielding taxpayers from the moral-hazard shocks of future financial crises are rattling confidence in the banking industry. With monetary policy expansion factored in, many banks are struggling to remain profitable.

There are myriad regulatory challenges, low or no credit growth because of weak investor sentiment, and in some cases negative deposit rates.

The banks have risk portfolios exposed to real estate bubbles and the depressed oil/gas and shipping markets. There are unpredictable litigation costs, and widespread market distortions precipitated by the policies of the European Central Bank and other central banks.

Two-thirds of respondents to a special Euromoney poll believe Europe is heading for another major banking crisis, although it might be quite dissimilar to the one in 2008, with opinions split over whether it will be Italy-focused, Europe-wide or have global implications.

The interconnected nature of the global banking industry is a concern, especially with the results of the latest stress tests by the European Banking Authority due out this Friday (July 29) helping to shed light on the extent to which the region’s lenders are exposed to shocks.

Deutsche Bank is a major concern in the wake of a record loss pressuring its share price and forcing branch closures, amid rumours that the institution might be split up.

The German flagbearer is too big to fail, but has lower capitalization than its competitors. It has a large trade in derivatives, some of which are in contrasting positions, making it unclear how large the risks are, but with the added concern of counterparty risks affecting the entire sector.

The stress tests are limited in scope, however, explains Tomas Kinmonth, who is one of the team at ABN Amro contributing to Euromoney’s survey.

Writing in a special explanatory note before the release of the latest test results, he indicates that the sample of banks is less than half what it was in 2014, none is from Cyprus, Greece or Portugal, and only one bank that failed then will be retested.

Another Lehman Brothers moment?

A contributor speaking under condition of anonymity stated that the problems in Europe will probably not produce a major banking crisis, but argued that the risks are clearly growing, with Italy the special case.

There the government is trying to find a politically convenient solution to resolve €210 billion-worth of bad loans on the banks’ balance sheets, centring on Monte dei Paschi di Siena, the third largest, which would lead to contagion if it is not managed properly.

Italy already has a gross debt burden exceeding 130% of GDP, with very little economic growth to speak of.

The non-performing loans on Italian bank books were not dealt with after the last banking crisis (in 2008) and are the third highest, behind Cyprus and Greece, which went through their own shocks.

“Italy's banking system is still loaded with legacy debt issues that require resolution and exemplify a similar situation in Slovenia and Greece, and to a lesser extent Spain, Portugal and Ireland,” says ECR survey contributor and Europe expert Constantin Gurdgiev, who is now professor of finance at the Middlebury Institute of International Finance.

He adds: “The current mechanisms for resolving these loans – a combination of a limited bail-in on the funding side with a bailout via state-backed investment vehicles – is neither sufficiently clear nor legally secure.” 

Gurdgiev believes a hybrid approach to resolution, combining bail-in with bailout, might reduce the size of the state-sector exposure to the losses, but it also increases the adverse impact of the resolution measures on the economy.

In particular, the bail-in component of the resolution will result in Italian banks facing a higher cost of funding at a time of already depressed margins.

In other words, this measure will trade short-term gains from the bail-in for longer-term pain of the banking system being unable to competitively price risks, leading to continued credit depression, undermining potential investment.

At the same time, a state-led bailout relying strongly on private equity participation in funding will likely accelerate the crystallization of losses across the system, putting pressure on households and corporates and, through this channel, reducing aggregate demand in the economy.

This comes with a huge political cost given Italy’s moribund economy. The populist Five Star Movement is making gains and Italy’s membership of the EU is threatened, not least since the UK’s decision to withdraw in the referendum last month has given Eurosceptic movements a lift.

Gurdgiev believes prime minister Matteo Renzi's plan is probably a better option. “Renzi is not pursuing a complete bailout, but a creation of a 'bad assets' pool, similar to Sweden's and different from the Irish one,” he says.

This requires a robust plan for reforming the “good banks” remaining after the split is achieved.

If all goes well the worst-case scenario of Italy’s bank crisis leading to a break-up of the eurozone will be avoided, but the political and economic stakes are high.