This article was originally published on Mountain Vision:
The banking sector is not in a good shape in 2016, and that is probably a huge understatement. Just seconds ago, we read this excellent quote on MarketWatch which really says it all: “The risk of a crash in eurozone bank equity prices has increased … The market is ready to pay a higher price to hedge against a substantial fall in eurozone bank stock prices. This suggests rising unease about the sector.”
Given current market conditions, it was very interesting, to say the least, to read the results of the 2016 stress tests of Europe’s banking sector.
For anyone who paid attention to the changes in the methodology of this year’s stress tests of Europe’s biggest banks, the results released last week did not hold any surprises. Overall, a “clean bill of health” was issued, while the keywords of the take-away message were “significant improvement”, “optimism” and “crisis-resilience”. The good news should have reassured investors about EU banks, but their response would indicate that they didn’t get the memo: the report was welcomed by the markets with a sharp share price decline across the sector, suggesting that investors remain unconvinced about the rosy picture it painted. And such cynicism appears to be justified: many analysts have already questioned the stress tests’ reliability and accurate reflection of the sector’s challenges. Breaking with past practice, this year’ tests did not come with a pass/fail mark, while the adverse scenario that the European Banking Authority (EBA) used to assess the 51 banks did not take into account the zero and negative interest rate environment. Additionally, the EBA used stated book value as a basis to assess the banks, vastly overstating the real value, reflected in the market. It also did not factor in the effects and aftermath of Brexit and no banks from Portugal or Greece were included in the stress tests; both countries still presenting major concerns, grappling with high debts and low growth.
In sharp contrast to the report’s attempted optimism, fundamental figures reveal that the European lenders are facing serious, structural problems that seem to be setting the scene for a banking crisis. Euro STOXX Banks, the index which tracks 48 of Europe’s largest banks, is down 34.6% only in 2016. Last July saw the sector hit its highest point since 2008, yet since then, European banks lost around 40% of their value (more than half a trillion euros), as can be seen in the chart below. Or to better illustrate the scale of the problem, these losses exceed the total value of Italy’s entire stock market.
Individual banks’ performances in 2016 also hint at a brewing banking crisis: Credit Suisse has fallen 51%, Deutsche Bank and Commerzbank shrank by over 45%, the Spanish BBVA saw its profits decline by 54% last quarter, while Swiss UBS’s profits plunged by 64%. And as for the Italian banks, the magnitude of their troubles had to be acknowledged in the EBA stress test report as well: 17% of funds loaned out by Italy’s retail banks are risk of default, the assessments revealed, which is over three times the average of the EU banking sector.
Specifically, concerns focused on the world’s oldest bank, Banca Monte dei Paschi di Siena SpA, which has already been bailed out twice by the government since 2009. The bank, was the only one flagged in the stress test as severely underfunded, as shown in the graph below. Now officially holding the title of the riskiest bank in Europe, Monte dei Paschi has experienced a 65% slide in its share price during recent weeks.
The making of the next banking crisis
There are a number of forces that contribute to what could easily spiral into a sector-wide crisis (read also The Health Of U.S. And European Banks Becoming A Concern In 2016). An obvious aggravator is the overall European economic growth pace, the slowest in decades, as well as Brexit, that also stuck a severe blow to the already ailing industry, along with the rising political tensions throughout the continent that further exacerbate uncertainty and unease. The biggest threats to the EU banking sector are, however, systemic and largely self-inflicted.
Negative interest rates have played a major role in pushing European banks this close to the edge. The ECB’s policy of reversing the “natural” relationship between interest and time, and the incentives that it has traditionally carried so far for banks and for their customers, has resulted in a paradoxical dead-end. The ECB’s deposit charges, that were meant to ease and encourage lending, have diminished the banks’ profit margins. Last week, Commerzbank AG, the biggest lender to German companies, echoing a previous statement by Deutsche Bank, suggested that their clients would face higher fees, in order to sustain the costs of the record-low rates. The bank, that earlier this year reportedly considered storing billions in physical cash in vaults instead of depositing it with the ECB, also released an estimate of the cost of the negative rate policy: 161 million euros ($180 million) of lending revenue at its two biggest units, in the first half of 2016.
The roots of the EU banks’ troubles go even deeper, however, and they can be traced back to internal and external mismanagement and the adoption of inept policies. The consistent trend of bad banking of the last years has been encouraged by the ECB’s own monetary and regulatory agenda. The much needed write-offs did not take place, as the cost of funding decreased and it just became cheaper to keep carrying the soured debt – which is why, today, the market value of major European banks stands at around 70% of the stated book value. Investors have caught on, and they have already factored in the inevitable losses, while the banks themselves are using delaying tactics and kicking the can down the road.
A recent study, by Sascha Steffen of ZEW, Viral Acharya of NYU Stern and Diane Pierre of the University of Lausanne, has also brought to light another sign of managerial mishandling. According to the report, there is an estimated a capital shortfall of €123bn across the 51 banks tested last month by the EBA. Yet, despite this, 28 of the 34 publicly listed lenders that took part in the stress tests, have paid out €40bn in dividends in 2015 (more than 60 per cent of their earnings), while the 10 banks that performed the worst in said tests, have paid out almost €20bn since 2011. The authors of the report further pointed out that if European banks had stopped paying dividends in 2010, “the retained equity could have funded more than 50% of the capital shortfalls we estimate in 2016”. As opposed to regulators in the US, the EBA does not stop undercapitalized banks from distributing dividends. Such a policy stance, combined with the implicit (and sometimes even explicit) assurance that “help will always come”, through QE, bail-outs or any other shape or form of state rescue, encourages reckless and irresponsible choices that simply pass the risks onto the taxpayers.
End of the line
As the situation stands today, any mention of prospective bail-outs is politically toxic, and no national or European authority dares raise such a possibility in this climate, for fear of further market unrest or even bank runs. Nevertheless, institutional denial of the troubling facts, reluctance to face the numbers, and regulatory gloss-overs and perpetuation of the problems, can hardly suffice to “wish away” a looming banking crisis.
Banks are the cornerstone of our current financial system and thus, a crisis in this sector can reverberate and pose serious threats across the entire economy. Also, the degree of centralization and interdependence means that a “European banking crisis” is anything but: it can quickly spread into an international one.
Therefore, any wise investing response would be a proactive one. A balanced, diversified portfolio in 2016 should include vehicles and assets that effectively preserve value and isolate it from the banking sector. Qualitative diversification, investing in traditionally resilient assets and holding physical gold, is in-line with this approach. Of crucial importance, as well, would be to apply a portfolio-appropriate degree of geographical and jurisdictional diversification: hedging through holding positions in multiple markets internationally, physical storage of assets in safe and stable jurisdictions, shielded from the volatility of any one country or region.