Despite a slight rebound in European bank stocks yesterday the rout has resumed today with a vengeance. It has predominantly been a very bad year for the sector so far. Banks large and small across a number of European countries have been struggling. The chart below shows the perfomance of the Euro Stoxx 600 Bank index. This has prompted the obvious question over what has changed and what has caused this bank rout? Fundamentally, it is very hard to say and it is certainly hard to point to any single factor. Ultimately, when it comes to market sentiment shifts there doesn’t always need to be any singular explanation. There is a potential confluence of factors which might have played a part in the banking stocks rout, a few of which are laid out below.
  • Chronic lack of profitability – fundamentally it is becoming clear that the sector is struggling to regain profitability. This is combined with and exacerbated by the points below but there is a feeling that European banks may never recreate previous profit levels. This makes capital raising and managing their liabilities harder. The ultra-low returns in a number of areas have also made this worse. As the chart below shows, return on equity and return on assets has been low for between 2007 and 2014. Net interest income recovered somewhat between 2007 and 2010 but has shown little improvement since then. These figures cover the huge European banking sector in aggregate so generalise the issue but the struggles of the sector as a whole are clear.
bank profits copy
  • Fear of negative rates – while this is not new there has been a growing sense that the ECB will push rates deeper in the negative territory. This has seriously worsened the existing profitability problems. Ultimately, the excess reserves which banks hold end up at the ECB’s deposit account and now are being charged negative rates. However, due to fears over losing customers the banks have so far resisted passing on these rates to depositors (although some have to larger commercial depositors). This means that the running costs of the banks rise and eat into profitability.
  • Huge stock of non-performing loans – despite it being many years since the financial and Eurozone crisis hit, the continents banks continue to be weighed down by huge number of non-performing loans on their balance sheets. This is a widespread problem but is more acute in certain countries as we have notably seen in Italy in recent weeks. Even states which adopted a bad bank approach, such as Ireland and Spain, continue to have significant levels of non-performing loans. This forces banks to post provisions against potential souring of the loans but it also impacts their broader approach. It is hard for banks to take on more risk or expand lending significantly when their books continue to be weighed down by these loans. Furthermore, the stock of bad loans is tied to the health of the broader economy – if it sours then the stock may be expected to expand.

bank npls
  • Energy exposure direct/indirect – there has been a clear correlation between the declining oil price and the decline in bank stocks over the past six months or so. Exactly why this is remains unclear (low oil prices are usually seen as a boon for the European economy which is a large net importer of oil) but the obvious candidate is that the banking sector is heavily directly exposed to the oil and broader commodity sector. While European banks don’t publish any clear breakdowns on such exposure it is possible that a number of banks may have a significant chunk of loans out to firms in these industries (as demonstrated by the Morgan Stanley estimates below via Zerohedge) – loans which could quickly turn bad. There have also been reports of more indirect impacts of the struggles in the oil sector. Notably, that Sovereign Wealth Funds which had been heavily invested in European banks have begun to sell off holdings amid pressure from the decline in oil and commodity prices.
MS Euro exposure 1
  • Broader economic concerns – Of course it is also unlikely to be a pure coincidence that the bank concerns have coincided with broader economic concerns mostly around China and emerging markets but also increasingly around growth in the US and core European economies. Recent industrial production data for these latter markets has been poor. These concerns have added to the concerns above with regards to profitability and challenged previous assumptions about the recovery in both growth and inflation in the developed world.
  • Detached from fundamentals – linked to the point above is the fact that bank stock prices have becoming detached from underlying fundamentals such as their profit margins or the health of the economy in recent years. This has largely been driven by the significant liquidity injections by the ECB in the form of the long term lending operations and quantitative easing. There may have been an implicit view that the fundamentals would eventually catch up with the improved stock prices. However, with profits not recovering and broader economic trends souring slightly once again, investors may have reassessed the value of banks.
  • Lack of restructuring of sector – it has been clear for some time that the European banking sector also never underwent the serious restructuring and consolidation needed in the aftermath of the financial crisis and the Eurozone crisis. The combination of bailouts and central bank liquidity allowed many to keep their outdated structures and balance sheets intact. A number of countries, especially in the periphery, have fragmented systems with a huge number of small and inefficient banks. As I’ve noted before the stress testing of the sector undertaken in Europe is far from comprehensive and the underlying assumptions have been tested by the prolonged downturn. All meaning that concerns around the capital position of many of the continents banks remain. This is also manifesting itself with specific localised issues seen with the struggles of the Italian and Portuguese banking sectors.
  • Further costs of regulation and litigation – additional risks also loom, one more certain than the other. It is clear that banks are facing a much tougher regulatory environment and will continue to have a high regulatory burden over the coming years, especially in Europe. Furthermore, risks remain of unknown litigation costs such as those thrown up by the Libor rigging investigations. The European Commission is considering other investigations along these lines. Uncertainty over the implementation of regulations may also be adding to uncertainty. I’m thinking her specifically over the plans for bank bail-ins and bank recovery and resolution more widely. As I noted recently with regards to Italy and as we have seen in Portugal, there remains a significant amount of disparity around how struggling banks are dealt with.
All this said, I’m not certain even all of this may not capture what is driving the rout. After all many of these are quite specific to Europe – especially the lack of restructuring post crisis – and yet the US, which did properly stress test its banks, is also seeing huge declines in its own banking stocks. But with economic outlooks souring, deeper negative rates on the horizon and the potential for shocks be it from the oil sector or from litigation, concerns of the health of Europe’s banks could continue for some time.