A eurozone crisis appears to be unfolding right in front of our eyes. Eurozone banks such as the Ireland’s Bank of Ireland, and Germany’s Commerzbank AG and Deutsche Bank AG (ticker: DB), are down more than 35 percent for the year as nervous investors panic and focus on these financial companies.
The last European financial crisis was triggered by sharply escalating interest rates on the government bonds of the EU’s southern members, such as Greece, Cyprus, Italy, Spain and Portugal. Our current situation can be attributed to multiple issues, some from leftovers of the previous crisis and others from unexpected new events, including the Brexit vote, weak earnings, poor capital coverage and glut of bad loans that have put Europe’s largest lenders in a difficult position.
What makes the current eurozone situation so important is the significant interconnectivity between banks both in the eurozone and abroad, making the risk of contagion one worth considering.
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Below, we explore the three key issues we believe could trigger Europe’s next banking crisis.
The first domino, Deutsche Bank. Deutsche Bank is integral to the eurozone. Its interconnectivity is just one of the reasons why investors are spending so much time focusing on the institution. Deutsche Bank isn’t the typical retail institution. Rather, it is focused on financing Germany’s exporters, the backbone of the German economy.
As of the end of September, the company reported a 98 percent decline in net income for the second quarter which could be partly attributed to the Brexit decision as Deutsche Bank derives roughly 19 percent of its revenues from the U.K. Besides Brexit, the bank has been hit with multiple negative events on top of its structural issues and losses keep piling up.
Deutsche Bank, one of the largest in the world, has been described by the International Monetary Fund as one of “the most important contributors to systematic risk.” Banks across the world have struggled with low interest rates, but Deutsche Bank is significantly undercapitalized, as evidenced by its failure during June’s U.S. Federal Reserve stress test. What’s more, the financial institution is exposed to trillions of euros in derivatives intertwined with companies across the globe.
A failure within Deutsche Bank’s derivatives book could start a chain reaction and a bailout using taxpayer monies may not necessarily be on the table.
Bailout versus bail in. Things were made simple with the U.S. financial crisis as taxpayers ultimately footed the bill to bail out banks deemed “too large to fail.” The EU’s banking union prescribes that, when an institution runs into trouble, existing stakeholders are required to take a loss before public funds can be used. This means that not only equity holders who are used to the risks associated with stock ownership, but bondholders as well will take a hit. This is important because a significant portion of bondholders are retail investors, not large institutions that could arguably weather the fallout better than the investor next door.
What’s more, the EU has been strict about the rules, preventing taxpayer monies from being used to bailout struggling institutions, including those in Greece and Portugal. More recently, Italy’s efforts to recapitalize its banks by bypassing these rules has been met with resistance from Germany as well as the European Central Bank. This is important not only because retail investors could suffer losses but this is another reason that countries are using to fuel “no” votes on EU membership. Indeed, there are five more referendums expected on EU membership for 2017. If there were some more viable options for companies such as Deutsche Bank, they would be noted here. However, each seems as bad as the next and the requirements around bail-ins would likely exacerbate the issue.
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Bad loans. The problems caused by the last financial crisis have not been resolved in Europe and there exists massive amounts of bad loans that continue to weigh on firms’ balance sheets. What’s more, banks, responding to sluggish economic growth, have essentially kicked the can down the road, resorting to rolling over these non-performing loans. More recently, the ECB has begun implementing measures to resolve the situation by forcing eurozone banks to write off these bad loans. One of the side effects, however, is that the policies are curbing new lending and hindering the region’s economic growth.
For context, the amount of nonperforming loans across Spain, Portugal and Italy is now more than 540 billion euros. In Italy alone, it exceeds 360 billion euros, and amounts to 18 percent of all bank loans in the country. What’s more, the World Bank estimates that the ratio of nonperforming loans to gross loans in Europe reached 4.3 percent in 2015, a small uptick from where they stood during the 2008 financial crisis.
Among the $3 trillion in stressed loan assets worldwide, European institutions are saddled with just over 43 percent of the total. Once again, borrowers are having trouble paying off debt in the current economic environment of falling commodity prices, weak growth, and currency headwinds. All this means that bank profits will likely continue to struggle over the near term.
Italian companies aren’t alone. The stress test also highlighted poor performers outside of Italy, including Spain’s Banco Popular, Allied Irish Bank and Germany’s aforementioned Deutsche Bank.
In conclusion. At this point, it isn’t clear how EU officials will deal with the situation and they are increasingly seen as reluctant to bend on unpopular regulation but are equally afraid of sparking a political crisis that could threaten an anti-EU backlash across the region. However, it appears the EU has painted itself into a corner by requiring not only equity holders but also bond holders to suffer losses before taxpayer money can be used to rectify the situation. Neither forcing retail investors to suffer losses nor using taxpayer funds to solve the issue are going to be popular resolutions but, issues such as Deutsche Bank’s financial situation and widespread nonperforming loans must ultimately be addressed.
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The economic forecasts set forth may not develop as predicted and the content is for general information only and not intended to provide specific advice or recommendations for any individual. The financial consultants at Carson Institutional Alliance are registered representatives with and securities offered through LPL Financial, member FINRA/SIPC. Investment advisory services offered through CWM, a registered investment advisor. LPL Financial is under separate ownership from any other named entity.
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3 Things That Could Lead to a European Banking Crisis originally appeared on usnews.com
