Telegraph e-paper

A bitter cocktail of worries for the banks

BEN WRIGHT COMMENT 1 An economic slowdown 2 Dodgy loans 3 Central banks 4 Low interest rates 5 Capital cushions 6 Bail-in regimes 7 Cocos 8 Regulation 9 Restructuring 10 Litigation costs 11 Uncertain future 12 Self-fulfilling prophecies 13 Co

European banks have been rocked by a multipunch combination rather than a single knockout blow. Almost all are affected by a wide range of worries – the exact blend varies from bank to bank. Here are the 13 ingredients in the cocktail of worries playing on the market’s mind:

The cooling of the Chinese economy, long the engine of global growth, is bad news for banks with big operations in emerging markets, large exposures to commodities or sit in the midst of big trade flows.

Soon after the financial crisis, US regulators forced their banks to confront past mistakes and write down the value of dodgy loans. A similar process has been conspicuous by its absence in Europe. Deutsche Bank, for example, is currently valued at about 30pc of its book price. This demonstrates a fundamental disconnect between what the bank thinks its assets are worth and what the market thinks.

Markets are concerned that central banks are running out of ammunition. Some trace the latest sell-off to the Bank of Japan’s decision to cut interest rates to negative. This didn’t have the desired stimulatory effect – the Nikkei has since fallen 11.5pc.

The actions of central banks are now actively hurting some lenders. It’s very hard for banks to make money when rates are low and even harder when they’re negative.

Lots of hard work has been done by banks to plump up their capital cushions, which act as buffers if they start losing money. But they have to be built up further to hit tough European targets in 2019. There are three main ways of doing this – by increasing profits (not likely), shrinking balance sheets (not easy) or asking shareholders for more equity (not clever with share prices so low).

Governments want to make sure that taxpayers are never again on the hook for bailing out the banks. Or, at the very least, not until bank creditors have suffered losses, too. So a new investor hierarchy has been established that imposes losses on certain bank creditors. This was tested during the Cypriot banking crisis in 2011, when even depositors (who are technically lending money to their bank) were hit. This has made bank investors more aware of where they sit in the hierarchy and led to a more realistic pricing of bank credit risk. This is necessary but extremely discomforting.

There is no doubt that some creditors recklessly lent money to banks before the financial crisis in the (not mistaken) belief that governments would step in if anything went wrong. Contingent convertible bonds (Cocos), which convert to equity if banks get into difficulty, are an attempt to remedy this so-called “moral hazard”. The problem is that most people invest in either equities or bonds, so there aren’t many natural buyers of Cocos. This means they can lose value very quickly at the merest hint of stress.

New rules have rendered many business lines unprofitable. But many banks have hung in there, hoping rivals would give up and they would get a larger slice of a shrinking pie. It was like a huge game of ‘chicken’. No European banks blinked for years. Now they all are.

Those banks that have finally woken up, smelt the coffee and decided that they cannot be all things to all people are shutting down unprofitable units and restructuring. This is probably a good thing, but it is not easy nor cheap.

Banks are still getting fined for past misdemeanours. When will this end? No one knows.

Banks have plotted their paths back to profitability over coming years. But much can go wrong. A big global recession, financial scandal, or other things could derail their plans.

Banking is based on confidence. A bank can tell people it is not facing liquidity issues but if creditors are worried and stop lending it money, all of a sudden, the bank will not be solvent.

Banks are interlinked because they lend to, and trade with, each other. Investors, therefore, worry that if one bank goes down it could take others with it. Fear spreads quickly.





Daily Telegraph