Europe’s headline-grabbing financial crises in 2009 and 2012 were not strictly sovereign debt crises - they were also banking crises. While concern regarding European sovereign debt has abated, the systemic issues of Europe’s derelict banking system have yet to be convincingly addressed. The latest episode of stress in the European banking sector began on January 19, when the ECB asked Italian banks for more information on their non-performing loan portfolios. Since then, we have seen a fall in European banking stocks that has managed to outpace the precipitous plunge across broader equities in the past several weeks.

The rapid decline in stock prices has a much broader impact than a negative turn in financial markets sentiment might otherwise suggest. Europe depends heavily on bank loans for survival. Challenges in the banking sector thus move quickly into the real economy. Global markets have felt the pain of falling oil prices and a strong dollar over the past 18 months, and Europe’s strategy of relying on a weaker euro to boost economic growth is already reaching the limits of its effectiveness. With these and countless omnipresent political crises (Brexit, Grexit, and Schengen), Europe’s bank health is one of the most important economic factors to watch in 2016.

Europe’s banks are not well capitalized

In the wake of the US financial crisis in 2008-2009, the Federal Reserve required banks to raise capital, and lots of it. As a result, US banks’ capital bases are currently even stronger than the Basel III accords require. Unfortunately, Europe’s banking authorities have not been so proactive. While the Fed’s stress tests conducted restored confidence in the country’s financial sector, European tests were undermined almost immediately by the failures of large banks, putting the common currency at risk. The efficacy of the ECB’s stress tests were further called into question when tests in 2010 gave a clean bill of health to Ireland’s two biggest banks just months before the country’s entire banking system collapsed, necessitating widespread bailouts. In mid-2011, Belgium’s Dexia similarly passed stress tests, only to require a second rescue shortly thereafter.

2014’s stress tests were a good first step towards improving the eurozone financial system, but made the mistake of allowing banks to assess their own risks, which resulted in national differences across key measurements including in the definition of capital. Two aspects of the ECB’s 2014 findings were particularly alarming and again alluded to a return of banking crisis. The first is that Italian banks fared by far the worst in stress tests, with a capital shortfall of €9.6 billion, €1bn more than even that of Greece. The banks with the largest capital shortfalls, Monte dei Paschi di Siena, suffered a 20.4% stock price decrease at the time, followed by Banca Carige with a 16.1% decrease. Second, in German banks, implicit national guarantees of German debt saved the landsebanken (regional state-backed banks) from otherwise significant capital shortfalls. If the definition of troubled banks were expanded to include those that barely passed the tests, four of Germany’s largest banks would join the list.

This round of stress tests made clear that the European banking sector was significantly undercapitalized and lacked a clear path to improvement. Capital levels in Europe remain heavily reliant on contingent products or even questionable (“between secured and unsecured”) loans. In addition, much of Europe’s household and business banking is done from regional and cooperative banks, which, due to their small size, are not monitored and pressure-tested by the ECB. Any decline in the value of these assets could result in swift credit contraction, creating a substantial risk for MNCs.

Falling stock prices mean trouble ahead for companies operating in Europe

The start of 2016 has seen financial market disarray extend across all industries and geographies, so why would European banks merit any additional attention? The simple and startling truth is that European businesses disproportionately rely on bank lending to fund their working capital. More than 80% of European corporate financing comes from bank loans rather than corporate bonds and equity (the reverse is true for the US, where just 15% or less of corporate financing comes from bank loans). Low interest rates in Europe have squeezed margins, making it difficult for banks to improve profitability and make additional loans. Falling equity prices for those banks makes them even less willing to lend to the real economy, bringing business expansion in Europe to a halt.

This is not like 2009 or 2012 – you will have to pay closer attention

During prior financial crises, FSG advised companies to monitor sovereign bond spreads as a signal of financial market duress. However, bond yields will not evolve now the way they have in the past. The European Central Bank’s quantitative easing program allows the ECB to own up to 33% of any sovereign bond issue, and 25-33% of any country’s total sovereign debt. This means that, even if there were substantial selling pressure on risky government bonds as capital seeks safe assets, prices might not move very much as ECB ownership of these bonds will dampen the price fluctuations normally driven by supply and demand. While these measures are helping to keep Europe’s economy safe, they will also mean that companies exclusively reliant on monitoring these high-level signals may miss the signs that financial trouble is unfolding.

For this reason, sovereign bond yields have not yet responded to banking pressures, with the notable exception of Portugal, whose ten-year bond yields reached pre-bailout levels of stress.

Signposts to watch

It is still worth keeping an eye on bond yields. As result of the mechanism just described, rising yields will indicate even more selling pressure than they have in the past. Increasing sovereign yields mean higher interest costs for governments, which increase their deficits and could result in public as well as private financial crises.

However, if sovereign bond yields could remain low longer than they have in the past, then what else can you monitor to understand where your local operations and partners may be under stress?

• Credit default swaps (CDS) spreads: CDS are insurance policies on a financial market participant’s exposure to credit risk. Increasing prices of these contracts signal rising concern of default, and thus provide an early sign of deteriorating funding conditions.
• Interbank lending: A sharp contraction in interbank lending signals that banks do not trust one another, which is a leading indicator of a contraction in credit to the real economy.
• Lending to households and businesses: The reliance of households and businesses on traditional bank loans means that a reduced availability of credit will limit their ability to make important investments, or hire extra workers. Lending to the real economy is very closely linked with broader economic health (GDP growth); a sustained contraction will signal recession.
• Signals from partners: Now is the time to be in touch with your partners to assess their financial health, and consider assistance that you could give (longer payment terms, direct financial assistance) to guide them through a systemic shortfall in working capital.
• German supply chain developments: As FSG analyzed in a recent series, the financial crisis has caused a shift in European industrial supply chains. Companies tend to hold less inventory to reduce their risk. Contracting lending conditions will make this practice more difficult, increasing storage and production costs.

For our latest updates and insights, FSG clients can visit the client portal. Not a client? Contact us to learn more.