Europe is beginning to recover but many investors still fear European banks could derail the economy. Tim Rocks, Head of Market Research & Strategy, considers the challenges for European banks and support from policymakers.
A question of profit
European banks are struggling with profitability and this has been a key concern for investors. Two main themes have affected their profitability.
- High numbers of non-performing loans (NPLs)
These are loans where repayments have not been made and the likelihood that the loan will be repaid in full is very low. Some European countries have a particularly large number of NPLs, for example in Italy NPLs account for 18% of all loans (Source: Datastream). This is a result of country-specific factors like Italy’s lengthy judicial processes, complex system of corporate restructuring and insolvency and a tax system that discouraged write-offs until recently. These have made it difficult for banks to sell on these loans.
- Negative interest rates
The European Central Bank (ECB) moved its policy rates below zero in June 2014. While European banks have decreased the rates on loans, they have been unwilling to move interest rates on deposits below zero. This has made it harder to generate returns. On the positive side though, negative interest rates have increased the value of banks’ security holdings, lowered funding costs, raised credit quality and boosted loan volumes.
Still in the black
So while profit may be a challenge, European banks have actually improved their solvency levels in recent years. Overall, capital ratios (that is, the proportion of capital a bank holds compared to riskier holdings like loans) are actually higher for Europe than Australia or the US (Source: Datastream).
The banking sector is also being supported by policymakers.
- Europe is in the process of relaxing bail-in rules (which forced bank investors like depositors to bail out the bank in a crisis by having part of their deposits written off). Italy is currently negotiating for a bail-out of its banks (where the State or another investor would support a company financially to prevent it from failing).
- The Italian Government has implemented reforms aimed at speeding up bankruptcy and foreclosure proceedings, fostering bank provisioning and easing NPL disposals. Over the past year, Italy and the European Commission agreed on a mechanism that provides government guarantees for the securitisation of bad loans, while Italy’s largest banks created a fund to purchase non-investment grade tranches of NPL securitisations.
Although there are challenges for the banks, support from increased solvency and policymakers mean they are unlikely to derail recovery in Europe. As it continues its recovery, there may be growth opportunities for investors in European share markets with negative interest rates and low inflation continuing to support and encourage business investment and spending.
For more information on the impact of European banks on your investments, please contact your financial adviser.
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