A spectre of doubt is haunting Europe’s banks

The Australian 12:35pm October 3, 2016

Stephen Bartholomeusz

Last week Credit Suisse’s chief executive, Tidjane Thiam, described Europe’s banks as “not really investable as a sector.”

While the focus today is on Deutsche Bank, Thiam’s comments point to the wider problems faced by European banks.

Thiam cited a number of factors that explain the banks’ predicament.

Negative interest rates, the weak macro-economic environment, uncertainty about future regulatory capital requirements and the potential for massive fines, like the $US14bn claim the US Department of Justice has made against Deutsche Bank for its role in the residential mortgage securities meltdown in the US, were among them.

He also, however, referred to a particular problem faced by Europe’s banks.

Generally they aren’t generating profits that cover their cost of capital and their shares trade at discounts to their book values.

That makes it impossible to strengthen their balance sheets via new equity raisings unless they are prepared to decimate the interests of their existing shareholders.

He didn’t say, but could have, that there is general scepticism about the quality of European bank balance sheets and their stated asset values, which might help explain the discounts to book values. The US regulators have taken a far tougher approach to their banks’ balance sheets and capital adequacy than the Europeans.

The various uncertainties create a “very fragile situation,” he said.

“I think there is also a lot of doubt, a fundamental doubt. Is there a viable business model that covers its cost of equity?”

It was the big European and UK banks, Deutsche among them, that pioneered and aggressively pursued global “universal bank” models in the 1980s that brought together traditional banking and investment banking.

The US has its fair share of banks with similar ambitions and structures — Bank of America Merrill Lynch, Citigroup and JP Morgan Chase — but where the US financial conglomerates tend to be weighted more towards traditional banking, the Europeans and UK banks tended to expand internationally more via their investment banking activities.

It was a faster and less capital-intensive way to grow internationally, and particularly to expand into the US, than traditional banking.

Thus Deutsche evolved into a giant global investment bank sitting on top of a disproportionately small traditional bank. Credit Suisse and UBS were, when the financial crisis broke, not dissimilar in structure but the Swiss authorities imposed punitive capital requirements that have forced quite dramatic and still-continuing changes to their structure and strategies.

In the UK, the authorities have decided to create a synthetic separation of traditional banking and investment banking, with the ring-fencing of retail and small business banking within discrete entities with their own conservative capital requirements and taxpayer support. From 2019, beyond the fence, within a separate legal entity and without a taxpayer backstop, will be wholesale and investment banking and other higher-risk activities.

In the US, there has been talk about bringing back the Depression-era Glass Steagall Act, which separate commercial banking from investment banking.

In both those jurisdictions the banks are probably sufficiently well-capitalised and their balance sheets sufficiently credible to manage the regulatory uncertainties and costs, in the context of a the general increase in global regulatory capital requirements that has cast a shadow over the stability of Europe’s banks because of their poor profitability and ability to generate organic capital.

The particular cause of Deutsche Bank’s wobbles is the DoJ’s claim for a $US14bn fine that Deutsche wouldn’t have the current capacity to fund. On past experience, the DoJ’s position is an ambit one and the amount will be negotiated down significantly, although even a 50 per cent reduction would still be a major issue for Deutsche.

The size of the fine, and others that the DoJ has levied on European banks for various forms of misconduct, is causing some angst in Europe, with some seeing it as a form of trade war. That ignores the fact that the biggest fines for misconduct have been incurred by Bank of America and JP Morgan Chase.

According to the UK’s Conduct Costs Project, international banks were fined a total of about $US325bn between 2011 and 2015. Bank of America’s fines totalled about $US60bn and JP Morgan Chase’s about $US34bn. Lloyds (about $US20bn), Citigroup ($US17bn) and Barclays ($US15.5 n) were next in line. Deutsche was the worst-hit of the eurozone banks, with fines of about $US10bn.

The US and UK banks have been able to absorb those fines while still meeting the stringent stress tests applied by their regulators.

Those regulators, and their governments, took far more decisive action to bailout and recapitalise their troubled banks in the aftermath of the financial crisis and to continue to strengthen them even as conditions stabilised.

The US and UK banks are also operating within economies that have been growing, albeit at modest rates, and with monetary policies that are less unconventional and profit-draining than those in place in Europe.

The other problems facing the European banks are the highly-fragmented nature of European banking markets — there are too many banks — and the absence, until quite recently, of consistent regulation, supervision and rules for responding to distress.

Ironically, the new “banking union” is an ingredient in Deutsche’s current instability, given that it prohibits taxpayer support unless existing loss-absorbing capital has been exhausted.

For Deutsche, that places a question mark over its contingent convertible securities, which could be forcibly converted if Deutsche were really in trouble, and its senior unsecured debt, which could be forced to absorb losses.

There is an obvious strategy for stabilising Deutsche and reducing its over-reliance on investment banking in an era where there has been very little profit available from markets-facing activities. It should be merged with a more traditional bank — Commerzbank is the one usually touted — to create a more diversified and stable entity. The two German banks are said to have discussed a merger earlier this year but both decided they needed to focus on cleaning up their own houses first.

Thiam pointed to the obstacle for consolidation at the big end of eurozone banking. If Deutsche were deemed, as it is, “too big to fail” today, why would the regulators and legislators agree a plan to make it much bigger?