Europe: Banks continues to be important issue for investors - BBH

Research Team at BBH, suggests that the health of European banks continues to be important issue for investors.  

Key Quotes

“The IMF identified three European banks it said posed the greatest threat to the global financial stability.  The branches of two European banks failed the Federal Reserve’s stress test.  The problems at Italian banks, especially Monte Paschi, were seen as more pressing.  It was the only bank that failed the recent European stress test.  Last week, the banking index of the Euro Stoxx 600 was flat and the MSCI European bank index rose 0.5%.  In contrast, an index of Italian banks fell 6.2%, which includes a 5.5% rally in the last two sessions.

A few hypotheses have been suggested as possible explanations for the reason the stress tests did not seem to make a difference to investors.  One is that what ails European banks is not the capital cushion needed in an economic crisis.  That is to say that the regulators have done their job.  They have delivered a more resilient banking system.  

Another hypothesis is that the stress tests are largely irrelevant.  What concerns investors may not be whether banks have sufficient capital to whether a prolonged economic downturn, but whether they can survive the grind of the status quo.  There is no end in sight of negative interest rates, loan growth is slow, the nonperforming loan problem has barely been addressed, and, arguably, there are too many banks and branches in Europe.  But apparently, a deep and protracted economic downturn won't wipe out their capital.  

The stress tests may be irrelevant on another level.  Officials stress tested around 50 banks.  These are large institutions.  These are the ones that have been under pressure to raise regulatory capital, adopt better risk controls, and address governance issues.  Surprises do not often arise from where one looks, but from where one doesn't.  

Italy's bad loan problem is not limited to the five banks that were stress tested.  German Landesbanks are not seen as systemically significant.  Many institutions that failed, including Bear Stearns, may not have been systemically important.  A year ago, it was relatively small Greek banks which were not systemically important, but appeared to threaten to bring down the entire EMU.

Ultimately, Europe's problems are symptoms of the failure to complete the banking union.   It is caught in a Catch-22.  Germany and the creditor nations do not want to move to greater union without first reducing risk in the system.  It is proving difficult if not impossible to reduce risk without greater union.

While not discounting the insight of the second hypothesis, there is a third possibility.  The simplest and most benign hypothesis is that observers are rushing to judgment.  The bank shares did continue to fall in the first couple days of last week but finished with a 2-3 day advance.  Let’s see what happens this week.  The danger of attributing short-term price action to macro forces is that the price action often reverses before the purported cause are removed.”