The challenges for European banks

At the ACO AGM, we presented a few thoughts on the global economy and market prospects, and dwelt briefly on the challenges for banks in Europe and elsewhere. What’s clear is that stress in bank funding, financial protectionism, financial regulation and risk management are driving both ongoing home bias and also concerted cross-border de-leveraging.

This will have profound implications for credit availability, cost and economic growth in some countries and segments, and without federalisation and confidence in the EMU, we should expect more fragmentation or so-called ‘balkanisation’ – the splitting of once seemingly coherent geographies into smaller constituent parts.

The drivers of these developments are bank regulation, which traps capital and liquidity at a national level, sovereign funding stress, which leads to financial protectionism, and bank funding stress, which coupled with the need to de-leverage pushes European banks to retrench homewards and reduce credit overseas.

Clearly the longer the uncertainty and funding stress, the greater the need for banks to move to constrain funding and redenomination risk and there has already been significant shrinking of cross-border finance. Now it would seem that despite the LTRO, stress within Euroland is becoming more intense and given ongoing political instability and the lack of co-ordinated policy response, we may expect banks to continue to shrink, especially cross border, with so-called ‘balkanisation’ of operations to insulate from external shocks. Reduction of Europe’s out-sized banking system was always going to be required, but the pace and scale of deleveraging are huge. Thus, we can reasonably expect multi-year de-leveraging of capital and funding structures, and material shifts in pricing and who provides credit. Policy makers must recognise the lessons from Japan, and both the US S&L and Asian crises. Meanwhile, there has been a step change in cost and availability of unsecured debt, with banks rationing credit and seeking to get loans to deposits nearer to 85-100% vs. 115-130% now. This is common with many banking crises in history. Whilst the LTRO helped prevent a chaotic breakdown in Euroland, sovereign stresses will take many years to overcome and constrain credit availability. Against this backcloth, the key policy focus must be to ensure that de-leveraging and re-balancing inflict as little lasting damage as possible.

Turning to the data, lending by Europeans outside the EU is tailing off broadly. In April, loan growth outside the Euro Area fell to -2.3% year on year, and this is the lowest level since the onset of the second phase of the crisis. Lending within the Euro Area remained higher at 4.4% year on year, but was primarily driven by the core countries. Of greater concern is European bank lending across European borders. For example the French banks’ Euroland funding gap increased from zero 15 years ago to over €700bn at the peak, but has been reduced to €50bn at the most recent data. If this trend continues, there will be significant impact on the over-leveraged. The four largest French banking groups provide c€150bn of parent funding to their European peripheral activities, including funding provided to retail subsidiaries in Italy, Greece or Spain, and other commercial activities such as consumer finance, equipment finance, and corporate lending. Altogether they provide €70bn of parent funding to their Italian subsidiaries and €50bn to their Spanish subsidiaries. Although bank managements are not openly discussing clear strategies to shrink their cross-border activities within Euroland, recent banks’ moves (asset transfers, ECB usage) and declarations (BNPP now saying it is reducing parent funding provided to BNL) support this thesis.

In the days of apparent stability, cross-border funding and capital allocation were the norm for regional and global banks, but uncertainty over Euro fungibility and regulation and the sovereign/banking solvency connections and risks are putting more pressure on banks to rebalance their asset/liability strategies on a country-by-country basis.

The problems are clearly not just evident in the bond markets. There are strains in the interbank and corporate deposit markets and retail deposits too have started to look less stable. In Spain, BBVA’s gross lending fell by 2.5% quarter on quarter (10% annualized), while Santander cut lending by 1.7% quarter on quarter. Given the anaemic economic backdrop and mounting market pressures on the sovereign, we can only expect further de-leveraging in the medium term. Similarly, Q1 data for Italy revealed that loan growth had turned negative during the quarter, making it the worst 6-month period in 20 years.

There has been progress including an increase in non-bank lending, and this has helped corporations in recent years, and we may expect more dis-intermediation ahead in both Euroland and emerging Europe for investment grade borrowers. However many would-be borrowers are mid-sized companies in countries that are no longer investment grade and such companies may be reliant on weakened banking systems. Local wholesale funding gaps and systemic dependence on cross-border funding and capital expose significant financing and ultimately growth vulnerabilities in the region. The pace of de-leveraging threatens a credit squeeze and medium-term financial stability.

Turning to protectionism and regulation, national supervisors are looking to trap more capital and funding in subsidiaries. National protectionism is hard wired into the rules (Swiss, Austrian, UK are good examples), and with particular focus on the UK, banks such as Barclays, RBS, HSBC, Lloyds took LTRO to reduce redenomination risk in Euroland, and the Vickers report would create a new formal ring-fence around retail activities. Meanwhile the UK regulator has become increasingly focused on capital and liquidity ratios of foreign owned subsidiaries – e.g. US, Spanish and regulators will be keen to avoid rules arbitrage

As for the broader economic issues, policy makers have underestimated the drag of bank de-leveraging on economic recovery, but central bankers have moved significantly to support the banking system in the last 12 months. For instance, the Bank of England has changed its economic models to reflect the bank channel and has changed tack on its explicit support for bank funding.

Looking ahead, weakness will be greatest where there are the greatest imbalances in loans/deposits, or where sovereign/bank funding stress re-pricing is leading to pressure on assets, particularly those which need unsecured funds or dollars. That’s why it is important to remain intensely focused on the South/periphery and we should be concerned about a credit crunch in Italy as well as continual tightness in Spain, but also for CRE, SMEs and CEE/SEE. The economic impact is clearly critical, and likely to be a drag on the credit conditions in the South and can only reinforce divergence.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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The Local Authority Treasurers’ Investment Forum September 25th, 2012, London Stock Exchange
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