European banking sector ill-equipped to weather downturn

When we look at the credit conditions across Europe and compare them with other historical credit cycles, it looks clear that bank losses are set to pile up over the next few years even if Europe finds a near-term solution to the sovereign debt crisis.

The broad deleveraging that is taking place will continue since both public and private sector borrowers
remain over-indebted. Thus far, real economy loan losses across Europe have been modest, but as the region dips back into recession brought on by austerity and constraints on credit, delinquencies should rise meaningfully. European banks, with gross leverage ratios of 29 to 1, are not adequately capitalized to
deal with a severe economic downturn, despite the largely clean bill of health they received from the EBA. When we look at the numbers, either by examining what is priced in or relative to what has occurred in other deleveraging cycles, we think that Europe’s banks could be staring at €1tn of losses over the next two years, resulting in a capital hole of about €556bn.

This means that already strained sovereigns may need to provide material new amounts of support to their banking systems, and that the ECB, which is already lending over €834bn (and recently at a €60bn a month clip) to member banks, is likely see a big increase in its balance sheet and credit risk-taking. All of this will increase the possibility that something breaks. And at a minimum, these pressures will only exacerbate the situation because banks facing capital raises, higher funding costs and an increased reliance on the public sector are much more likely to de-lever, leading to a downward spiral in economic activity.

To the extent that banks continue to draw on the ECB at a rate consistent with what we’ve recently witnessed, the ECB will be lending about €1.7trl to the European banking system by 2013. While
this seems a large number, it’s not an unreasonable one, considering how tight the interbank funding markets have become and how reliant many European banks are on wholesale funding. And of course, there is always the risk of deposit flight emanating from the various sovereign debt crises. On balance, we don’t think that bank funding conditions will improve nor will banks’ reliance on the ECB diminish until banks are adequately capitalized and enough money is provided to create a credible plan to prevent sovereign defaults.

Current ECB lending rates are not cheap for stronger banks, and not surprisingly, a larger portion of that
borrowing is being done by peripheral banks and probably weaker core banks. 70% of ECB (and ELA) lending is to peripheral banks. This is in contrast to 2009 when the ECB pushed out cheap one-year money, akin to a quasi-quantitative easing, and many banks, good and bad, took the money. The result was €200bn of additional borrowing, but 70% of the proceeds were taken down by core banks (and have since been repaid). However, we have recently seen that in addition to peripheral bank borrowing, there has been a huge surge in core banks drawing on the ECB as banks domiciled in Belgium, France and the Netherlands have been rapidly replacing withdrawn sources of private funding with public sources of funding.

The ongoing deleveraging in Europe represents a continued threat to the health and solvency of the banking sector. This means that in order to avoid the total collapse of credit in Europe, the ECB and sovereigns will be forced to increase their support of the banks. Whether or not their response is sufficient will impact economic growth and asset values across Europe.

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