Confidence crisis in European Banks

Since the start of 2016, shares in European banks have been affected by a crisis of confidence which in the last month has seen lower share prices and higher Credit Default Swap prices. But have the recent movements affected risk for depositors? The banking sector as a whole is being forced to hold more regulatory capital, so shouldn’t banks be safer?

Understanding the reasons behind the recent share price and CDS price movements should give deposit holders some understanding of the increase in risk associated with bank deposits.
Worries that a protracted period of slowing global growth, falling oil prices and the expectation that low or negative interest rates will stay around for longer, have combined to undermine investor’s confidence in financial institutions.

CDS Feb 2016

Rising rates are good for banks because they can increase the spread between what banks charge on loans and what they pay for their deposits and other funding. The growing list of countries with negative interest rates is leading investors to believe that a profit recovery in the banking sector could be years away. Add in the concerns over bad loans that are still to be uncovered because of the oil price fall and exposure to emerging markets, and investors are starting to question how sound banks balance sheets really are.

Deutsche Bank, the flagship of the German banking sector and considered too big to fail, saw its share price fall by 9.5% on the 8th of February alone as the strength of its balance sheet came under the spotlight. On the same day shares of most other banks hit 12 month lows and fell far more than other sectors of the market.

The share price falls also fed into the CDS market as holders of bank debt rushed to buy insurance cover for their holdings. One reason that CDS prices reacted so dramatically to the share price falls was that liquidity in the CDS market has contracted sharply since the financial crisis which exaggerated price movements. Deutsche Bank, who ironically suffered one of the biggest CDS price spikes, withdrew itself from single stock CDS market making in 2014.

So the profitability of the banking sector is a major systemic risk and one that is being exaggerated by volatile price movements. Until banks start passing on negative rates to customers or start to increase the margins on their loans profitability will continue to suffer. Switzerland and recently Denmark have started to increase the cost of their mortgages, European banks could be forced to follow suit.
A tightening of credit however, would have the opposite effect to that desired by the ultra-loose monetary conditions imposed by central banks, as they seek to restore growth.

The low interest environment was intended to force banks to lend to businesses and create growth in the economy. The balancing act between maintaining liquidity and creating a systemic risk for the banking sector must now be examined by central bankers.

Currently most Eurozone banks have enough capital to avoid default but many need to further increase capital through earnings to hit the 2019 targets. Central banks cannot maintain ultra-low interest rates and expect banks to build sustainable capital through profit.

While the crisis of confidence in banks continues, depositor risk with those banks will increase, however we are not in the same set of circumstances as 2008 when banks needed to be bailed out due to lack of capital.
The regulatory capital held by banks is now a key indicator to their security and levels require careful monitoring. Although investors may not currently like investing in the finance sector, the share performance of banks should be viewed as an indicator of the banks expected profitability rather than their security.

It is prudent to assess bank limits regularly and spreading risk over numerous counterparties through diversification is currently more important than ever.

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