“Greply yes no Switzerland,” quipped one analyst on March 20, after Greece’s central bank chief assured investors that his country’s banks would not suffer from Credit Suisse’s implosion last weekend. Affecting banks in the Eurozone. Their share prices have fallen since March 9 and are still volatile.
That was a disappointment. After being hit by the global financial crisis of 2007-09 and the sovereign debt crisis shortly thereafter, the euro zone’s big banks were placed under the supervision of the European Central Bank (European Central Bank). Banks are duller but more resilient as rules tighten and obsolete assets are cleaned up. Now, “the market seems to be sifting through balance sheet after balance sheet,” worries one influential source. Three major risks stand out.
The most immediate is liquidity crunch. In September, liquid assets held by European banks were well above the 150% of deposit outflows assumed by regulators in the critical month. But the speed at which deposits are rapidly draining away from SVB and Credit Suisse suggests that assumption is overly optimistic. It also doesn’t help that European banks disclose less detailed data on the nature of their deposits than in the United States, prompting some investors to assume the worst.
Thankfully, large deposits are held by households, most of which are insured. Those that don’t tend to belong to a variety of firms rather than a group of depositors that mimic each other, such as Swiss family offices or Silicon Valley startups. Europe also lacks the depth and convenience of money markets like Uncle Sam’s, so there are few liquid and lucrative alternatives to bank accounts. That’s why most of the overnight corporate deposits that have been withdrawn – some 300 billion euros ($325 billion) since the summer – have re-entered banks as “term” deposits, which offer higher returns in less flexible accounts.
The second threat facing European banks is deteriorating assets. Here, too, the danger seems manageable. As with bonds, when interest rates rise, the value of existing loans on banks’ books shrinks. But European regulators have forced banks large and small to buy hedges.
The third is that the borrower does not repay the loan. Investors are particularly concerned about credit extended to owners of commercial real estate. Rising interest rates and a deteriorating economic outlook have put pressure on home prices and rents, while landlords have had to pay more to service debt. The saving grace is that European banks have less exposure to commercial real estate than U.S. banks.
Broader lending could be problematic as the economy stalls. But banks now have ample capital buffers to absorb losses. Between 2015 and September 2022, banks’ core equity financing increased from 12.7% to 14.7% of their risk-weighted assets, well above the 10.7% threshold required by regulators. Some companies have made provisions for loan losses during covid-19 that can be repurposed to absorb new losses. A large number of corporate loans also remain under government guarantees.
That leaves euro zone banks with a painfully familiar problem: they make too little money. It’s a question that’s dogged them since the 2010s, when a glut of distressed assets, low interest rates, sluggish economic growth and stricter rules constrained margins and revenues. In 2022, things finally seem to be looking up, as higher interest rates boost bank profits. That year, the industry posted its first double-digit return on equity in 14 years.
But those cash-laden dreams are shattering. One reason is that interest rates may peak sooner than expected just a few weeks ago, as central bankers adjust to vulnerabilities in the banking sector and a slowing economy. This will depress the bank’s income. At the same time, financing costs are expected to rise. Depositors are seeking higher yields, forcing banks to offer fatter returns.At the same time, investors in banks’ Tier 1 bonds will demand higher premiums, as some bonds are Swiss bankAcquired Credit Suisse.
These pressures will squeeze net interest margins – just as other costs threaten bank profits. Wages, which account for 60% of the bank’s total costs, have not fully caught up with inflation. Premiums paid by banks for deposit insurance are also likely to increase. JPSuch costs alone could shave a percentage point off returns on tangible equity, JPMorgan predicts. Regulators are also likely to tighten rules to ensure institutions can withstand rapid bank runs fueled by digital banking and social media.
All in all, a return on equity of 10% or less could be the future of European banking. That’s not the end of the world. Ronit Ghose of Citigroup, another bank, said such returns were enough to allow banks to grow their balance sheets by 2% to 3% a year, meaning clients need not expect credit rationing anytime soon. There should be no lack of investment in core services like digital banking. For shareholders, it’s like investing in a utility — great dividends, but little action.
The downside is that more competitive companies such as startups will have to look elsewhere for funding, pushing risk into the shadowy corners of the financial system. Bettors hoping for great returns will be disappointed. To avoid bottom-line boredom — for better or for worse — investors will likely continue to look across the pond. ■
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