Back in 2008, the U.S. was reeling from a banking crisis that subsequently plunged our economy into a recession. The Federal Reserve would unleash unprecedented measures to shore up the financial system and prevent the likelihood of a systemic worldwide collapse of the banking system as we know it. Announcing new emergency lending measures, the Fed cut interest rates, created an alphabet soup of programs such as TARP, TALF, TAF, as well as a series of QE programs. All of this was done to give the banks time to recapitalize their balance sheets, reduce leverage, and allow the markets to clear in a somewhat orderly process.
Europe now has a banking crisis of its own. The financial institutions in Europe and the European Central Bank (ECB) are headed down an eerily similar path, but for entirely different reasons. As a result, European bank stocks, all of them, should be avoided.
The bad news
The European Central Bank may soon be put in a position to support some of the largest financial institutions in order to prevent further contagion across the sector and the economy as a whole. Since July 2015, we have seen the iShares MSCI Europe Financials ETF EUFN, +0.13% by more than 27%. Some of the largest European banks — such as Deutsche Bank DB, +0.21% Barclays — have crumbled 53% and 50%, respectively, over the same period of time. These price swings will not abate soon. In fact, the situation could get far worse before it gets better.
On an economic basis, many financial institutions, but especially those headquartered in Europe, are fighting strong headwinds that may grow to gale-force strength if conditions continue to deteriorate. One of the largest structural issues is low to negative interest rates throughout much of the European Union.
A positive yield spread across the term structure of interest rates is of paramount importance for the profitability of the banking sector in general. Equilibrium rates across the euro area have been driven lower over the past nine years, and the ECB has instituted Asset Purchase Programs to help fulfil the mandate of maintaining price stability while achieving high levels of economic activity.
With nearly $13 trillion in negative-yielding sovereign bonds worldwide, it appears some of the strongest nations are caught in a disinflationary trend as evidenced by the reaction of bond yields that continue to spiral lower. In fact, the Swiss Yield Curve remains negative past 30 years. While financing for the nation is cheap, the cost is felt at the banks. The available bond supply continues to get bid up by central banks, is it any wonder why yields are being pulled lower?
More bad news
Underperforming loan exposure is another large risk for these institutions. Current estimates show banks in the euro area have nonperforming loan ratios (NPLs) of over 7%. At the height of the financial crisis, U.S. banks had a NPL ratio of just 5%. In fact, current estimates show Italian banks have a NPL ratio as high as 17%. Accordingly, share prices of some of the oldest banks in Italy reflect this reality.
Wall Street didn’t see the Brexit coming. This has created a tremendous amount of uncertainty. Housing bubbles have risen in certain select locations across Europe and the capital ratios of some institutions are well below 5%. While many European financial institutions are currently in full compliance with Basel III requirements, this compliance will come at a cost to profitability. These new rules intend to make banks safer. Add to all of this the complex derivative exposure and the interdependency of these institutions on one another and we can easily see a picture emerging that says to invest elsewhere.
Banks worldwide are now competing in the digital age. Technology has put pressure on bank profits as alternative-payment services, crowdfunding and peer-to-peer lending are only growing in popularity, scale and scope. This trend will continue to take business share away from these institutions. In fact, many of them have taken the approach,”if you can’t beat them, join them” and have launched competing services meant to retain their influence on our wallets.
Where there’s smoke there’s fire. Right now, we see a lot of smoke coming from the European banking system in the form of low-to-negative interest rates, downward bond yields, the risk of underperforming loan exposure, and the uncertainty of Brexit. Therefore, we are steering clear.