Blain's Morning Porridge - July 19th 2017: European 2nd Tier Banks and NPLs - an unsorted proble

Blain’s Morning Porridge – July 19th 2017

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One of the things that’s been niggling me for years has been the question of just how unfixed the European banking sector is.

This morning I’ve attached a note my associate Ben Steethman and I have put together on Non-Performing Loans (NPLs) in Second Tier European Banking. It’s a simple look at the publically available numbers. Nobody will be surprised a North/SouthWest line divides Europe into good banks and less good banks. North of the line there are a few issues. Italy remains the problem - 16 out of 19 Italian banks don’t meet European standards on NPLs! We conclude the Italian second tier banks need to raise some €32 bln of new capital just to cover their existing holes. (€32 bln isn’t a massive number any more, but it’s a very large number for what are essentially very small banks – meaning further calls on Italian tax-payers look likely!)

In recent weeks we’ve seen a gamma burst of activity across European banking: the resolution and bail-in of Banco Popular, the bailout and transfer of the Veneto banks, and a number of completed NPL sales by Italian banks. However, this morning, the FT highlights how new European Securitisation laws may kill the market for Hedge Funds and PE Funds to buy NPL and fund them via Securitisation.

That sums up much of the confused thinking on European banks.

The Eurocrats have made grand assumptions, plans and visions for European Banking Union, including a single regulator, rules and definitions. But the reality is European banks remain very national in their characteristics and outlook. They have little common that would define a “European Bank”.

Readers may recall European banks were barely touched by the initial outbreak of banking uncertainty in 2007 and 2008. I remember being told how stupid the British banks were in comparison to the clever European names that hadn’t got involved in structured and secured debt. And then the Lehman moment changed everything and the Global Financial Crisis went critical. Then we tumbled into the European Sovereign Debt Crisis and European banks became mired in a deepening crisis. A collapse in sovereign confidence triggered worries across weaker European banking names.

Since then we’ve seen multiple rescues, bailouts, handouts, defaults, restructurings, recapitalisations and bail-ins across Europe. Regulators and politicians talk big about banks being fit to fail without recourse to taxpayers – therefore they should have lots and lots of capital.

But, it’s never a lack of capital that kills a bank. Its access to liquidity – which depends on confidence. Folk will keep depositing in a bank as long as they are confident they will get their money back. When confidence unwinds, the bank will fail. Simples.

Regulators have made the assumption you can solve the confidence problem by putting in enough capital to cover any event. Because of the importance of national banking systems, pre-2008 investors read that as a bail-out charter, correctly anticipating banks would be bailed out.

Now it’s changed – but only slightly. The Italians have no choice but to continue bailing out their banks. Otherwise, the reasons confidence in banks collapses is different every time. It might be because of fears a massive mismatch on the derivative book will trigger overnight crisis (watch this space), or might be something more simple. Some of the triggers are obvious – like how certain Irish banks got sucked into unwise property games because they thought they understood the market and the politics of property better than anyone else. Or it might be German and Austrian banks overwhelmed by toxic investments. Some names were simply swept away in the Netherlands. I watched a sinking property market trigger crisis in Spain. (On the other hand, I’m still struggling to understand how the French banks seemed to skate across the thin ice largely unscathed – a story for another day perhaps..)

What became quickly apparent is that there is no such thing as a European Bank. That was particularly true before the ECB became the regulator across the Eurozone. National self-interest trumped Europe every time – still does in many countries. National Characteristics and Politics still define the way in which banks operate.

Post crisis there has not been a clean banking sweep across Europe. Some countries; notably Spain and Ireland, addressed the crisis and have come out with stronger banks. Selective names were rescued, rebuilt and rebranded. Some names were mercy-killed.

But in most cases the symptoms of chronic unwise lending and resulting undercapitalisation were treated with sugar lumps, lashings of free ECB money and a general hope banks would recover as/when/if the European economy recovered.

In the US, banks were put on diet of forced recapitalisation and clean up – it worked.

There has been much talk about European Banking Union – trying to create common rules and practice to make real the illusion European banks are homogenous group. But they aren’t.

Years of regulation, and selective memory gives us a European Systemically Important Financial Instututions (SIFI) Banking sector of some 30 core banks that could be described as healthy(ish). They all meet the core capital tests. They are recapitalising themselves to the levels determined as appropriate by the regulators.

But, there still isn’t any standard definition of European capital, and there is still no single Pan-European banking champions! The German banks seem to be retreating into their home market. The Dutch are focused on their domestic markets. Only the French show any real ambition – and even they have learnt caution from just how doomed they would have been if Greece, Portugal or Ireland had actually exploded! (Now I wonder how large French exposures to Turkey might play out…)

I could ramble on for paragraphs about how national banks reflect national outlook – The UK banks as merchantile commercial funders and mortgage providers, the German banks as instruments of regional economic policy, French banks as lending conduits for the State’s industrial policy, or Italian banks as SME lenders.. Too simplistic – but bear with..

Let’s not worry about the big banks. Sure there is a chance the next European financial crisis might be spawned within one of them.. but, it’s far more likely we’ll continue to see a series of smaller crisis gestate in lower down the European banking food chain. There are simply far too many of them..

We’ve looked at European banks with a balance sheet of €10bln plus. We didn’t worry about subsidiaries. Most of Europe’s second and third tier banks are perfectly fine. But a worrying number aren’t – they have flashing red signal lights screaming Danger, Danger! I suspect many depositors (including investors in their bond issues) to these second tier banks continue to lend because, contrary to the evidence, they think they are safe. Maybe it’s national interest, politics or implied government support – but a significant number of Southern European banks still look in crisis, but still attract deposits.

After looking at capital, management, and focused on NPLs, guess what? The bulk of Europe’s smaller banking problems are bound up in Southern Europe – Italy in particular.

We’d be interested in any feedback on the attached file.

Bill Blain