WES: The Uneasy State of European Banks

With Brexit, US presidential election, and the Basel III rules on the horizon, European banks are facing a period of turbulence.

Europe is currently witnessing record low interest rates as well as close to anaemic growth, the combination of which casts a gloomy shadow on the profitability of banks. Nevertheless, the stress test of 51 bank across Europe this summer revealed that the top banks are stable and have sufficient capital to face the financial crisis. The accuracy of the tests, however, should be questioned due to the failure to factor in shocks like the long-term ramifications of Brexit, negative interest rates, the wave of impending banking regulations, or Trump’s presidential victory.

Several notable banks, including Italy’s embattled Monte dei Paschi, RBS, and AIB, emerged from testing as clear underachievers. The former’s capital ratio (core equity capital versus total risk-weighted assets) became negative into the adverse scenario, alluding to insolvency.

Share prices, especially of the unsteady banks, plunged swiftly after the Brexit vote, as investors feared the outcome would hurt the cross-border operations of the major banks. The Stoxx Europe 600 Banks index fell by 14%, with Barclays PLC, the hardest hit, tumbling a staggering 30%. Brexit also triggered the Bank of England’s lowest interest rate cut in history. In August, the BoE reduced rates to 0.25% in an attempt to prevent a descent into recession.

Perhaps the most recent of shocks to the banking industry, is Donald Trump’s victory in the US elections. Though international media has exploded with broadcasts of discontent, shock, and pessimism, his presidency may, in fact, turn out to be lucrative for European banks. During the current period of uncertainty ensuing the election, banks’ bond and currency trading operations are seen as potential benefiters. In the long run, Trump’s promise of a public spending splurge should trigger inflation and a subsequent interest rate hike. Considering that the US bond market has a guiding tendency to Europe, yield curves in the latter should mirror the steepening effect.

With European banks such as UBS, Credit Suisse, and Barclays deriving about a third of their revenue in the US, a huge reliance materialises. However, Trump’s victory poses some threats to European market players. Corporate clients, for instance, may be cautious in the coming weeks, retracting their issuance of debt or equity, which will eat into the profits of investment banking.

Finally, as to the third source of distress for European banks, the new year is set to bring on a wave of new accounting rules. The changes can be ascribed to Basel III, a global voluntary framework of bank regulations. The most recent instalment of the Basel Accords, represents a response to the regulatory deficiencies which resulted in the 2007-08 financial crisis. The framework aims to improve risk management, increase transparency, and enhance banks’ ability to absorb shocks during financial and economic stress periods. According to KPMG’s estimations, this means an extra 350bn of capital requirements for Europe’s largest banks. The riskier the bank is gauged, the larger its requirement will be.

The Basel Committee of supervisors is scheduled to clinch the rules in a meeting on 28-29th of November. Understandably, there is mounting pressure to ease the impact of the rules. The ECB’s head Daniele Nouy has warned of the stifling effect that capital requirement hikes could have on the banks’ lending spirit. Nevertheless, any rules will first have to make it past the European Commission, which offers a spark of hope to jittering banks.

By Maike Kusserow

This piece is part of Warwick Economics Summit’s #WESWednesday blog series. The Boar Finance section is WES’ official student media partner for the academic year 2016/2017. You can view the original piece and other blog posts here.