European Banks May Be More Vulnerable Than U.S. Counterparts Despite Regulations

Deposits at U.S. commercial banks have fallen to the lowest figure in nearly two years, according to the Federal Reserve.

This figure has fallen by $500 billion since the Silicon Valley Bank collapse. Total banking credit has risen to a new record high of $17 trillion, according to the U.S. central bank. Fewer deposits, but more credit. What could go wrong?

The inevitable credit crunch is only postponed by a consensus view that the Fed will inject all the liquidity required and that rate cuts will come soon. It is an extremely dangerous bet. Bankers are deciding to take more risk expecting the Fed to return to a loose monetary policy soon and expecting higher net income margins due to rising rates despite the elevated risk of increasing non-performing loans.

The fact that the banking crisis has been mitigated does not mean that it is over. The banking system collapses are symptoms of a much larger problem: Years of negative real rates and expansionary monetary policy that have created numerous bubbles. The risk in the banks’ balance sheet is not just on diminishing deposits on the liability side, but a declining valuation of the profitable and investment part of the assets. Banks are so leveraged to the cycle and the expansion of monetary policy that they simply cannot offset the risk of a 20% loss on the asset side, a significant rise in non-performing loans or the write-off of the riskiest investments. The level of debt is so high that few banks can raise equity when things get worse.

Deposit flight is not happening because citizens are stupid. The largest depositors are businesses, small companies, etc. They simply cannot afford to lose their cash if a bank goes to liquidation. Once the Fed introduced the discretionary decision on which banks’ deposits are made whole and which are not, fear took over again.

Investors and businesses in America understand this. However, in the U.S. eighty percent of the real economy is financed outside of the banking channel. Most of the financing comes from bonds, institutional leveraged loans, and private-direct middle market loans. In Europe, 80% of the real economy is financed with bank loans, according to the IMF.

You may remember in 2008 when European analysts repeated that the subprime crisis was a specific event that only affected the U.S. banks, and that the European financial system was stronger, more capitalized, and better regulated. Well, eight years later, the European banks were still recovering from the European crisis.

Why are European banks equally at risk, or more?

European banks have strengthened their balance sheet with a very risky and volatile instrument, contingent convertible hybrid bonds. These look incredibly attractive due to the high yield they have, but they can create a negative domino effect on the equity of the firm when things turn sour. Furthermore, European banks’ core capital is stronger than in 2009, but it can deteriorate rapidly in a declining market.

European banks lend massively to governments, public companies, and large conglomerates. The contagion effect of a rising concern about sovereign risk is immediate. Additionally, many of these large conglomerates are zombie firms that cannot cover their interest expenses with operating profit. In periods of monetary excess, these loans seem extremely attractive and negligible risk, but any decline in confidence in sovereigns can rapidly deteriorate the asset side of the financial system rapidly.

According to the ECB, euro area banks’ exposures to domestic sovereign debt securities have risen significantly since 2020 in nominal amount. The share of total assets invested in domestic sovereign debt securities has increased to 11.9% for Italian banks and 7.2% for Spanish banks, and close to 2% for French and German banks. However, this is only part of the picture. There is also a high exposure to state-owned or government-backed companies. One of the main reasons for this is that the Capital Requirements Directive (CRD), permits a 0% risk weight to be assigned to government bonds.

What does this mean? That the biggest risk for European banks is not deposit flight or investment in tech companies. It is the direct and uncovered connection to sovereign risk. This may seem irrelevant, but it changes fast and when it does it takes years to recover, as we saw in the 2011 crisis.

Another distinct feature of European banks is how fast the ratio of non-performing loans may deteriorate. When the economy weakens or stagnates, loans to small and medium enterprises and families become riskier and the lack of a diversified and alternative lending system like the U.S. has means that the credit crunch hurts the real economy in a deeper way. We can all remember how non-performing loans went quickly from a manageable 3% of total assets to up to 13% in some firms in two years between 2008 and 2011.

European banks’ assets are more exposed to sovereign risk and the worsening of solvency in small businesses, but also significantly exposed to large zombie industrial firms.

The latest lending survey of the ECB shows that credit standards are tightening across the board for enterprises, households, and real estate lending. When the real economy is 80% financed through bank loans and banks are heavily exposed to sovereign risk, the domino effect of a weaker economic environment on the financial system comes from all sides, the allegedly low-risk government link, and the higher risk small and medium sized businesses.

So far, analysts are saying -again- that the banking crisis has nothing to do with Europe because regulation is stronger, and capitalization is more robust. The same consensus repeated in 2008.

Depositors have withdrawn €214bn from eurozone banks over the past five months, with outflows hitting a record level in February, according to the FT and the ECB. It is not true that deposit flight is not an issue in Europe.

The biggest mistake European authorities and investors can make is to think -again- that this time is different, and the banking crisis will not hit the euro area system. It is important to strengthen the core capital base, buy-back the convertible bonds that may wipe out the equity and put in place strong procedures to avoid a sovereign-to-real economy negative effect.

The combination of ignorance and arrogance led Europeans to believe they were immune to the 2008 crisis because they believed in the miraculous power of their bureaucratic and bloated regulation. No amount of regulation helps when the rules are all designed to allow rising exposure to almost-insolvent governments under the excuse that it requires zero capital and has no risk. Sovereign risk is the worst risk of all. European banks should not fall into the trap of thinking that tons of rules will eliminate the risk of a financial system crisis.