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Europe’s banking woes should worry the In camp

by Alan Wheatley | 11.02.2016

Commentary

Crumbling confidence in euro zone banks has the potential to sap the bloc’s already fragile economic growth and even reignite its debt crisis. That in turn would increase political tensions, already running high because of unchecked immigration into the European Union. These risks, if they materialise, will be a gift for Brexit campaigners in the In/Out referendum pencilled in for late June.

There are plenty of culprits for the plunge in global equities since the start of the year. Financial markets are grappling with three key challenges – China’s poorly managed economic slowdown, a dramatic drop in oil prices, and uncertainty concerning the US Federal Reserve’s exit from super-easy monetary policy. But the most recent leg down can be traced to worries about the ability of major banks, especially in Europe, to adapt to what could be several more years of ultra-low interest rates.

France’s Societe Generale on Thursday became the latest big bank to warn that it may miss profit targets because record-low interest rates are compressing its lending margins. Its shares slumped as much as 13%. Credit Suisse, Santander, Standard Chartered and UniCredit have also been in investors’ crosshairs. A plunge in the price of Deutsche Bank’s bonds and shares prompted German Finance Minister Wolfgang Schaeuble to state on Tuesday that he had no concerns about the country’s largest lender.

Yet there are good reasons to be worried.

First, Europe will not enjoy strong growth without strong banks, and the verdict of the markets is that, although they have increased their capital since the financial crisis, they are still vulnerable. For instance, about 17% of Italian bank loans are non-performing.

Second, the euro zone can ill afford a blow to consumer and business confidence from banking strains and tumbling share prices. Global demand is weak and the euro is strengthening again, hurting exporters, as prospects for higher US interest rates fade. Industrial production unexpectedly fell in December in Germany, France and Italy – and in the UK. Weaker growth may cause more loans to go bad, adding to the problems in the banking sector.

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Third, what used to be the unquestioned solution to all financial and economic woes – ever lower interest rates – has now become part of the problem, at least for lenders. Official interest rates across much of Europe are negative, meaning banks have to pay to park surplus funds with their central banks. At the same time, the expectations of deflation that have spurred central banks to take such extraordinary action have driven down the yields on government bonds, especially in the stronger economies. This scissors effect is squeezing bank margins hard.

All this would be less of a concern if Europe’s governments were in a position to inject taxpayers’ money into banks, thereby strengthening their balance sheets. But government finances in peripheral Europe are too weak to make this an easy option. Recently, yields on Portuguese, Spanish and Italian bonds have risen sharply as markets anticipate that governments would be ultimately responsible for bailing out their countries’ banks.

Moreover, Europe’s new “bail-in” rules, which took effect on January 1, restrict the use of public funds to recapitalise banks: private investors are supposed to help finance rescues by accepting losses. In keeping with this policy, Portugal has imposed losses on holders of nearly 2 billion euros of bonds issued by Novo Banco.  In Italy, the closure in December of four regional banks saw thousands of pensioners lose their savings. But there are political limits to governments’ ability to hit private savers. This is complicating Rome’s efforts to stabilise its banks. The Italian government would like to offer sweeteners to investors to buy distressed bank debt. Brussels may not permit that.

The fate of banks on Europe’s edge may seem remote from the Brexit debate. It is not. A banking crisis could trigger political instability and shake the euro zone, diminishing Europe’s attraction for British voters. Politics in peripheral Europe are already fraught. Portugal has a new left-wing government feuding with Brussels over its budget; Italian Prime Minister Matteo Renzi’s patience with Brussels, not only on banking, is wearing thin; Spain’s parties are deadlocked after inconclusive elections in December. The talk in Athens is of new elections. All this against the background of fears, voiced by European Council President Donald Tusk, that a wave of populist politics could take the EU to the brink.

What should be particularly worrying for the anti-Brexit campaign is the timetable of debt relief talks now getting under way between Greece and its creditors. The negotiations are sure to be fraught. They always are. Last year, Athens seemed to be on the verge of being forced out of the euro before an 86 billion euro bailout deal was reached. As things stand, the latest talks may well drag on till the likely referendum month of June.  A banking crisis coupled with another Greek debt drama would be an inauspicious backdrop for the In camp.

Edited by Sebastian Mallaby

Tags: Categories: Articles, Economy, Industry