Eurozone banks have fallen dramatically in the stock market, despite the results of the stress tests carried out by the European Central Bank, and the EU Banks Index is down 25 percent on the year, despite year-long bullish recommendations from almost every broker. This should not surprise anyone, because we have seen that these tests are only a theoretical exercise.
Moreover, stress tests’ results are widely challenged, and rightly so, because the exercise starts with the most ridiculous premise in economics: ceteris paribus, or “all else remaining equal,” which never happens. Every asset manager knows that risk builds slowly and happens fast.
Disappointing earnings, rising risk in the eurozone as well as in their diversification markets such as emerging economies, weak net income margins, and low return on tangible equity are factors that have contributed to the weak performance of European banks. Investors are rightly suspicious about consensus estimates for 2019 with expectations of double-digit earnings-per-share growth rates. Those growth rates look impossible in the current macroeconomic environment.
Capital Structure Improvement
Eurozone banks have done a good job of strengthening their capital structure, reaching almost a 1 percent annual increase in tier one core capital. The question is, is this improvement enough?
Two factors weigh on sentiment:
- More than 104 billion euros ($117.85 billion) of risky “hybrid bonds” (CoCos) are included in the calculation of core capital.
- The total volume of nonperforming loans across the European Union is still at around 900 billion euros ($1.01 trillion), well above pre-crisis levels, with a provision ratio of only 50.7 percent, according to the European Commission. Although the ratio has declined to 4.4 percent, down by roughly 1 percentage point year-on-year, the absolute figure remains elevated, and the provision ratio is too small.
This is what I call the “1 trillion eurozone timebomb”—1 trillion euro risk when the MSCI Europe Bank index has a total market capitalization of around 790 billion euros ($895.24 billion).
Let us focus on the CoCos, because few people do.
The 104 billion euros ($117.85 billion) of CoCos can be a double-edged sword.
On one side, they have been one of the favorite instruments to improve core capital rapidly. It was a very popular instrument in recent years to reinforce capital and diversify funding sources. On the other hand, it is a highly risky asset that can create a domino effect on equity and the other bonds of the entity. Let’s face it—the idea that a CoCo can default with no contagion risk to the rest of the capital structure is ridiculous.
These CoCos are hybrid bonds. Rating agencies assign them up to a 50 percent of “equity” component because the investor can lose the entire coupon, as well as part or all the principal if the issuer’s capital ratio falls below 7 percent or 5 percent.
These high-risk bonds have been issued widely and with great success in a world in which investors were hungry for some yield in the face of falling interest rates when many assumed banks were on the up and up. It was almost a “no-brainer.” Core capital was rising, banks were stronger than ever, and the yields of these CoCos ranged between 4 and 7 percent, except the risk was much higher.
In 2011, European banks issued 10 billion euros ($11.33 billion) in these products with returns that reached 10 percent. It seemed a safe business with almost no risk of default.
The policy of central banks and financial repression, once again, led investors to take more risk for lower yields.
By 2017, eurozone banks had issued more than 70 billion euros ($79.32 billion) of these securities with yields that fell as low as 4 percent.
From 10 percent to 4 percent yield as risks were gradually building, bank stocks were falling, and economic data began to disappoint.
‘Impossible’ and ‘No Risk’ Are Dangerous Words
These products were extremely popular because few investors thought that the banks would have no problem meeting the required 10 percent tier one core capital figure. The risk of breaching the core capital threshold seemed impossible.
“Impossible” and “no risk” are very dangerous words in any asset class. In hybrid bonds, it is reckless to believe in no risk.
A recent paper, “Contagion in the European CoCos Market” by professors Pierluigi Bologna, Arianna Miglietta, and Anatoli Segura, concludes: “The recapitalization of the banks as a going concern provided by CoCos cannot be detrimental for the stability of the rest of the market. Should the operational features of CoCos keep on proving destabilizing in future stress situations, rethinking their role as bank regulatory capital tools would be necessary.”
Unsurprisingly, CoCos have fallen sharply during the recent market rout and created a domino effect that impacts equities as well.
The idea that a bond can default with no threat to the equity or solvency of the issuing bank could have only occurred to central planners with no clue of risk and contagion.
Risks in CoCos are evident, especially regarding eurozone non-performing loans (NPL):
- Borrowers will report weaker earnings due to the economic slowdown in Europe. According to the Bank for International Settlements, the percentage of large zombie companies (those that cannot pay interest expenses with operating profits) has soared to 9 percent of quoted names.
- The need to accelerate recapitalization to avoid the next crisis, which will make it less easy to refinance NPLs.
- The impact of the global slowdown on banks which chose to grow in emerging markets, commodities and public infrastructure financing.
Anyone who believes these problems will be solved by extending quantitative easing (QE) and low rates has learned nothing from the past years, and this is beside the fact that QE is not even on the table at the moment.
Challenges Remain in 2019
What these risks show is that eurozone banks need to implement a much more aggressive recapitalization plan. Capital increases and eliminating cash dividends will likely have to return. Managers do not want to do it because the stock prices are too low, at least according to them.
However, waiting for a bounce has proven to be a big mistake. 2018 was the year of the perfect combination to drive banks shares higher: confidence in the eurozone, the likelihood of rate hikes, improvement of fundamentals and earnings growth. None of it happened, shares remain at depressed levels. Hoping for things to get better is not enough.
Although eurozone banks are better off than three years ago. They are nowhere close to having solved their challenges.
Daniel Lacalle is chief economist at hedge fund Tressis and author of “Escape From the Central Bank Trap,” published by BEP.
Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.