Stop Digging

And other advice for Europe’s banks

If you ever wonder if your daily toil creates value for the world, be thankful at least that you are not a European bank. Since 2007, their collective stock market prices have dropped by more than the annual economic output of Spain, jobs and branches have been slashed and still market valuations suggest that they are destroying value with each new loan.

For all the mistakes you have made, you have likely never been responsible for the loss of $ 115 billion. As perspective, if you bought a basket of bank stocks in August 2007, you have now lost nearly two-thirds of your money. If you bought German and Italian banks, you are down 85 percent. You may not dare ask what little remains in Portugal.

Keen value investors are surely scrutinizing the wreckage and looking for signs of sustainable profit models that might emerge. There is always big money to be made when you can buy a bank at less than book value just before it begins a run of lending growth on top of expanding interest margins.

But the health of the banking sector, of course, is far more important than its potential for stock returns. European companies rely on bank financing to a much greater extent than their counterparts elsewhere, with bank assets representing three times the size of the European Union’s economy. (In the United States, by contrast, companies depend more on capital markets.) If it is true that European banks are suffering because of persistent weakness in Europe’s economy, it is also true that no sustainable recovery is possible without healthy banks.

Of course, banks everywhere are facing pressures from low global growth, negative interest rates and new regulatory requirements, all of which erode their profitability. But there is, in fact, an emerging case to be made for Europe’s banks.

• While only now having returned to pre-crisis levels of output, the European economy actually enjoys some important tailwinds from low energy prices and a substantially weaker currency. Growth in the United States remains steady even as China’s slowdown seems to be bottoming out, both of which provide hope for Europe’s exporters.
• Negative interest rates remain a huge burden on bank profitability, but some banks are starting to protect their margins by passing costs along to customers. If the European Central Bank demonstrates continued resolve to reflate the economy, reflation will come.
• On average, banks have done a reasonable job rebuilding capital ratios from just under 9 percent five years ago to just over 13 percent today. Across the continent, there are also pockets of remarkable strength with Nordic capital ratios exceeding 15 percent, and pockets of recovery with Spain’s bad loans in steady decline and fresh credit rising.
• Britain’s decision to abandon the European Union also opens up brand new opportunities for euro-based institutions to capture the business of any firm now isolated in London from the “real” Europe.
• Finally, even the muddled efforts to tackle the mess at Italy’s Monte dei Paschi di Siena seems to be nearing an end, removing a large cloud over the entire sector.

But today’s rock-bottom bank valuations have yet to draw in investors because there is a sense that, for all their positive efforts, European regulators and bankers continue to dig.

Alas, there is a track record here of glossing over potential problems and ignoring likely losses. European officials were furious in the early stages of the financial crisis when the IMF highlighted the need for more bank capital.

Repeated designs of bank stress tests and capital adequacy assessments since then seem to willfully ignore the risks that are highest in investors’ minds. Even the latest round still excludes scenarios that acknowledge the risks of holding sovereign debt, which we all know by now is not without risk. One simple compromise would be to require banks to diversify their sovereign exposure across all euro-area governments, but German banks will surely resist having to own Greek debt.

Another chief concern is that non-performing loans still represent 9 percent of Europe’s GDP or about twice their 2009 level. Definitions of NPLs across Europe are now finally harmonized, but investors still have the sense that banks and their regulators have been slow with the recognition and clean-up. Here there is some hope in the creation of a European market for NPLs, but progress has dragged.

There are further worries about the implementation of Europe’s new bank resolution rules, which will force losses onto shareholders and creditors before qualifying for public support. Since many of the creditors are depositors who were sold bank paper as low-risk and high-yield, there are serious political implications of following these new rules to the letter. Banning the practice of banks selling their own debt to depositors would help with future problems, but does little to help with the current dilemma.

Owning bank shares involves making reasonable assumptions about economic growth, financial market dynamics and corporate strategy, but the task is immeasurably more difficult when book values remain suspect and bailout procedures remain opaque. Amid the dissipating clouds in Europe, even the best investment case is still a stretch for most bank investors strolling through the debris of collapsed stock prices.

Christopher Smart was Deputy Assistant Secretary of Treasury for Europe & Eurasia and Special Assistant to the President for International Economics, Trade and Investment. Before that, he managed international portfolios for Pioneer Investments.