European Banks: Be Mindful of Risks in 2017

European banks seem to be on an upward trajectory – although improvements are likely to come at a slow pace and with some risks. For the time being, European bank CEOs will continue to look enviously at their counterparts across the Atlantic as US bankers enjoy an optimistic outlook on the possibilities of a stronger domestic economy, higher interest rates and some loosening of US financial regulation. Combined, these factors should increase bank profitability and dividends to shareholders.

European economies are looking slightly healthier than before:

GDP growth is gradually picking up, which is a bit surprising given the shocks in 2016 from the Brexit vote and the Italian referendum that caused  the resignation of Prime Minister Renzi.

• European government bond yields have picked up slightly from very low or negative levels .

• However, short-term eurozone interest rates are likely to stay negative for the foreseeable future, which will continue to put pressure on bank profitability.

The best news from European banks is that Italy is finally shrinking its burden of non-performing loans (NPL).  Italian banks currently have a worryingly-high 17.6% NPL ratio[i], with most of the NPL dating from the 2008-2009 financial crisis.  While the new inflow of NPL has been low, until recently Italian banks haven’t managed to reduce their NPL or build adequate reserves.

But now Italy’s second largest bank, Unicredit, is raising €13 billion from private investors. Its third-largest bank, Monte Dei Paschi, is being bailed out by the government.  Both banks will be able to use the additional capital to help boost reserves and reduce the size of their NPLs.  Unicredit has agreed to securitize €18 billion of its NPL to private equity companies, as part of its plan to reduce non-performing exposures from 15% to 8% of total by 2019.[ii] 

Outside Italy, large European banks are currently well capitalized after years of slowly rebuilding capital since the 2008-2009 crisis. In the 2016 European Central Bank  (ECB) bank stress test, European Union banks reported aggregate capital ratios of 13%, up from 9% in the 2011 stress test which will ease the biggest vulnerability of European banks.

In my view, the biggest risks for European banks in 2017 are political risks:

• The Netherlands will have a general election in March 2017.  The far-right Freedom Party is currently leading in the polls, though other parties are likely to gang up to form a majority government that excludes them.
• France will have a general election in April and May 2017, with far-right Front National currently second in the polls.
• Germany will have an election in late 2017 with Angela Merkel seeking to retain her post as chancellor.

In each of these elections, a surprise victory by a populist party could substantially increase the risk of a breakup of the European Union.   That could cause a recession which could be very painful for banks, whose profitability is highly sensitive to economic conditions.  Things are getting better for European banks, but we should be mindful of the risks in 2017.

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[i] Bank of Italy, Financial Stability Report, as of November 2, 2016.

[ii] UniCredit, 2016-2019 Strategic Plan, as of December 13, 2016.