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Insights

European Banks Are In Trouble

04/11/2016

From Euclid Advisors’ international investment team

The prospects for the European banking sector have grown dim. In response, over the last several months, we have sold down our exposure. Our top reason has been the very low interest rate environment in Europe, combined with the banks’ very high operational leverage. Our concerns have been further validated over recent weeks as the European Central Bank (ECB) accelerated its quantitative easing (QE) program, shifting from a zero interest rate policy (ZIRP) to a negative interest rate policy (NIRP).

Today, the operational leverage of bank profits relative to bank assets is more extreme in the euro area than in any other major European economy, such that the smallest decline in interest rates could severely hamper bank profits. According to BCA Research, the operational leverage of banks in Sweden is 33x; in Switzerland, it is 90x; in the U.K., it is 112x; and in the euro area, it is a massive 236x.

A bank’s bread-and-butter business is simple. Take in large volumes of deposits, and lend them out at a higher interest rate than the deposit rate. The difference in the two rates, the net interest margin, defines the bank’s profitability. Since bank profitability benefits from a steep term structure for interest rates, once the policy rate goes into negative territory, any profit-protection strategy hits the brick wall of a flat yield curve. Thus, for the time being, it is hard to see bank profitability returning, and for that reason, it is difficult to gauge the correct valuation of European bank stocks

A decade of financial and political crises has left euro area bank profits structurally depressed. At €50 billion, profits today are no higher than they were twenty years ago. Yet the level of bank deposits in EU banks is almost €12 trillion. Operational leverage of 236x creates a potential nightmare for the ECB. The smallest decline in banks’ net interest margin could sink profits by a very large amount. BCA Research estimates that a harmless-sounding 0.40% decline in the net interest margin could be enough to completely wipe out all euro area bank profits, thus the reason for our caution on the sector and reduced exposure.

Euclid - Euro Area Bank Profits are Structurally Depressed
Source: BCA Research. Used with permission.



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Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.