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Reforming the European banking system may be akin to squaring the circle, but it is essential for the long-term health of European governments and economies, especially those in the Eurozone. It also is essential for those who own or consider owning shares of large European banks or investing in European sovereign debt. Until the European banking system has been reformed, European bank investments are highly speculative and, in most cases, have to rely on the grace of the banks’ chartering nations and the ECB for the value of the shares not to fall to zero. But just as dangerous, the nations themselves run serious risks of downgrades if they bail out their banks. Most situations are not as fraught as Ireland’s because the banks are not as large in relation to the nations’ GDP, but Spain, Italy, France, Belgium all have banks that are large in relation to their economies.

We will begin today’s exploration by identifying the system’s key weaknesses, then we will discuss how efforts to save the euro are making the weaknesses more obvious, even while providing liquidity to stave off the day of reckoning, and we will end by identifying a few actions that could lead to substantial reform. Whether such substantial reform could become politically possible, I will leave to others to assess; certainly the politics involved are difficult and complex. For investors, the key will be to see early signs of reform so as to buy when others are still fearful.

Bank Lending

All commercial banking is fundamentally flawed, as I wrote in a recent two-article series (here and here), but European commercial banking is even more flawed than American commercial banking because European banks depend so much more on debt markets funding and so much less on deposits. Dependence on debt markets funding makes a low-capital situation dangerous because debt markets will not support a bank with low equity capital, as Bear Stearns and Lehman Brothers found out.

If one thinks about the relative creditworthiness of a European bank versus the creditworthiness of such a bank’s customers, one immediately sees the problem. If the bank borrows for the same durations as it lends, then its spread is, by definition, only the spread between its own credit rating and its customer’s lower credit rating. That small spread has to cover not only profit but also expenses and a reserve for losses. Almost by definition, there is no profit. Therefore the bank engages in what is euphemistically called “maturity transformation”, as if that were some kind of alchemy. In plain language, “maturity transformation” means borrowing short to lend long, which has two obvious problems: (1) liquidity risk, and (2) interest rate risk. And we must add those two risks to the material credit risk that lending to lower-rated credits entails. These risks can be managed through business cycles if a bank has abundant capital. But the European banking model does not feature abundant capital. It features meager capital in reliance on the idea (nowhere enshrined in law) that European governments do not let their banks fail. Thus, when European banks run out of capital, as they have done from time to time, their chartering governments are expected to bail them out, as they did in 2007-2009. Doing so practically bankrupted Ireland, and it could seriously affect other countries’ credit standing in the near future.

Capital Markets Funding for Banks

The Eurozone crisis has exacerbated European banks’ funding problems. “For some banks, the cost of borrowing has jumped above the rate at which they are able to lend, potentially limiting one source of credit to the wider economy.” The FT reported on December 30, 2011.

“Some market participants say Europe’s banks will simply have to get used to a higher cost of financing and smaller, more selective, lending capacity. That could hark back to the days before they supersized operations using cheap funding from markets. But the transition could be painful.

‘Banks’ business models will have to change,’ says Matt Carter, who runs RBS’s financial debt capital markets business.” The FT further reported.

Capital Markets Funding for Non-Financial Businesses

Yes indeed, European banks’ business models will have to change. And there really is only one way for them to change that can ameliorate the fundamental flaws in their business models. They must promote more direct access to capital markets for their borrowers so that the banks do not have to intermediate those loans as principals. That way the banks can shrink their balance sheets without giving up their customers, earning fees for acting as agents and facilitators and keeping their customers’ deposit balances. Whereas European banks account for about 80% of the financing of European businesses (the businesses get only about 20% of their funding directly from capital markets), in the U.S. the 80-20 split is reversed, which allows American banks to fund themselves more from deposits and less from the capital markets. (Bear Stearns, Lehman, Merrill, and Goldman and Morgan Stanley before October 2008, did not have access to large deposit markets, since they were investment banks rather than bank holding companies.)

For European banks to change their business models to account for a smaller percentage of non-financial business funding will be hard not only for the banks, but also for the many traditional, family-owned European businesses that rely on them for artificially cheap funding. Those businesses will have to either pay substantially more for bank loans or change their business models to gain access to the capital markets, which may require consolidation or public disclosure of finances. In a country like Italy, where tax evasion is part of the way of life and one’s degree of wealth usually is publicly opaque, accessing the capital markets would force enormous changes in the ways that businesses and wealthy families function and would impose costs that businesses will fight. Many businesses may decide to pay up for bank loans rather than exposing their books to the marketplace.

Will Banks’ Business Model Change?

The process of change that I am forecasting already is being promoted. European banks are being required to raise their equity capital ratios, which in turn will force them to pay more attention to which types of business they do that is truly profitable and to discontinue or sell those businesses that are not. The process of balance sheet shrinkage thus has begun. To serve clients, the process of intermediation as agent should begin in the near future. But I have not yet seen signs that the process of providing more direct access to capital markets for non-financial business customers has begun. Governments all over Europe are jawboning their banks to continue to lend to business customers, which makes it hard for banks to begin to change their emphasis. But serving customers differently is the only logical way forward.

Breathing Room to Change

The ECB’s liquidity facilities, such as three-year funding under LTRO, are making it possible for European banks to get some breathing room to effect reforms. If they use the breathing room to continue business as usual, they will find themselves insolvent within a few years, and the nations that charter the major banks will find themselves in a financial bind to bail them out—yet again. That could have serious consequences for the finances of countries such as France, whose large banks are among the most undercapitalized in Europe and whose bailout tradition most likely would rule out letting those banks fail. As an investor, those factors make me leery of investing in Europe at all at this time, except in the large multinational non-financial companies or specialist small companies in the northern countries. One of my favorite small companies for the long term is Rofin-Sinar Technologies (NASDAQ:RSTI), a laser manufacturer that has dual headquarters in the U.S. and Germany. I am long RSTI.

Source: The European Banking System Must Be Reformed