The European Banking Crisis, Pt 3

by: Peter Newell


Back in October 2008, Lehman Brothers collapsed taking $10 trillion off the global markets with them. This also caused 75 other companies to go belly-up.

As the world's financial system has gotten more tightly knit, the contagion risk has intensified as banks are layered with inter-dependencies around the world.

Stemming from weak earnings reports and a bleak outlook, European banking shares are down dramatically. In some places more than 20%, and some banks are on the verge of insolvency.

New regulation has something to do with the sell-off. Bondholders and large depositors will now be forced to write-off there accounts to help struggling banks.

Europe's banks are struggling to make money and struggling to keep investors. That's a bad combination that doesn't bode well for the markets.

Parts 1 and 2 in this series on Europe's potential banking crisis have focused on falling profits, rising costs of doing business, excessive levels of non-performing debt, and Italian banks' contribution to the problem. This article will delve into the systemic risk associated with the European banking system.

Bringing back Lehman Brothers

I think most of us remember the havoc that Lehman Brothers cause when they collapsed almost overnight. To refresh your memory consider that it was the biggest bankruptcy proceeding in U.S. history, as the company had $639 billion in assets on $619 billion in liabilities. The company failed primarily because the value of its' roughly $350 billion in mortgage-backed securities evaporated in a fairly short time and when the news of Lehman's bankruptcy was announced, global markets shed roughly $10 trillion in October 2008. That's still the biggest one month sell-off on record.

According to PwC, the biggest reason the Lehman Brothers collapse caused so much damage to investors across the globe was because of its "extensive global footprint in the debt, equity, and derivatives markets." The company was directly and indirectly associated with more than 7,000 financial institutions in more than 40 countries at the time of its collapse, and this network of interdependencies meant that, when they went belly-up thousands of other institutions found their assets exposed or lost.

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In the aftermath of the Lehman Brothers insolvency, more than 75 separate bankruptcies occurred around the world and were directly attributed to losses suffered from Lehman's collapse.

Current Context

So why am I talking about this? Do I expect that Deutsche Bank (NYSE:DB) or Credit Suisse (NYSE:CS) or UBS (NYSE:UBS) are on the brink of collapse? Short answer: no I don't. But the situation has become quite precarious due to a lot of external forces that none of these banks can control. Revisiting the Lehman Brothers example is a way of giving context to the potential implications and contagion affect that a banking crisis in Europe could have on the global financial system.

We have already seen the stocks of most European banks plummet so far this year, and I've already wrote about Deutsche Bank's CoCo bond situation. European banks are having a harder time making a profit as their costs are increasing and demand for their products (especially loans) has hit a wall. Furthermore, banks in Europe are facing a more pressing problem: €1 trillion in non-performing loans throughout the EU, or 10% of the total outstanding loans to non-financial entities. Italian banks alone hold €200 billion of these bad loans.

Needless to say…

European banks are on shaky footing right now. External factors such as negative interest rates, poor economic growth, strong deflationary headwinds, weak demand, and slowing trade across Europe and much of the world are all external factors that are weighing on banks' revenues and profits. Interdependencies throughout the global financial system are potentially exposing Europe's banks to problems in China and other parts of the world; where more mountains of non-performing debt and weak growth are hitting the banks' bottom line.

Another cost of doing business

What's more, the whole bank sell-off that has started the year just happens to coincide with the full implementation of the Bank Recovery and Resolution Directive (BRRD). This Directive is a unique piece of legislation that changes many things for European banks; one of the biggest changes is the "bail-in mechanism". What is a 'bail-in' you ask? In contrast to a bail-out, when outside investors (taxpayers?) inject cash into a company or bank; a bail-in forces the banks creditors to shoulder some of the burden by having part of the debt they're owed written off. In Cyprus, bondholders AND depositors with more than €100,000 were bailed-in to save the Bank of Cyprus (OTC:BACPD) and Laiki Bank.

The BRRD lays out the framework for resolving a failing bank in the Eurozone, and before any type of government or ECB action can be taken, investors and creditors representing 8% of the banks' balance sheet must be bailed-in. Certain accounts up to €100,000 are exempt from the bail-in resolution, but clearly the relationship banks have with large depositors will have to change. At a time when banks are already facing strong headwinds, this regulation creates additional pressure on banks' ability to finance their operations.

Putting it all together

From the banks' perspective, the ECB is saddling them with extra costs in terms of BRRD compliance and negative interest rates. Poor performance in terms of revenues and profits since last summer has been amplified by the fear of a global recession and a potential crisis. As such, European banks have seen investor flee both: their stocks and bonds. Fleeing stocks is a response to poor financial performance and generally worsening market conditions. The sell-off in bonds is clearly related to the bail-in risk now posed to bondholders, whose fears have been exacerbated by all the volatility in recent months.

With revenues and profits falling at Europe's biggest banks, a growing mountain of non-performing debt in the Eurozone, and new regulation scaring off investors and depositors, Europe's banks are going to find it even more expensive to lure investors to their firms and finance their operations. Italy had to bail-in four of its banks last year and Greek banks, which have already shed 24% this year, look ready to test out their BRRD readiness. Meanwhile Deutsche Bank, Credit Suisse, Commerzbank (OTCPK:CRZBY), HSBC (NYSE:HSBC), et al are also feeling the pain as investors are clearly anticipating further weakness in the sector.

The Lehman Brothers collapse didn't happen overnight, and neither is the meltdown in Europe. Many of the factors driving the carnage on these stocks have been building for months, and have already wiped a significant amount of money from the markets. If Lehman (one bank) erased $10 trillion from the markets, and caused another 75 bankruptcies, how painful will it be if several of Europe's banks fall?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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