So the headline ran, (subscription required) "Contagion fears spark broad selling across the European financial sector".
The potential for a sell-off in banks has animated commentators as Italy's vote on constitutional reform approaches, and seemed to cause European bank share prices to weaken yesterday. Actually, by the standards of European bank stocks, what occurred wasn't that dramatic with the SX7E index dropping 2.22%. Still, if this continues, it could well give us buying opportunities in European banks outside Italy and might even give us buying opportunities in the U.S. given that U.S. Banks have sometimes reacted in sympathy with European banks during periods of financial stress.
This certainly happened in the early part of 2016. But at the time there were two major global deflationary dynamics gathering pace in the shape of the Chinese slowdown and the oil price collapse. DBK came under acute selling pressure with its CoCos falling with the equity, as did the Italian banks when the government failed to secure its long hinted at deal with the EZ to assist the banks opposite their NPL problems. These European events fueled commentary about banking problems "in general" and helped provide wonderful buying opportunities in U.S. banks and in quality European names like ING and the Swedish banks.
To recap on the Italian problem, a large number of banks there have high balances of net NPLs when cash provisions are deducted from the gross NPL figure, that easily outweigh their regulatory capital. The remaining NPL number, the net NPL balance, is covered by collateral mainly in the form of real estate. It takes a very long time in Italy - think seven years - to foreclose on an asset and the court system has not so far markedly responded to government decrees encouraging speedier resolution.
The delay affects the price of NPLs on the secondary market and limits the market's size and liquidity. Banks would have to cover the gap between their book value on a net NPL and its current disposal value, which is usually about 20%. If such charges were taken through the P&L on a material chunk of NPLs, the banks would experience capital loss. This gives the banks a pretty strong argument to hang on: why would I take a loss now, when I can realize full value in the future?
To my own mind, while I understand the arguments of the banks, an eventual deluge of foreclosure demands seven years out appears problematic because (1) I can't see how the Italian court system could get this done in an orderly manner as it seems resistant to change (Italian lawyers, correct me if am wrong!) and (2) real estate prices would be impacted by wave upon wave of resolution disposals. Equally though I think the banks are mostly stable for now (ultimately this depends on the regulator, the ECB, passing them in stress tests which it mostly does) and most have time to strengthen capital ratios further before eventually taking losses on NPLs in the future over a realization timeline that I think will extend over about five years when it eventually clicks into gear.
How should investors react?
Do nothing for now and be aware that should PM Renzi lose the referendum and then step down, which seems likely given the polls and his own statements, then Italy will probably end up with an interim technocratic government.
Even if the "populist" Five Star Movement came to power, this should not threaten Eurozone or EU membership given a recent moderation of its tone with Beppe Grillo calling for EU reform "from within". The ECB has the tools to contain banking crises through emergency liquidity provision, but, again, there should not be runs on banks given that the Italian electorate doesn't anticipate financial instability as the result of it making a choice about Italy's constitutional arrangements. Remember, in seeking to change Italy's power structure, Renzi to many Italians is the destabilizer and denying him his reforms is supporting the status quo. And think of Brexit, which while posing long term risks to the UK economy did not -amazingly enough - result in a collapse of economic confidence in consumers who had voted to leave the EU at the ballot box. Renzi, simply put, does not hold up Italian banks. To the extent that an external agent does, it is the ECB and the European monetary system and that won't change with a change of government in Italy.
Markets will learn from the post Brexit and Trump experiences and probably stop panicking into potentially "anti-establishment" votes that don't immediately threaten economic continuity. However, if global bank prices do fall on Italy, then buy the likes of ING (NYSE:ING), SHBA (OTCPK:SVNLY) NDA (OTCPK:NRBAY) and should we be so lucky, the U.S regionals, Bank of America (NYSE:BAC) and Citi (NYSE:C).
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