Banks are (still) key to European stock markets

European banks are currently held hostage by the European Central Bank and Eurozone governments, from whom we are waiting for a credible solution to the great sovereign debt problems. A solution is essential for the future of the continent's banking sector.

It has almost become every man’s knowledge by now that European banks hold huge amounts of PIIGS sovereign debt on their balance sheets. (The yield increases i.e. price declines have drastically increased the risk of the whole financial system, chart 1.) This is the crux of the solvency issue in the banking system, i.e. if financial institutions would have to book sovereign debt assets at market price these institutions might in many cases prove to be insolvent. (We are very cautious especially about French and Italian banks in the coming weeks.)

On top of all of this we still also have limited information regarding each individual institution's asset quality, which is further creating distrust. This is increasingly reflected in the European interbank market which is getting dangerously close to a total standstill. (An actual interbank funding collapse becomes more probable for each day that passes, with interest spreads now starting to move higher after a few weeks of consolidation, chart 2.)

Scary picture
The financial market is about to enter a death spiral as anxiety regarding solvency issues becomes more apparent and banks with funding deficits and/or extravagant ventures in PIIGS become isolated in the interbank market. Furthermore, what is the rational approach to solving the sovereign debt issue? Will there be hair-cuts and if so, which financial institutions risk ending up in solvency trouble? As a net lender in the interbank market you would want to make sure you avoid any exposure to these potential victims. A “rather safe than sorry” approach can be fatal for the victims.

European bank funding – one more time around the block
It seems like the regulatory bodies in Europe have a hard time understanding that the financial sectors’ main commodity is trust. Trust is the key collateral when working in the interbank funding market. A lack of trust means a lack of funding, which again means banks across Europe cannot meet their commitments.

Based on the current state of affairs internal funding (measured as shareholders’ equity + term deposits divided by total assets) indicates a wide dispersion amongst major European banks, chart 3. Combining this picture with the Loan/Deposit ratio concludes that European banks are experiencing a structural funding deficit that needs to be covered going forward, chart 4.



Nordic banks well represented - yet less unstable
Nordic banks are well represented at the high end of the Loan/Deposit ratio scale since a substantial part of the mortgage loans are run through the solid Covered bonds system of the respective countries, i.e. with perfect duration matching not creating any funding need.

Overall the funding need in Europe represents a major systematic risk. Italian and French banks will almost certainly be put further to the test in the coming weeks.

Probable action going forward
It’s increasingly possible that solving the debt crisis will entail losses in the European banking sector. Therefore we should expect European regulators, central banks or governments to step in with capital in the form of share capital in the most systemic banks and institutions. At the same time the creation of transparent balance sheets is needed to gain trust in solvency. This would have a much greater effect than continuing intervening with small steps in the sovereign debt markets.