Why the Cost of Hedging European Banks Stocks Has Soared

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Anyone wondering why it costs so much to protect against losses in European bank stocks in the options market saw the reason on Monday.

Shares of Deutsche Bank AG slid 4.6 percent to 30.13 euros, the biggest drop in 15 months, as the lender lowered a profitability target and set a plan to cut costs, in a sign that the industry may be poised for declines. That’s even after first-quarter earnings exceeded analyst estimates and the Frankfurt-based company posted near-record revenue. It had rallied 26 percent this year through Friday.

Around Europe, investors are paying the most in more than two years to hedge against threats to an industry where equity prices have doubled even as concerns mount about fines and tighter regulations. Banco Bilbao Vizcaya Argentaria SA and BNP Paribas SA report results this week. Lenders of the Euro Stoxx 50 Index dropped the most in more than a week on Tuesday.

“There is a mistrust that the regulators will continue to increase the capital requirements and hold back dividend distribution, coupled with outstanding fines for past misbehavior,” said Kevin Lilley, who helps manage about $23 billion as head of European equities at Old Mutual Global Investors U.K. in London.

The options market is implying a 2.3 percent gain or drop in BBVA shares after the earnings report, while BNP’s implied move is 3 percent. Those are more than the average moves following the past eight releases. The most-owned options on the two companies are all bearish. Ignacio Moreno of Citigroup Inc. says the European economic recovery will take some time to bear fruit, pushing investors to protect gains.

Too Far

“Although banks are being traded as the best way to play Europe’s economic recovery, the reality is that this will take longer than people thought,” said Moreno, a bank specialist in equity sales at Citigroup in London. “Investors who own bank stocks will be concerned that share prices may have gone a little too far, and hedging is their way to lock gains if growth doesn’t quite kick in.”

Companies tracked by the Euro Stoxx Bank Index rallied 18 percent in 2015 through Monday and were up 118 percent since European Central Bank President Mario Draghi pledged to preserve the euro area in July 2012. At the same time, at 13.4 times estimated earnings, valuations are about 18 percent lower than the rest of the market.

Earnings Drag

Few industries in Europe have more to navigate than banks. BNP Paribas has warned that new rules and higher taxes will drag on earnings. Deutsche Bank said last week that lenders of the European Union may have to issue new debt that’s as much as three times as expensive as that of U.S. competitors to comply with planned rules on how to impose losses if a bank fails.

The Basel Committee on Banking Supervision is working on new requirements to cushion balance sheets from shocks such as the failure of a big lender or a rise in interest rates. That’s forcing banks to set aside capital that could otherwise be used to return cash to shareholders. The regulators are seeking to wrap up the revisions by the end of 2016.

BNP, which reports on April 30, said in February that tougher demands from regulators and escalating levies on Europe’s largest banks will dent 2016 net income by about 500 million euros ($545 million). It also said the economic recovery in the region is weaker than it anticipated. Analysts predict France’s biggest lender will post a 16 percent drop in first-quarter profit to 1.4 billion euros.

Share Sale

Commerzbank AG led banks lower on Tuesday. The company said after the market close on Monday that it will raise 1.4 billion euros by selling shares to boost its common equity Tier 1 ratio, a measure of financial strength.

Banco Santander SA, which tapped investors for 7.5 billion euros in January and cut its dividend to allay concerns about its balance sheet, lost 3.2 percent this year through Monday. The stock climbed 1.2 percent on Tuesday, after the Spanish lender reported a profit gain for the first quarter.

BBVA also increased capital, selling 4.9 percent of China Citic Bank Corp. for about 1.46 billion euros. Its earnings more than doubled to 1.3 billion euros in the last quarter, economists estimate the company will say on Wednesday.

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