European Banks: More Pain on the Way?

As Europe enjoys a long-awaited summer heat wave, a sense of sunny optimism has taken hold of its financial capitals. Many in the region's beleaguered banking community reckon the worst of economic downturn is over. Equities markets have rallied since early 2009, property prices are leveling off, and signs of a recovery in consumer and industrial confidence are starting to surface.

But before Europe's financial-services industry pats itself too hard on the on the back, bankers and investors may want to heed the sobering analysis released recently by the European Central Bank (ECB). Analysts at the ECB, which oversees the 16-country bloc that uses the euro, forecast that euro-zone banks could still record a further €283 billion ($398 billion) in writedowns by the end of next year, predominantly from defaulting corporate and consumer loans.

If that eye-popping figure were to be reached, it would bring the total for European bank writedowns since 2007 to €649 billion ($913 billion)—about equal to the damage wreaked on the balance sheets of U.S. institutions, including such stalwarts as Morgan Stanley (MS) and Merrill Lynch (BAC). The impact on workers also could be acute: In Britain alone, the Confederation of British Industry, a trade body, figures the country's financial-services industry could shed an additional 28,000 jobs by the fourth quarter of this year.

Most of the problems for Europe's banks are linked to struggling economies. Although financial markets have largely recovered, the European Commission still expects the European Union's gross domestic product to contract by 4% this year and a subsequent 0.1% in 2010. The broader downturn has hit consumer spending and led to rising loan-default rates, particularly among small and midsize businesses. The expected jump in defaults also has raised concerns that major banks, such as Germany's Deutsche Bank (DB) and Spain's BBVA (BBV), may be undercapitalized and will need to raise more money from investors to cover their exposure.

lower consumer spending will hurt

"Banks still have a number of problems on the horizon," says Pete Hahn, a fellow at City University's Cass Business School and a former managing director at Citigroup (C). "Debt levels have come down, but [the banks] must come to terms with lower consumer spending and a sharp drop in business activity."

Until now, investors looking for a recovery have piled into the market. So far this year, the Dow Jones Euro Stoxx Bank Index, a composite of leading financial stocks in the euro zone, has risen 16.2%. The wider DJ Stoxx 600 Bank Index, which adds institutions from Britain and other non-euro countries, has jumped 16.7%. Cheap loans from the region's central banks and multibillion-dollar stimulus packages, both in Europe and farther afield, helped reignite investor appetite for banking stocks, which had fallen as much as 90% in the two years before the most recent rally.

But for those expecting the rally to translate into bumper profits for banks, the next 18 months could prove disappointing. According to Brussels-based Eurostat, which provides the European Union's official statistics, unemployment in April—the most recent figures available—rose to 9.2%, up 3.4% for the month. The worst-hit areas are Central and Eastern Europe and highly indebted Western European countries such as Spain and Ireland. Even as European business sentiment starts to recover, major economic indicators remain at historic lows.

The problems in Central and Eastern Europe already have taken a toll on many Western financial institutions. Over the past 15 years, banks such as Italy's Unicredit (CRDI.MI) and Sweden's SEB (SEBA.ST) had flooded into the region, gobbling up smaller rivals and offering sophisticated financial products to customers. When credit started to dry up last year, the banks quickly cut off funding. That led many of the worst-hit countries, including Ukraine and Hungary, to tap the International Monetary Fund for multibillion-dollar bailouts. Now analysts fear that more writedowns could be in the cards as the region's economy struggles to stay afloat. The ECB estimates that total losses there could top €34 billion ($48 billion) by the end of 2010.

moves to strengthen the books

"In many European countries, the rates of domestic loan losses in 2009 will be double that for 2008," says Scott Bugie, a credit analyst at Standard & Poor's (MHP). Rising unemployment levels and the specter of further defaults also have raised anxiety about European banks' capital reserves. Many have already written off billions of dollars in assets since 2007, so any additional bad-loan exposure could lump unwanted pressure on core Tier 1 capital ratios, a key measure of a bank's financial health.

Some have moved to strengthen their books. Swiss financial giant UBS (UBS), which already had tapped shareholders for billions in extra cash, announced on June 25 that it will raise a further $3.5 billion through a share issuance. That followed Britain's Barclays (BCS) pocketing $13.5 billion through the sale of its investment unit Barclays Global Investors to investment giant BlackRock (BLK). The deal helped Barclays raise its core Tier 1 ratio to 8%, above the European average of 7.5%.

For those below the European average, though, time may be running out to tap investor appetite. Figures from Thomson Reuters (TRI), a data provider, show Europe's banks have raised $41.9 billion so far this year, about 29% of the global total. That's down from the 40% share the Continent's companies took in last year. Market watchers say a number of recent rights issues from U.S. banks, including JPMorgan Chase (JPM) and Bank of America, have drawn investor interest away from European companies, such as Deutsche Bank and France's BNP Paribas (BNPP.PA), that now appear undercapitalized compared with rivals.

For sure, no one expects a repeat of last September, when Lehman Brothers imploded and the rest of the global financial-services industry was sent into a tailspin. But for those already predicting the rapid rise of Europe's financial-services industry, the ECB's review of the sector had cautionary words: "Policymakers and market participants will have to be especially alert in the period ahead."

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