Krisztian Bocsi/Bloomberg

If Bank Stocks Are Linked to Bank Lending, Europe Should Worry

Deutsche Bank study says equity rout plus regulation could choke credit growth

Don’t underestimate the toll that the post-Brexit bank equity rout can take on the euro-area economy.

Initial calculations of the effect of the U.K. referendum on the region’s recovery have suggested that the blow will be relatively mild, with European Central Bank President Mario Draghi telling European Union leaders that the impact from direct trade could add up to 0.5 percentage point over three years.

But such scenarios don’t take into account the consequence of the 23 percent decline in bank stocks since the Brexit vote. Historically, bank equities have correlated strongly with bank lending, with about a year's lag, as the chart below shows.

Deutsche Bank AG analysts led by Marco Stringa argue in a July 5 paper that there’s also a causal link: As banks are now under regulatory pressure to raise capital, slumping stock prices and low profitability make it very difficult to build up funds either externally or internally. Deutsche Bank’s own share price has fallen by more than 25 percent since June 23.

If banks struggle to raise capital, they may come under extra pressure to shrink assets. That could mean less lending to the economy.

Bankers often claim that asking them to have more funds of their own instead of borrowing from the market hampers their ability to extend credit. Regulators retort that higher capital requirements in fact strengthen a bank's ability to make loans, not the opposite.

Brexit Impact

Even so, it might mightn't take much for Brexit to put a stop to the timid pick-up in euro-area bank lending that started just last year. That’s not least because of the impact of uncertainty on households’ and companies’ investment choices.

The impact of a renewed credit crunch on Europe’s largely bank-dependent companies could be severe. Not by chance, fixing the banks to restart credit to the real economy has been one of the main goals of the ECB’s policies since the crisis.

Stringa estimates that if banks decide to keep their balance sheets unchanged until the end of 2017, this could halve economic growth in the euro area next year. Worse still, if lenders only manage to raise half of the funds they need to meet what the economists refer to as “Basel IV” requirements, this could force them to reduce their loan book’s risk-weighted assets. 

Even a 2 percent credit contraction could lead to a euro-area recession and a rise in unemployment, according to the study, which doesn’t take into account the repercussions from potentially lower global demand. That would be the region’s third recession in less than 10 years.

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