ECB Taper Spells Profits for European Banks
European bank shares are on a roll, regaining in the past nine months about half of what they lost in the year to mid-2016. Moreover, they're in for an additional boost as an improving economic backdrop persuades the European Central Bank to begin relaxing the unconventional measures introduced to cope with the aftermath of the financial crisis.
At his regular press conference last Thursday, ECB President Mario Draghi was asked whether his institution could raise interest rates before its bond-buying program is due to expire at the end of the year. "I don't want to speculate," he replied, after dancing around the question for a while. The following day, Bloomberg News reported that policy makers did indeed discuss how that might happen.
The improvement in European banks coincides with increasing evidence that the ECB is moving closer to tapering its quantitative easing program. From next month, the central bank's bond purchases will drop to 60 billion euros per month from 80 billion euros previously. The program is designed to run until the end of the year.
Draghi is navigating a fine line between acknowledging that the strength of the euro-zone recovery means tighter monetary policy is coming, and not moving in that direction prematurely. The bond market, though, knows change is coming -- which is adding impetus to the recent rally in European bank shares.
It may seem perverse that the impending halt of emergency central bank measures designed to bolster growth would be good for financial firms. Banks, though, are still basically in the business of borrowing short-term money and lending it out for longer periods.
So the shape of the yield curve -- the gap between (typically lower) two-year yields and 10-year levels -- plays a large part in how profitable they can be. And in the past six months or so, the yield differential has more than doubled in Europe's benchmark bond market as traders and investors anticipate faster inflation and the accompaniment of higher borrowing costs:
On a total return basis, including reinvested dividends, the Stoxx Europe 600 bank index has delivered almost 55 percent since reaching a nadir in July. That compares with a return of less than 20 percent from the broader Stoxx Europe 600 index.
That outperformance is reflected in the credit-default swaps market, where traders and investors buy insurance against any deterioration in the creditworthiness of bond issuers. The cost of buying default swaps on financial companies is down to its lowest in about a year, and has spent the past month or so below the cost of buying insurance on the broader investment-grade index:
After years of lagging their U.S. counterparts, European banks have finally bolstered their capital bases, with their average Core Tier 1 ratios as measured by retained earnings plus common equity divided by risk-weighted assets improving to 14.1 percent from 12.5 percent at the end of 2014, according to the European Banking Authority's most recent figures. They're also getting help on the regulatory front, with European policy makers lobbying the Basel Committee to abandon a proposal that would limit the benefits banks get from using their own models to calculate how much risk they're exposed to.
Problems remain. Banks remain burdened by more than 1 trillion euros of bad loans. Progress has been either slow on introducing reforms that would make it easier to sell those nonperforming assets, or almost nonexistent where the European Banking Authority's proposal for an EU-wide bad bank is concerned. And the better economic backdrop may reduce the pressure for much-needed consolidation in the banking industry, with regulators still shying away from cross-border mergers.
But there's evidence of a renewed appetite to take on business. Last week, The Wall Street Journal reported that Tim Throsby, the head of investment banking at Barclays Plc, has told his staff to let their "commercial instincts" come to the fore and increase their appetite for taking on risk. Also last week, Deutsche Bank AG Chief Executive Officer John Cryan told Bloomberg Television it's time to stop discussing "shrinking or reducing risk" and focus instead on engaging with clients.
And for some customers at least, being able to choose a European bank willing to commit capital to the market would provide an attractive alternative. "The geopolitical environment has great opportunities for a non-American bank as customers are looking for alternatives," Paul Achleitner, the chairman of Deutsche Bank's supervisory board, said in an interview with the Welt am Sonntag newspaper earlier this month.
Having ceded market share in equity and bond underwriting to their U.S. peers in recent years, it's about time Europe's investment banks rediscovered their animal spirits. Steeper yield curves will aid and abet their recover.
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