Return of the repressed: Europe’s unresolved banking crisis – BBH

Research Team at BBH, suggests that the worries about the threats to stability are emanating from the periphery in Europe as policymakers, investors, and economists still refer to the "Greek, Irish, Portugal and Cyprus' bailouts.  

Key Quotes

“The biggest threats don't come from the periphery, but from the core.  The peripheral countries were not bailed out, while official and many private sector creditors were made whole.  

A week ago the IMF warned that the biggest contributor to global systemic risk was Deutsche Bank, followed by HSBC and Credit Suisse.  The IMF's assessment came shortly after the Federal Reserve found that for the second consecutive year, Deutsche Bank did not pass its stress test (Spain's Banco Santander was the only other bank that failed of the 33 tested).  

Our constructive outlook for the US dollar has long been predicated on divergence.  In the short version, we emphasize the fact that the ECB and BOJ are still easing policy, while the Fed began the gradual normalization process.  In the longer version, we discuss other areas of divergence, including the relative health of the financial system.  Whatever metric one chooses, such as profitability, level of non-performing loans and coverage (loan-loss reserves), core capital, and leverage, large US banks are simply in a superior position to large European banks.  

Two financial issues are eclipsing the threats to the global financial system that the IMF identified.  The first is the health of the Italian banking system, with the immediate lightning rod being Monte Dei Paschi.  The second is the closure of at least three UK real estate funds to prevent redemptions.  

Italian bank problems were on investors’ radar screens long before the UK referendum.  Due to its dysfunctional politics, Italy was particularly slow to address its banking problems. And now that circumstances are forcing its hand, its options are severely limited by the new rules, such as the Bank Recovery and Resolution Directive that requires equity investors and subordinate creditors to take the first losses before taxpayer money (government funds) can be used.  

The European Central Bank and the European Banking Authority will announce the results of its stress test on banks on July 29.  

Attention on what the IMF has identified as the biggest systemic financial threat is also being deflected by the decision by three different commercial real estate funds (affecting roughly GBP12 bln in assets) in the UK to prevent redemptions.  Falling commercial real estate prices will likely have a wider effect and could impact bank exposures.  

Commercial real estate by the very nature of the asset class is not liquid in the sense that it cannot be readily sold and turned into cash.  The UK experience is bound to raise all sorts of regulatory issues, including whether asset managers can be systemically important financial actors that central banks need to oversee.  

As pressing as the Italian and UK events seem today, their resolution will do little, if anything to address the largest systemic risks of the financial system.  Europe still does not have a banking system commensurate with its size and economic importance.  The eventual outcome will be to reinforce the sense that Europe has shrunk.”