(Bloomberg Opinion) -- For a brief moment, Europe’s banks appeared to have escaped the unhappy legacies of the financial and sovereign debt crises. Lenders were emerging from a never-ending cleanup of their balance sheets, they’d built larger capital buffers against potential shocks and they’d promised to return more of their profit to investors.
Shares in the industry rallied impressively and even the riskiest bank debt was back in vogue. There were reasons to hope that profitability would improve, albeit slowly.
The honeymoon didn’t last long. Draconian, yet essential, measures to contain the coronavirus will deal an incalculable blow to the region’s economies. A fresh wave of credit losses is inevitable as Italy enforces a nationwide lockdown and other parts of Europe follow suit. Not every country will be hurt equally, but for many lenders the future’s bleak.
While the arrival of more government spending, cheap central bank funds and some regulatory forbearance will mitigate the strain, the latest setback puts renewed pressure on banks’ meager returns. Lenders’ stocks fell back to post-crisis lows in recent days — for good reason.
An immediate strain on liquidity isn’t worrying investors yet. Banks are flush with funds, in part bolstered by healthy growth in deposits: up 4.5% in the 12 months through January in the euro area, according to estimates from Goldman Sachs Group Inc. Temporary measures to give customers breaks on mortgage payments, as banks in Italy and elsewhere are weighing, should be manageable, especially if supported by government relief.
Banks are entering the latest crisis in their strongest financial position in recent history. The biggest lenders in Europe ended 2019 with an average ratio of common equity Tier 1 of 13.7%, the highest ever reading, according to Bloomberg data.
Even in an extreme scenario that saw gross domestic product contract by 2.7% across the European Union over three years, and house prices decline by about 20%, about eight out of 10 of the largest banks should maintain capital levels that allowed them to keep paying dividends, according to analysts at JPMorgan Chase & Co.
Yet it’s the potential erosion to profitability that would hurt lenders for years to come. In that stress scenario highlighted above, return on tangible equity (ROTE) would drop by about half from what analysts are expecting to an average of 4.2% across the 35 lenders tracked by JPMorgan. Profit would decline by 62%. Deutsche Bank AG, UniCredit SpA and ING Groep NV would see their ROTEs drop to between 2% and 3%; at Societe Generale SA, it could fall to below 2%, according to JPMorgan. And this was calculated before the Saudis started an oil-price war.
A protracted economic decline will hurt lenders on a number of fronts: A persistent squeeze on margins from negative interest rates, sluggish demand for loans and a likely slump in commissions.
The Bank of England has already cut interest rates by 50bps and the European Central Bank will probably have to follow. Christine Lagarde is expected to cut rates by 10 basis points to -0.6% on Thursday. Even if she tries to shield lenders by offering further relief on their deposits, interest rates will probably stay low for years, eating into bank revenue.
Sure, banks could impose more charges on depositors. And further cost cuts are possible for the industry. But it also needs heavy spending to scrap outdated IT systems and to adapt to new technologies. Upstart fintechs may come and go, but new competition will strip legacy lenders of revenue.
While Europe’s banks weren’t ready for another downturn, there’s something they could do — even if politicians would balk. Out of 3 million bank employees in Europe, the industry could probably do with 1 million fewer, says Davide Serra of Algebris Investments, a fund manager. Bank mergers are a rare beast in Europe, but they’ve just become all the more pressing.
To contact the editor responsible for this story: James Boxell at jboxell@bloomberg.net
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Elisa Martinuzzi is a Bloomberg Opinion columnist covering finance. She is a former managing editor for European finance at Bloomberg News.
©2020 Bloomberg L.P.