We crave turning points. As we mark five years since European Central Bank (ECB) President Mario Draghi’s “whatever it takes” speech — which crushed government and corporate bond spreads and contributed towards an 80% rally in eurozone stocks — are we on the cusp of another inflection?
The eurozone has just enjoyed its best quarter for economic growth in five years — twice that of the UK. Eurozone banks have also outperformed the broader market for the first year since 2009.
Not only has the eurozone economy turned out to be stronger and more balanced than investors expected, but there were no new spanners in the works: no populist governments, no spillover from resolving problematic Italian and Spanish banks, no return to deflation fears.
The macro data in the euro area may well continue to surprise to the upside. Could eurozone banks offer more positive surprises?
Eurozone banks still trade well below peers due to fears of the long tail of bad debts, concerns of higher capital required and risks to earnings power given negative rates – although individual banks are in very different positions. I suspect four developments will help their situation.
First, we are likely to see further progress in boosting confidence in their balance sheets. The wave of capital-raising by the largest banks, and the moves to address the weaknesses in some troublesome banks in Italy and Spain, is proving cathartic, even if it is an uncomfortable spectator sport. But the stubborn problem has been non-performing loans, particularly in the periphery. New ECB rules should prompt banks to address them more quickly. Meanwhile, low fixed income returns and recovering economies means there is a deeper and active pool of funds looking to work out bad debts.
Second, eurozone banks should be beneficiaries of ECB tapering, slow though this may be. The case for emergency rates has long since passed. The most positive scenario would be if the ECB reversed its forward guidance and raised the deposit rate first, as so many loans are priced off Euribor, the European interest rate benchmark. But even if bond buying is tapered first, this can help indirectly as the ECB has been crowding out commercial bank lending.
Third, the uncertainty around bank capital and funding requirements should fall. The US Treasury report on bank regulation is a seminal document that lays out a range of options to recalibrate post-crisis rules to work in practice without endangering the safety and soundness of the system. This heralds an end to the ratcheting up of regulation in the US. But it is likely to put pressure back on Europeans to find a compromise on global bank rules as well as reflect on the effectiveness of their post-crisis rules.
Fourth, greater confidence should boost activity. Loan growth, while still modest, is likely to continue to improve. Confidence is driving more activity in investment activities, lifting returns in banks’ wealth management units.
So what are the risks? Low inflation, which continues to confound central bankers’ fair-weather models, means they may continue with deleterious negative rates for longer. It is as if they are playing a fiendish edition of Where’s Wally, hoping they will eventually find higher inflation. But central bankers need to be mindful of the risks to financial stability from emergency rates for too long.
Also, the clearing price for bad debts may prove to be lower than marked on banks books and so require some more capital. But with the improving economic backdrop, the risks of major mispricings should now be lower for the larger listed banks.
Eurozone risks have been far from solved. Many structural and economic problems need to be addressed, including the half-finished banking union.
But the longer term risk may be out-of-date business models. The challenges of low rates and disruptive technology call for dramatic improvements in efficiency. In any other sector, low returns and overcapacity would drive a wave of M&A. But regulators, non-performing loans and labour laws have made major cross-border eurozone deals near impossible.
So banks on the whole will need to transform their operating models themselves and harness technology to their advantage. This is no mean feat.
As a midterm report card might say, much done, but much still to do.
The above article was previously published by Schroders on 9th August 2017