Worries over the state of Europe's banking sector have moved from the financial pages to the evening news. The squeeze of negative interest rates imposed by the European Central Bank are magnifying the stress EU banks were already under. Dismal earnings have led to plummeting stock prices. The number of bad loans is growing, and the cost of credit default swaps even for the biggest banks is spiking.
This nervousness doesn't stop at the usual suspects -- the troubled financial sectors of Italy and Portugal. Last week's scare that the mighty Deutsche Bank may default on some bond payments rocked the markets, putting more scrutiny on falling profits at the EU's largest banks.
The Stoxx 600 Banks index has racked up seven straight weeks of weekly losses, the worst showing since the 2008 financial crisis. This worrying fall in bank stocks comes as some analysts doubt the ability of the average bank to cover their cost of equity (i.e. provide a return to shareholders.) Even the biggest banks are working through a painful restructuring, shedding employees and exiting some market sectors.
Profits and revenues are cratering due to the plummeting price of oil, the economic slowdown in China, and new requirements to limit the amount of risky investments and to keep more money on hand to cope with a run on the bank. The biggest problem for European banks, however, is the one thing they counted on to rescue them: the European Central Bank.
The ECB, facing blistering criticism over using taxpayer money to bail out banks in 2010, has changed its stance. Instead of bailing out banks, it will force bail-ins. This means that investors and even depositors in a bank will take the losses, instead of the public. This was first seen in Cyprus during its banking system collapse, and refined in the Greek banking crisis. This has frightened many small investors from buying stock or bonds from banks in most European nations. These worries were magnified last December, when the Portuguese central bank "played favorites" with investors in distressed bank Novo Banco, regarding who would lose their money, and who wouldn't.
When one looks at this precedent, then looks at the frailty of the German banking sector, worry gives way to horror.
After putting Greek banks and Greeks themselves through the wringer by forcing bank shutdowns and capital controls, there is no way that the ECB can turn around and bail out a German bank. This would confirm what many already suspect or charge: that the EU was run for the benefit of Germany, and no one else. This would leave the German government to bail out Deutsche Bank and/or other large German banks. This would blow out Germany's debt load, which it is bound by regulation to limit. Politically, the EU would fracture if Germany ignored the rules after being so self-righteous to Ireland, Portugal, and Greece over their spending. The Euro monetary union would be destroyed.
But the worst thing that the ECB has done to the EU banking system is implementing negative interest rates. Banks are now paying the ECB interest on their deposits, instead of earning risk-free interest. Of course, it would be suicide for the banks to pass these charges to their customers, so they have to eat the loss. If banks started charging buyers, they would withdraw their money. The banks would then be in worse shape, having less money to lend, which would lead to more customers taking their money out and moving to another bank. This snowballs until the bank fails, so there's no recourse but to eat these losses caused by negative interest rates.
The requirements instituted to guard against a second government bailout for banks, called Basel III, has limited the types and amount of risky investments banks can have, and has increased the amount of money they are required to keep on hand to deal with a financial crisis (which exposes them to paying more interest to the ECB for holding more of their money.) Combine this with the negative interest rate regime, and you wonder where banks can make a profit at all.
The desperate measure of implementing negative interest rates has had the opposite effect that the ECB wanted. It's harming the economy instead of stimulating it. It isn't clear what Draghi can do to reverse the damage, and it isn't clear whether many banks will last long enough for him to figure it out.
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