Explaining where the risk of contagion from European banks is

Deposits at US commercial banks have fallen to their lowest in nearly two years, according to the Federal Reserve. This figure has decreased by $500 billion since the collapse of Silicon Valley Bank. However, total bank credit has risen to a new all-time high of $17 trillion, according to the US central bank. Less deposits, but more credit. What could go wrong?

The danger of a credit crunch

The inevitable credit crunch is only postponed by the widespread belief that the Fed will inject all the liquidity needed and that interest rate cuts will soon follow. It is an extremely dangerous bet. Bankers are choosing to take more risk as they wait for the Fed to return to easy monetary policy, and banks are expecting higher net income margins due to higher rates, despite the elevated risk of rising non-performing loans.

The fact that the banking crisis has abated does not mean that it is over. Bank collapses are symptoms of a much larger problem: years of negative real rates and easy monetary policies that have created numerous bubbles. The risk in the banks' balance sheet is not only in the reduction of deposits in liabilities, but also in the decrease in the valuation of the profitable and investment part of the assets.

Banks are so leveraged in the monetary policy cycle and expansion that they simply cannot offset the risk of a 20% loss on the asset side, a significant increase in non-performing loans, or the write-off of riskier investments. . The level of debt is so high that few banks can raise capital when things get worse.

The interconnection between European and American banks

Investors and companies in America understand this. However, in the United States, 80% of the real economy is financed outside the banking channel. Most of the funding comes from bonds, institutional leveraged loans, and direct private lending to the middle market. In Europe, 80% of the real economy is financed by bank loans, according to the International Monetary Fund.

You may remember back in 2008 when European analysts repeated that the subprime crisis was a specific event that only affected US banks and that the European financial system was stronger, more capitalized and better regulated. Well, eight years later, European banks were still recovering from the European crisis.

Why are European banks equally or more at risk?

European banks have strengthened their balance sheets with very risky and volatile instruments: contingent convertible hybrid bonds. These look incredibly attractive due to the high returns they have, but can create a negative ripple effect on company capital when the going gets tough. In addition, the core capital of European banks is stronger than it was in 2009, but it can deteriorate quickly in a declining market.

European banks make massive loans to governments, public companies and large conglomerates. The contagion effect of growing concerns about sovereign risk is immediate. Furthermore, many of these large companies are zombie firms that cannot cover their interest expenses with operating profits. In periods of monetary excess, these loans appear extremely attractive and of negligible risk, but any decline in confidence in sovereigns can rapidly deteriorate the asset side of the financial system.

According to the European Central Bank (ECB), the exposure of eurozone banks to national sovereign debt securities has increased significantly since 2020 in nominal terms. The proportion of total assets invested in national sovereign debt securities has risen to 11.9% for Italian banks, 7.2% for Spanish banks and close to 2% for French and German banks. However, this is only part of the picture. There is also high exposure to state-owned or government-backed companies. One of the main reasons for this is that the capital requirements directive allows a risk weight of 0% to be assigned to government bonds.

Pointing out the risk of the European banking system

What does this mean? That the greatest risk for European banks is not the flight of deposits or investment in technology companies, but the direct and uncovered connection to sovereign risk. This may seem irrelevant, but it changes quickly, and when it does, it takes years to recover, as we saw in the 2011 crisis.

Another distinguishing feature of European banks is the speed with which the non-performing loan ratio can deteriorate. When the economy weakens or stagnates, lending to households and small and medium-sized businesses becomes riskier, and the lack of an alternative, diversified lending system like the one in the United States means that the credit crunch affects the real economy of deeper way. We can all remember how non-performing loans quickly went from 3% of total assets to 13% in some companies in two years, between 2008 and 2011.

European bank assets are more exposed to sovereign risk and worsening solvency in small companies, but are also significantly exposed to large industrial zombie companies.

The latest ECB lending survey shows credit standards are tightening across the board for business, household and property loans. When the real economy is 80% financed through bank loans and banks are heavily exposed to sovereign risk, the ripple effect of a weaker economic environment in the financial system comes from all sides, both from the supposed government link of low risk as well as small and medium-sized companies with higher risk.

So far, analysts are saying, again, that the banking crisis has nothing to do with Europe because regulation is stronger and capitalization is more robust. These were the same factors that the consensus repeated in 2008.

Depositors have withdrawn 214.000 billion euros from euro zone banks in the past five months, with outflows reaching a record level in February, according to the Financial Times and the ECB. It is not true that the flight of deposits is not a problem in Europe.

The biggest mistake that European authorities and investors can make is to think, once again, that "this time is different" and that the banking crisis will not affect the Eurozone system. It is important to strengthen the core capital base, buy back convertible bonds that can wipe out equity, and establish robust procedures to avoid a negative sovereign effect on the real economy.

The combination of ignorance and arrogance led Europeans to believe that they were immune from the financial crisis of 2008-09 because they trusted in the miraculous power of their oversized and bureaucratic regulation. No amount of regulation helps when the rules are designed to allow increasing exposure to near-insolvent governments under the guise that it requires zero capital and is risk-free. Sovereign risk is the worst risk of all.

European banks must not fall into the trap of thinking that tons of rules will eliminate the risk of a crisis in the financial system.