Challenges for European Banks

Concerns about the health of the European banking system tend to focus on bad loans and profitability. In a speech this week, ECB's Vice President Constancio suggested that officials were looking at two other issues.  

First, Constancio expressed concerns about the "unconstrained" ability of banks to generate credit by creatively using collateral.  The collateral is pledged by the borrower, but they continue to enjoy the benefits of ownership. However, sometimes, the pledged collateral is used by the lender for their own purposes. This is called rehypothecation. The owner of the collateral is often compensated for this use, but there is a fear that this poses systemic risk.  

Constancio also warned about the re-use of collateral.  The same assets are pledged as collateral more than once.  Both of these practices can spur extensive lending among financial institutions.  The high levels of mistrust during the Great Financial Crisis had deterred credit extension, but now the fear is from the other direction.  

Second, and related, Constancio warned against attempts on the part of some banks to exclude repos from the calculation of leverage ratios.  Leverage ratios are one of the broadest metrics of risk.  Excluding repos weakens the standard and removes a check on the creation of liquidity.  

For financial institutions, one of the pressing problems in the repo market is the shortage of high-quality collateral at key times like quarter and year end and around particularly stressful events. Some institutions appear to post lower quality collateral with the ECB and use the higher quality collateral for private sector activities.  However, the stricter repo rules and the ECB asset purchases and still not fully conducive securities lending program frustrate banks.   Reuters reports the industry's International Capital Market Association is lobbying regulators to ease their and own rules and for the ECB to make more than of the 1.5 trillion of government bonds it hold easier for banks to borrow. 

European banks stocks are performing strongly here in 2017.  The bank shares in the Dow Jones Stoxx 600 are up 10.7% year-to-date compared with a 9.2% gain in the index itself.  The MSCI European bank index is up 11.4% so far this year.  An index of Italian banks has rallied more than 20%.  In contrast, US bank shares are significant laggards. The KBW bank index is practically flat this year, and while the NYSE financials are up 3.5%, the NASDAQ banks are off 3.5%.   We suspect the European outperformance has gotten ahead of itself and technical readings are stretched, warning investors to be wary of a reversal.   

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