Macro Wrap – Gradual Improvement in European Banks, $SX7E

by Enis July 30, 2013 7:34 am • Commentary

Undercapitalization of the European banking system has been a lingering concern for the European economy for several years now.  While the U.S. banks undertook a major capital raising program in 2008 and 2009 to replenish much-needed capital, European banks ignored the issue, resulting in periodic crises of confidence originating from various banking stresses over the last few years.

2013 has been a welcome relief from such troubles for Europe, but the issue of undercapitalization has not been resolved.  However, the headlines out of Europe this morning are a reason for optimism.

1)  Barclays is planning to raise almost $10 billion USD in a rights offering.  Basel III requirements for reduced leverage were the catalyst.  Whatever the catalyst, the capital raising to reduce leverage is necessary.  The real question is whether more needs to be done (the U.K. authorities are imposing a 3 percent leverage ratio – equity / assets – for banks).

2)  Deutsche Bank missed earnings expectations after higher-than-expected legal reserves.  More importantly for the long-run, the CFO stated that DB will cut assets on the balance sheet by 15% over time to reduce overall leverage.  DB already raised about $4 billion USD in April, but its leverage ratio (around 2%) is still one of the lowest in the world among large global banks.

3)  UBS announced that it plans to buy back the fund set up by the Swiss central bank during the crisis to help UBS unload toxic assets.  UBS is further along than other large European banks in improving its capital and leverage ratios, and this is one more step in that direction.  UBS has also dramatically decreased its risk-taking in its investment bank, focusing more intently on client-serving businesses, particularly in wealth management (similar to Morgan Stanley’s strategy in the U.S.)

All 3 of these news items are evidence that regulators are keenly pushing European banks to move quickly to plug the capital holes.  European bank stocks are still underperforming the broader European equity markets, trading around flat on the year:

Daily chart of SX7E, European banking index, Courtesy of Bloomberg
Daily chart of SX7E, European banking index, Courtesy of Bloomberg

More importantly for systemic risk though, the credit market has improved significantly for European financials over the last 2 years:

European Financials Senior 5 year CDS Index, Courtesy of Bloomberg
European Financials Senior 5 year CDS Index, Courtesy of Bloomberg

That chart essentially shows that credit investors and traders are more willing to buy European financial debt, reducing the market’s overall probability of default over the next 5 years.  The capital raising measures, as well as supportive action by the ECB, have helped ease systemic concerns.  The more time that passes with no major Euro crisis, the more time banks have to repair their balance sheets, and the less likely a future crisis becomes.  Here’s to hoping for many more capital raises this year.