Deutsche Bank’s woes may only be tip of European iceberg

These are challenging times for the European economy, with Brexit looming and the Greek bailout again becoming the focus of attention. But the issue dominating concerns in Brussels and Frankfurt is the state of the European banking sector.

Europe’s banking woes dominated debate on the fringes of last week’s annual autumn meeting of the IMF and World Bank in Washington, with senior bankers and policymakers from both sides of the Atlantic pitching-in with the latest take on the sector.

The IMF said that euro zone lenders threatened to undermine the global economy, while senior figures in US banking such as Goldman Sachs president Gary Cohn contrasted the current state of European banks with their US counterparts, who are "in the best shape ever".

Despite the low profitability of the sector and the continuing problems in Italian banks in particular, the travails of Deutsche Bank have really propelled the issue into the spotlight.

Last month the German government was forced to deny it would bail out its biggest bank after concerns about the ability of it to absorb a fine of up to $14 billion €12.4 billion) levied by the US justice department over its misselling of mortgage-backed securities.

Deutsche Bank, which only just scraped through European bank stress tests in July, is now facing reports that it was given special treatment by the European Banking Authority (EBA) after the European Central Bank (ECB) granted the bank a special concession. This allowed it to include the proceeds from selling its stake in a Chinese bank to boost its stress test results, even though the deal has yet to go through.

The bank is now in the process of devising a restructuring plan, which may involve a flotation of its asset management unit, according to some reports.

Beyond Deutsche

Germany's woes are not confined to Deutsche Bank: the country's second largest financial player, Commerzbank, has announced it was cutting nearly 10,000 jobs, reorganising its structure and suspending its dividend.

Meanwhile serious concerns remain about the health of the Italian banking sector, which is struggling with up to €360 billion worth of nonperforming loans.

Much of the focus has been on Banca Monte dei Paschi di Siena, the world's oldest bank, which finished bottom of the list in the EBA stress tests and which has now launched a fresh private-capital raising exercise.

Italy fought and ultimately lost a battle with the European Commission about its right to recapitalise the bank without hitting bondholders and possibly savers. New bail-in rules oblige banks to bail-in bondholders before state money can be used.

Across the euro zone, low profits and falling share prices are an increasingly familiar reality for banks. Many in the sector blame the ECB and its policy of record low interest rates.

With the main refinancing rate at zero and the deposit rate at minus 0.4 per cent, banks are struggling to maintain profitability and keep up their capital reserves.

Europe over-banked

ECB president Mario Draghi has argued that banks need to reform and streamline. He also said Europe is over-banked, with either too many banks in some countries or too many branches in others.

The health of Europe's banks is a concern, said Nicolas Veron, a fellow of the Brussels-based think tank Bruegel and a visiting fellow at the Peterson Institute in Washington.

“There is a fragility in the European banking system that is beginning to be recognised globally,” he said. “Deutsche Bank was an exaggerated example of this in one sense, but there are deeper concerns. Italy is a big piece of unfinished business, Portugal to a lesser extent.”

These worries are feeding into what is becoming an increasingly tense debate between Europe and the US over changes to Basel rules, which may lead to an increase in capital requirements for banks. The Basel group, founded 41 years ago to harmonise bank rules across the globe, is currently updating its Basel III rules.

In an uncharacteristic push-back from the European Commission, vice-president Valdis Dombrovskis said earlier this month that the EU would reject the rules if European concerns were not taken into account.

Onerous requirements

The issue dominated Tuesday’s meeting of European finance ministers in Luxembourg, with the officials coming out strongly against the changes amid fears they could put onerous capital requirements on banks.

Europe opposes new proposals to limit the use of internal models by big banks to calculate the risk profile of assets. It is also resisting proposals for a new “output” floor, which it believes would increase the capital requirements on banks.

Europe argues that the specificities of the continent’s banking sector are not being taken into account. In particular, it points out that, in Europe, most companies rely on bank lending for finance. In the US, 70 per cent of lending is provided by capital markets rather than banks.

Similarly, the US is not taking into account the huge role played by property in the European banking sector. Unlike the US, where property loans tend to be securitised, European banks tend to maintain loans on their balance sheet.

Though highly technical, the issue threatens to become politically charged at a time when transatlantic tensions are high in the wake of the European Commission’s Apple judgment.

Despite a suggestion by Dutch finance minister and eurogroup head Jeroen Dijsselbloem that changes to the way bank's calculate risk may be welcome, commissioner Dombrovskis insisted that the EU was united on the issue.

“Our current assessment is that proposals which are being discussed in the Basel committee may lead to a significant overall increase in capital requirements and reduce risk sensitivity of capital requirements,”he said after Tuesday’s meeting.

Encouraging risky business

Dombrovskis argued that more stringent capital requirements may actually encourage more risky business models. But Nicolas Veron believe the European argument is wearing thin.

“Europe’s position – that there is no overall need for capital requirements – is increasingly untenable,” he said. “There may be room for compromise on how far the proposal should go, taking the specificities of Europe into account. But the increase in minimal capital requirements is indefensible post-Deutsche.”

However, with banks battling a low interest rate environment, residual unresolved problems in individual banks, and sluggish economic growth, Europe will strongly resist anything that could more pressure on its already-fragile banking sector.

A protracted negotiating battle may loom in the months ahead as Europe seeks to protect its interests and its banks.