With investors fleeing the stocks of European banks, concern is growing that there could be serious underlying problems in some of the largest banks in the world. Even the creditworthiness of big financial organizations is being questioned. The fall in one of the important benchmarks used to gauge the health of the banking industry is one prime example. The KBW Nasdaq Bank Index, which is a critical benchmark for the financial industry, is down 20% in 2016.
Another sign of nervousness and fear in the financial markets is when investors rush to safe haven investments. Government bonds have consequently seen a rise in demand. And, when there’s a rise in demand, the bond prices rise too while the yield plummets.
On Monday, 8th February, the 10-year Treasury note fell by 1.75%. At the close of last year, the yield was 2.27%.
Another indicator of anxiety and fear in the markets is a rise in demand for gold. Presently, gold prices are rising. On Wall Street, expectations of increased volatility are high, as the Street’s own ‘fear gauge’, the VIX, seems to reveal. That measure of the level of volatility that investors are expecting has shot up by over ten percent.
Concern About Banks Growing
The bigger concern that seems to be engulfing the markets is the fall in the prices of bank stocks. A case of investors selling banking stocks or taking bets on the opposite side of banks in the credit markets is usually not a good sign. In most instances, it is a sign that there is serious financial turbulence ahead.
It is also an unspoken statement about a general economic weakness and it sends the message that the banks have become increasingly vulnerable to the volatility in the market. This is because when the economic performance is poor, banks become casualties of bad loans, which is reflected in losses.
And, with the low interest rates that are prevailing in much of the developed world not to mention Europe, the profit margins the lenders are expected to earn are low.
The Sell-Off in Bank Stocks
The fall in the prices of bank stocks is coming at a time when fear was just beginning to take a hold on the markets. Already, the traditional indicators that are used to signal fear have begun flashing with a majority of the investors being on the sell side of financial stocks. The sell-off, however, has not been limited to banking stocks alone.
Monday alone saw one of the most watched stock indexes, the S&P 500 decline by 2 per cent before recovering a little but still managing to close at 1.42 percent in the red. Less than two months into the new year, the S&P 500 had declined by 9%. Matched against last year’s high, it has lost 13% to date.
The tech stocks-heavy NASDAQ index has fallen by 1.82% since the year began. Compared to last year’s nominal high, it has fallen by 17.92%. That’s just over two percentage points shy of an official bear market.
One of the worst hit of the European banks is Deutsche Bank. It is the largest bank in the Euro Zone and it fell close to 10% on the Frankfurt Stock Exchange on Monday. Since the year began, the bank’s stock has seen a decline of close to 40%. It is currently valued at only thirty percent of the book value.
In the UK, Standard Chartered saw a decline of close to 6%. Citigroup stock fell by over 5%. Other European stocks in the banking sector including those of UniCredit, BNP Paribas, and Barclays all dropped by over 5 percent, a far worse performance than other sectors.
The reason for Deutsche Bank’s decline alongside other European banks can be attributed to investors seeing an increased risk in holding these stocks. One of the ways banks raise money to fund their operations and to lend is by issuing debt.
But in recent weeks, taking out insurance to guard against the risk of a lender defaulting has been costing banks significantly more. Investors are increasingly concerned that European banks are not sufficiently capitalized to weather the growing number of non-performing loans (NPL’s). Deutsche Bank’s leverage ratio, which measures Tier 1 capital as a percentage of total assets, is only 3.5 percent, the lowest ratio among its competitors.
Credit-default swap costs for Deutsche Bank especially have increased significantly. Since the year began, the cost of gaining 5-year protection on the German lender’s debt has doubled. But this is not a problem restricted to Europe alone.
The shares of Citigroup have fallen by over a fourth since the beginning of the year. The price of the stock is now close to 50% of the book value of the bank. This means it is trading at a discount. Such discounts can be found in the stocks of other big banks too serving as an indication that the ability of the banks to make strong returns on money invested in them is being doubted by investors. This is strange considering that in the case of Citigroup, more than 17 billion dollars worth of profits were made last year.
Low (and Negative!) Interest Rates
In a bid to increase lending and stimulate growth, central banks have lowered interest rates or at least kept them low. For the banks, interest rates at such a low level means low profit margins for them. This has a spillover effect since it may lead banks to lend less, consequently reducing or obliterating the impact on the economy that low lending rates are supposed to have.
Another factor is that deposits made by European banks at the ECB are subject to negative interest rates. But banks are wary of passing this cost on to their depositors leaving them with one option to recoup – charging higher for loans. This is also has a tightening monetary effect – the exact opposite of what the ECB intended.
European countries such as Denmark and Switzerland, which have negative rates of interest, are already experiencing an increase in costs of mortgages. The result is a paradox where a relaxed monetary policy instead ends in credit tightening.
To sum up, the freefall of European financial stocks is being fuelled by investors’ fear that banks are not sufficiently capitalized in order to survive the growing number of NPL’s and that banks will struggle to drive a profit in a market with low and negative interest rates. The financial sector is moving into uncharted territory and investors aren’t going along for the ride.