EU and US banks facing escalated risks

By Rebekah Tunstead | 23 November 2018

There has been a significant increase in credit risk in the EU this year, while US banks face increased regulatory risk in the months ahead.

That’s according to research and credit specialists at S&P Global Market Intelligence, speaking at an event this week in London.

“Across Europe, at the beginning of the year, on a weighted average basis we had 0.2% probability of default in the market, which over the course of the year increased up to about 0.5%,” said Pascal Hartwig, credit product specialist at S&P.

The US is closer to witnessing a turn in the credit cycle, said Alexandre Birry, head of analytics and research for global financial services, due to tougher banking regulation since the financial crash.

“We do see some pockets of risk that we think that US banks have behaved differently in terms of underwriting risks compared to before the previous crisis,” he said. “The US regulator has been even more drastic in the fall out of the crisis in terms of forcing banks to strengthen their balance sheets.

“Obviously we are watching the risk of a potential rollback of some regulations. You may have seen some rules rolled back by the Fed, especially for some of the smaller banks. But for us, it is not affecting the big picture for the largest banks, because we do think that this would affect more the smaller regional banks, not the JP Morgans of this world,” said Birry.

At a conference in Frankfurt earlier this week, Korbinian Ibel, director general at the European Central Bank’s banking supervision arm warned that banks had started taking on more risk.

“We’re seeing more and more banks take risks that, back in 2008 and 2009, they said they’d never do again,” said Ibel. “Banks argue that pressure to increase revenue has pushed them into riskier business and encouraged them to loosen their load-underwriting standards, Ibel said."

It’s a troubling time for European banks, said S&P’s Birry.

“If we look at the price to book of European banks, things got a little bit better towards the start of 2018, helped by the markets. We were getting closer to a price to book of one time, but with the market volatility of the last few weeks, the median of this price to book is already again significantly low. Banks are probably three-quarters of their equity, in terms of market evaluation.

“Our projection of a rise in equity may be inching slowly and painfully towards the 7% bar, by the end of next year. And remember we are looking at the top 50 European banks, so the largest banks should have economies of scale,” said Birry.

This comes after last week the Financial Stability Board published its list of global systemically important banks (G-SIBs) for 2018. Both Danish bank Nordea, and the Royal Bank of Scotland were removed from the list, while Groupe BPCE was added.

According to the IMF’s global financial stability report, banks have been successful at strengthening their balance sheets since the last economic downturn 10 years ago, however, some weaknesses in the global system are still visible.

“Increasing debt in the household and corporate sectors has left banks in some countries exposed to borrowers with high debt-service burdens. The combination of some highly indebted sovereigns and bank holdings of government bonds risks reigniting the sovereign bank nexus. In addition, some banks are exposed to opaque and illiquid assets, or are reliant on foreign currency funding,” the report states.

Bullish monetary policy has not been the boon to markets banks might have hoped for, said Birry.

“Macroeconomic growth is slowing down,” he said. “Monetary policy should be normalising which for banks typically is good. Higher rates or steeper curve is good for banks, it normally means the net interest margin improves. But we believe that the markets - I’ve taken this view - that the relief expected from the normalisation of the monetary policy might not be as great as we initially expected.”

He went on to say that while ratings agencies may have upgraded a number of banks, there are still some worrying signs in debt markets. 

“What we have here is what we call two headlines and a hidden story. The headlines are that things have gotten better for European banks,” said Birry.

“The first headline is that there have been a number of upgrades since 2016, and no longer the downgrades you could see before. The second headline is that the outlook is overwhelmingly stable with actually a healthy dose of positive outlooks.

“So, another way to phrase it is that European banks have turned a page on the cycle of downgrades, and we do have a more stable outlook,” said Birry.

“And the last driver for positive rating action is the hidden story I was referring to before. Here we are really talking about outlooks, and of the Issuer Credit Ratings (ICRs). What this is also masking is some changes in regulations forcing the largest banks to issue more and more debt that is billable in the case of a crisis ie debt that is loss-absorbing and therefore, yes, surprise surprise it is good for senior and secured creditors, and in some cases we have taken positive rating actions,” he said.

“It also means that these European banks have been issuing more and more debt that is not rated at the level of the ICR, that is rated maybe two or three notches below that. It is not a case of having your cake and eating it. European banks are paying the price for this better outlook at the level of the senior and secured debts.”

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