European banks are not (yet) at risk, but they will be if they make these mistakes

Elizabeth Smith

It would be wrong to say that European banks are now at risk of a total meltdown. Despite the Swiss crisis and the effects of the Silicon Valley Bank case, banks have held up satisfactorily.

Probably this good resilience is due to the rigor and safeguards with which European banks are equipped, the latter being quite different from those abroad. But this does not mean that they are totally immune to some potential setbacks.

European banks are not (yet) at risk, but they will be if they make these mistakes

European banks have not had rosy moments in the past six months. In fact, in March the fear of an international banking crisis was quite realistic, if you count that on March 9, 2023, the day of the Silicon Valley Bank crash, Deutsche Bank had lost almost 1/4 in the stock market (about 23%).

And it was among all the big European banks the one with the lowest recorded loss. The French Société Generale recorded a loss of 27%, or the Spanish Sabadell and Bankinter between 25% and 26% respectively.

They are slowly recovering from the March blow, strong in part because of the system of protections that European banks have compared to their American counterparts.

Despite the safeguards, European banks may still risk another slide into the abyss, since the strategy to be taken on certain points such as:

  • the U.S. housing market,
  • the “frozen” government bonds,
  • the Addition Tier 1 bonds.

All 3 are neuralgic points of how well the banking system is holding up. If the relevant institutions or authorities fail to rebalance all these points, the risk of a new 2008 would become a reality. And this time it would be all European.

Exposure to the U.S. real estate market

Exposure on commercial real estate in America could become a problem for European banks.

Important real estate market, they have cautiously kept around 6 percent of total lending (Deutsche Back at 7 percent). While in America the figures are extreme. U.S. holding companies have 16 percent exposure, regional banks as high as 36 percent.

Clearly, in the event of a housing bubble or mortgage defaults (their interest rates have exceeded 7 percent), the very high market exposure would put bank credit at risk.

And even if only limited to the U.S., a backlash in Europe is still to be expected. As happened with regard to Silicon Valley Bank.

“Frozen” government bonds and their sell-off

European banks hold up to 3.3 trillion government bonds. This is a gigantic investment, but one that could be sold off if there is a shortage of liquidity.

At the moment, banks prefer to keep them frozen at amortized cost (held to maturity). But in the event of losses of more than 13 percent (Mediobanca Securities estimates), banks would find themselves below the ideal “liquidity coverage ratio” of 100 percent, which they want to maintain at all costs.

Only ING and Deutsche Bank would trigger the sell-off in case of losses above 7-9% for retail deposits. Nor are they the ones with the most government bonds on deposit. BPER has them for 14 percent of total assets, as do Popolare di Sondrio (17 percent) and Dutch KBC (15 percent).

A massive sell-off of government bonds would lead to a scenario similar to that seen with the 2011 sovereign debt crisis, when countries such as Greece, Portugal and Italy were at risk.

The risk of AT1s: a 275 billion bomb

Another problem is that of AT1s, the Addition Tier 1s.

Financial debt instruments with sub-standard credit ratings, they have become popular because of their special features. They lack maturity, allow early repayment, and are intended to absorb losses without affecting the entity’s operations.

Too bad that if the solvency deteriorates, coupons are canceled or the principal is temporarily or permanently converted to equity or shares in the bank.

Simply put, no repayment can be made if there is a loss of ability to collect if the institution is extinguished and subsequently liquidated. Precisely the bankruptcy of Credit Suisse Bank, the bank among the most issuers of AT1s.

When the Swiss authorities zeroed out Credit Suisse’s AT1 securities without touching the shares, the market was shocked, though not violently.

Moreover, in the event of the total disappearance of AT1s, the impact would be small. According to Mediobanca Securities there would be only a loss on earnings per share averaging 10 percent.

The problem would be for savers, as AT1 is considered by FINMA, the Swiss financial regulator, reversed the order of instruments in the priority scale.

Therefore, the authorities preferred to value Credit Suisse’s $17 billion of AT1 bonds at zero. Which led to heavy selling in this market anyway.

And this was also against savers. It is estimated that more than $275 billion of AT1s were issued in Europe.

If they were sold off and abused by banks and authorities, the various bond-gates that have happened over the past decades would be nothing compared to the destruction such an event would generate.

Read also: The real estate crisis in Europe is getting closer: markets and banks on high alert

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