Why European Banks Are Sacrificing Growth

Illustration by Topos Graphics

By Anne-Sylvaine Chassany, Kevin Crowley and Charles Penty

Under pressure from regulators to bolster capital, European banks are selling some of their fastest-growing businesses to competitors from outside the region. The sales may leave them better able to withstand financial stress—and less able to boost future profits. Spain’s Banco Santander, which said in October it needs an additional €5.2 billion ($6.9 billion) to meet capital requirements, sold its Colombian unit in December to Chile’s Corpbanca for $1.16 billion. Germany’s Deutsche Bank is weighing options including the sale of most of its asset management unit, while Belgium’s KBC Groep may dispose of businesses in Poland.

Such sales are an unintended consequence of the decision by European regulators to make banks increase capital—a buffer that protects against credit losses—to help them survive the worsening sovereign-debt crisis. The European Banking Authority on Dec. 8 ordered the region’s financial companies to raise €114.7 billion of additional capital by the middle of 2012.

To reduce their reliance on the markets for funding, banks across Europe have pledged to cut assets by more than €950 billion over the next two years, according to data compiled by Bloomberg. About two-thirds of that will come from sales of profitable units and performing loans, says Huw van Steenis, a Morgan Stanley analyst in London. While it may be hard to get premium prices for those businesses in a crisis, other options for raising money are even less appealing. Lenders don’t want to issue additional shares because their stock prices are too low: The Bloomberg Europe Banks and Financial Services Index is down 33.5 percent this year. Selling troubled loans is also problematic. If the banks accept the low prices investors are willing to pay, the lenders would have to record losses on the loans, and those losses would erode their capital. As a result, distressed assets and souring loans will account for just 4 percent of asset reductions over the next two years, according to van Steenis.

That leaves selling entire business units outside of their domestic markets. These are the most profitable parts of their business,” says Azad Zangana, European economist at London-based Schroders, citing Spanish and Portuguese banks selling assets in Latin America. “You begin to become a less profitable organization. Your business model stops working if you’re being forced to lend only to an economy that’s going through a very deep recession.”

By shedding some of their best assets, the sales may make banks less stable. “Lenders are selling more liquid assets so they can get a price that avoids additional capital losses,” says Joseph Swanson, co-head of restructuring at Houlihan Lokey in London. “Unfortunately, this strategy can result in lower asset quality and increased earnings volatility.”

Santander completed the sale of its Brazilian insurance operations to Zurich Financial Services for $1.7 billion in October. The Spanish bank also sold a $958 million stake in Banco Santander Chile, the South American country’s biggest bank by assets. The Chilean bank’s net profit grew 45 percent between 2008 and 2010 and may increase 15 percent this year, to about $970 million, according to analyst estimates compiled by Bloomberg. Santander said it will also sell a stake in its Brazilian banking unit. The Spanish lender’s planned sale of part of its U.S. consumer loan business to a group led by KKR may cut net profit for Santander’s shareholders by €150 million, according to an Oct. 28 estimate by Raoul Leonard, an analyst at Royal Bank of Scotland Group in London. “Assuming multiple asset sales may be in the pipeline, this could lead to a meaningful negative drag” on earnings, Leonard wrote. A spokeswoman for Santander declined to comment.

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How Long Can the ECB Prop Up Europe’s Sick Banks?

ECB President Trichet working on Portugal's rescue Georges Gobet/AFP/Getty Images

By Simon Kennedy and Gavin Finch

Four years to the month since the global credit crisis began, the European Central Bank has emerged as the lender of first resort to the Continent’s broken banks. With the bond market shut off to all but the strongest lenders, the ECB’s unlimited loans are keeping the most afflicted banks in Greece, Portugal, Italy, and Spain afloat. “Banks are becoming more nervous about being exposed to other banks as they hoard liquidity and become more suspicious of other banks’ balance sheets,” Guillaume Tiberghien, an analyst at Exane BNP Paribas, wrote in a note to clients on Aug. 19.

On that date, banks deposited €105.9 billion ($152 billion) with the ECB overnight, almost three times this year’s average, rather than lend the money to other banks. They are also stockpiling dollars and hoarding cash in safe havens such as Swiss francs. “I’m not sleeping at night,” says Charles Wyplosz, director of the Geneva-based International Center for Money and Banking Studies. “We have moved into a new phase of crisis.”

Investors are concerned, too. The price of European bank stocks sank 22 percent between Aug. 1 and Aug. 22, led by Royal Bank of Scotland (down 45 percent) and France’s Société Générale (down 39 percent). The extra yield investors demand to buy bank bonds instead of benchmark government debt surged to 2.98 percentage points on Aug. 19, the highest since July 2009, data compiled by Bank of America Merrill Lynch show.

Despite the ECB’s best efforts, some of Europe’s banks may be inching toward insolvency. The cost of insuring the bonds of 25 European banks and insurers set a record high on Aug. 24 of 257 basis points, higher than the 149 basis-point spike when Lehman Brothers collapsed in the fall of 2008, according to the Markit iTraxx Financial Index of credit default swaps. The banks aren’t required to mark down most of their holdings of government debt to market prices. If they did, some would be forced to default or seek a bailout.

Morgan Stanley estimates that Europe’s banks need to raise €80 billion by yearend. Their ability to raise capital has been sharply curbed by investor fears. Banks in the region hold €98.2 billion of Greek sovereign debt, €317 billion of Italian government debt, and about €280 billion of Spanish bonds, according to European Banking Authority data.

The Federal Reserve, which provided as much as $1.2 trillion of loans to banks in December 2008, wound down most of its emergency programs by early 2010. One of the few exceptions is the central bank liquidity swap lines that provide dollars to the ECB and other central banks, so they can auction off the dollars to banks in their own jurisdictions.

In contrast, the ECB and its president, Jean-Claude Trichet, are still in the bank-rescuing business. “The central bank is the only clearer left to settle funds between banks,” says Christoph Rieger, head of fixed-income strategy at Commerzbank in Frankfurt. After increasing its benchmark rate twice this year to counter inflation, the ECB in August provided relief for banks by buying Italian and Spanish bonds for the first time, lending unlimited funds for six months and even providing one unnamed bank with badly needed dollars.

The ECB is maintaining a role it began in August 2007 when it injected cash into markets after they froze. The ECB’s balance sheet is now 73 percent bigger than in August 2007, and its latest round of bond buying has opened it to accusations that by rescuing profligate nations it’s breaking a rule of the euro’s founding treaty and undermining its credibility. The central bank is acting in part because governments have yet to ratify a plan to extend the scope of a €440 billion rescue facility so it can buy sovereign bonds on the open market, which would allow governments to inject capital into the banks. Although the euro zone member governments are supposed to approve the new funding by fall, no one can say for sure.

The funding difficulties of Europe’s banks is one reason cited by Morgan Stanley economists on Aug. 17 for cutting their forecast for euro-area growth to 0.5 percent next year, less than half the 1.2 percent previously anticipated. Europe’s consumers and companies are more reliant on banks for funding than their U.S. counterparts, says Tobias Blattner, a former ECB economist now at Daiwa Capital Markets Europe in London.

Lena Komileva, Group of 10 strategy head at Brown Brothers Harriman in London, says the ECB may have no option but to extend the backstop role it is playing. Refusal to do so would risk a European bank default by the end of the year, she says: “Markets are back in uncharted territory. The crisis is a whole new story now.”

The bottom line: Some European banks hold almost half a trillion euros in questionable government bonds. They’re relying on ECB funding to stay in business.

Kennedy is a reporter for Bloomberg News. Finch is a reporter for Bloomberg News.

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