Picture of ECB tower
Mika Baumeister on Unsplash

Published on March 26, 2021

Time is a bit warped in the COVID-continuum. Still, some of us may remember a little less than a decade ago when European financial stability occupied major headlines for what seemed like an interminable amount of time. Bank stocks there were going to implode, and Europe could not get out of its own way to stop them. 

Amidst increasing regulatory and product complexity, many wise investors shun investing in financials as a general rule. Accounting and balance sheet items in the larger banks have become meaningless jargon for all but specialists. 

In my post on Greece earlier this year, I referred to investing in Greek financials. To clarify, I invest in financials, but I tend to focus on institutions in smaller countries where the product mix is simple. Greece largely fits that bill, as do a few other countries in Europe.

I shorted larger financial institutions — like Spanish banks — but now look for a specific instead of systemic rationale for doing so at this stage in the game. For example, a certain Spanish bank was a great way to short Turkey and EM more broadly a few years back.

Now that bank stocks in Europe have not gone to zero and that tech, FAANGS and SPAC’s have occupied the media forefront for some time, I thought it would make sense to dive back into European bank stocks. Many of the underlying fundamental issues raised over the past several years have not gone away, but the market seems to have moved on.

Any time there is a divergence in sentiment and reality, you usually have an opportunity in waiting.

I’ll walk you through the following items in this post:

  • How Europe Got Where It Is
  • The Current Health of European Bank Stocks
  • What A European Banking Crisis Looks Like
  • Conclusion

In a subsequent post, I will run through some numerical examples of the issues banks are dealing with and some possible investment ideas on how to play European financials.  

This post is timely, as we have seen how the European system will react to unforeseen crises like COVID and the problems such an approach implies. 

How Europe Got Where It Is

Despite being in a monetary and regulatory union, different countries in Europe got into traps for different reasons between 2008 and 2012. Ireland and Spain had housing busts. Italy’s sclerotic system never could address non-performing loans, and German banks held US-subprime products and shipping portfolios that were nearly worthless. 

My personal favorite, many homeowners in Poland and Hungary, got low interest rate mortgages denominated in Swiss Francs.  When those countries’ currencies collapsed, people could no longer afford the interest rates.

There were, however, a few underlying themes common to many banks and the system as a whole. Like their US counterparts, and perhaps more so, European banks were very leveraged going into the GFC, and when their loans and assets went sour, the party was over.  

Additionally, in response to the financial crisis, the EU and the respective national authorities implemented a multifaceted and stringent reform process, which we will cover later. Additional rules and restrictions have been placed on banks regarding capital requirements, liquidity requirements, provisioning, etc. This was not unique to Europe, but Europe has certainly taken new regulations further and faster.

Importantly, these new rules came into place in a system that was still recovering from a crisis.  Balance sheets were still being repaired, and interest rates were still low. Banks were asked to begin implementing serious reforms before recovery. Remember that European institutions did not raise equity and repair their balance sheets as quickly as in the US. The whole process was like putting a player on the field before an injury healed.  

Finally, the sequencing had a material impact on Europe. Financial institutions were weak and asked to take on additional regulatory burdens that would slow down their lending and profitability. Since Europe is generally more reliant on bank lending than capital markets (bonds), issues in the banks themselves impacted the broader economy more seriously and likely led to some of the slow growth seen there.

These issues effectively lead to a system where profitability is muted and the ability to maneuver is difficult. Let’s talk about these drivers now in the current context.  

A report from Bain came out in 2013, popular at the time, highlighting some general issues in the European system. While the analysis focused on a single metric, return on risk-weighted assets, it is very important. We’ll delve into this in the next section. Current policy and past decisions have put a major constraint on the bank’s balance sheets’ earnings power.  

The Current Health of European Bank Stocks

Although all banks in the world seem to be converging on public utilities, nowhere is this more evident than in Europe. Due to interest policy within Europe, additional taxes to create rainy day funds, the European social contract, and stringent capital and liquidity calculations, European banks have little room to maneuver, as we’ll discuss at the end of the section.

Central Bank Policy and the Disappearing NIM

As I have referred to in other posts, central bank interest rate policy is important for banks.  While the short-term rate — the Fed Funds Rate in the US or the ECB policy rate in the EU — gets all of the attention, another important element is the steepness of the yield curve.

The curve is important for two reasons. First, banks generally take in short-term deposits and lend longer term. This is called maturity transformation. Secondly, interest rates for private borrowers are nearly always higher than the government, and that difference or spread increases the longer the loan.  

So, if the difference between 2-year and 5-year government rates is ~ 70 bps, or 0.70% in the US, a bank can expect to make at least that difference in a 5-year loan. Depending on the borrower, there will be an additional spread as well.   

When this difference between shorter and longer-term yields is increasing, we say the curve is steepening. The opposite is called flattening. Putting this all together, a steepening yield curve is generally good for banks’ profitability, while a flat yield curve is bad for banks. When the spread above is negative, an inverted yield curve, it is bad for banks because it inhibits their ability to lend profitability and halts credit growth. That is part of the underpinning as to why an inverted curve is a signal for a recession.  

So, how steep is the yield curve in Europe now? The chart below shows the 10yr – 2yr spread or steepness of the yield curve for several European countries and the US over the last five years.  I have included a few countries because Europe has no official risk-free rate, though Germany unofficially takes that title.  

5yr graph of 10-yr-2yr spreads for US, Germany, France, Italy and Portuga
Source: koyfin.com

Up until the summer of 2019, the trend for everyone was down. But, at that point, the US turned around and went from the lowest spread to the highest spread. Europe has turned up in the last month or so, but it is small. German spreads are a quarter of US spreads. Generally speaking, this means that all European banks should broadly be less profitable than US banks.  

Why is the European yield curve so flat? I can think of two main reasons. First, the ECB is buying sovereign bonds across the maturities, which pushes down yields, flattening the curve.  Secondly, they have guided the market to expect low-interest rates for a long time.  

In addition to spreads, interest rate policies by the ECB noted above have another negative effect that all savers around the world have felt. Low absolute interest rates mean that banks do not get paid for the cash they hold. Banks, increasingly more so, as we will discuss later, are required to hold cash to meet deposit withdrawals and regulatory requirements.  

They usually keep such funds in safe liquid securities like sovereign bonds. But with bonds in Europe having negative yields out to several years, banks earn no interest on these liquid investments. European banks have been forced to hold more of them right when they yield the least.  

Where these two points converge is a bank’s Net Interest Margin, or NIM. This number effectively captures the average spread for a bank between its interest-bearing assets and liabilities. It is the spread it gets from lending. While many banks have been in the doldrums for a long time, I still challenge someone to find a bank in Europe lending mostly in Euros with a NIM greater than 2%. They no longer exist.

So, the main driver of banking revenue has gotten worse over the last several years.  What else?

The Ugly Side of a Social Contract and National Champions

Any fundamental investor will be aware of the use of “one-off” accounting used by companies to attempt to illustrate the impact of non-repeating items in an income statement. The genesis, an attempt to show what the underlying business looks like. This seems noble, but what happens if the same type of one-off transactions happens for 2, 3, or even 5 years?

This question is particularly relevant for European financials. Because firing is difficult in most European countries, downsizing is a long, cumbersome, and relatively expensive process. This weighs on profitability over a long period of time as it is a longer and more expensive process.  For example, the Bank of Cyprus has spent close to EUR 150 million on “non-recurring” voluntary exit program packages for employees in the last 5 years.  The bank’s equity is currently worth ~ EUR 440 million. So, a huge portion, over a third, of the current equity value of the company has gone to terminate employees and been a major drag on profitability.

Beyond staff numbers, this also applies to branch networks. European banks simply had too many branches going into the global financial crisis, and consolidating that footprint is taking time and money.

So, how do banks combat further push-down costs? Bring in the robots! You cannot go through a bank stock pitch deck in Europe without talking about how they are digitizing their sales channels and product underwriting. By having the machines do more, you need fewer people and fewer places for people to meet.  It’s a win-win, right?

I won’t go into my skepticism regarding machine learning and underwriting (the quick takeaway: I think it is a great tool that will be abused), but there are more problems. First, technology saves money over a longer period of time, but you have to invest in it first. This is exactly what banks are doing now. This increases expenses. Second, if EVERY bank is investing in efficiency, who gets the benefit of that? The banks? Not likely.

Digitization is a necessary cost to stay competitive. Its benefits will be passed on to consumers.  Most of the cost reduction will benefit clients through better pricing, not the bank’s margins. Is there any circumstance that could change this?

Yes, but it won’t happen because it would require consolidation in European banking that simply has not happened yet. The analogy I would make is the following: Imagine that the largest banks in any US state were unique to that state. The biggest bank in Georgia might have a few branches in Florida, but mostly to help its home-based clients in Georgia.  

That sounds super inefficient, right? It is, ESPECIALLY when it comes to technology. The largest bank in Portugal likely has to spend a similar amount to the bank in Greece for the same amount of technology, but because there are no real pan European banks, those costs eat at all the banks. Consolidation could fix the issue, but it has not happened. At this point, I doubt there is a political will to do so.

Some of the most profitable banks in Europe, the Scandanavian banks, also have the greatest penetration across the regional markets.  The biggest banks in the region operate across countries at scale and can dilute their fixed technology costs.    

Regulations Have Created Banks with Strong Facades but Weak Internals

Global banking regulations have increased monumentally in the last decade but nowhere more so than in Europe.  I have spent my entire career in securities analysis, and the dizzying array of regulations, rules, and acronym soup in Europe is truly remarkable. It is a consultant’s fantasy and effectively legislates away any dynamism in banking. While much more complex, it can fall into three realms: Capital Adequacy, Liquidity Adequacy, and Adverse Outcome Clarity.

In banking, there are various regulatory hierarchies. The highest banking body is the Bank for International Settlements, or BIS, known as central banks’ central bank. While it has no binding authority in any country, its frameworks are adopted by various members over time. 

The most famous is the series of Basel Frameworks. Most of the OECD is on the third iteration of this framework, which guides financial systems on how much capital to hold against various risks, whether they be credit market or operational, and introduces the liquidity ratios concept.

Capital Adequacy  

On top of this framework, Europe added additional requirements based on different risk types. Institutions are required to disclose these reports under Pillar 3 disclosures. You can see the disclosure of one of Belgium’s largest banks, KBC Group NV, here. They outline risk-weighted asset calculations, capital calculations, remuneration, and an evaluation of any situations that needs remediation.

The underlying concept is that a bank should hold capital against a loan and other assets on its balance sheet.  If the loan has trouble or an asset declines in value, shareholders, not depositors, take any associated loss.  You hold more capital against riskier assets than you do for safe assets.

Liquidity Adequacy

Any entity has two main risks, solvency and liquidity. While there is a grey area between the two, the above deals with the former, and you can have sufficient capital but still run into problems due to liquidity. The authorities in Europe cover this via liquidity requirements, principally the LCR or liquidity coverage ratio and, over a more extended framework, the Net Stable Funding Ratio, or NSFR.

The LCR ratio attempts to ensure that a bank has sufficient liquid assets, like government bonds, to meet any deposit or other liability outflows. Banks in Europe are required to hold such assets in sufficient amounts equal to expected outflows (like depositors taking their money) over a 30-day adverse scenario, as agreed upon with the regulator.

The NSFR applies a similar framework to ensure that banks have sufficient long-term funding to address longer-term needs. This regulation came into force in Europe in 2021.

Adverse Outcome Clarity 

After the European financial crisis at the beginning of the last decade, Europe adopted rules that have attempted to address financial institution bailouts’ risk.  To do this, Europe has taken a two-pronged approach.  

Firstly, like the US, Europe requires banks to have a living will or resolution plan if things go wrong and consider how they think they can be wound up, whether through an asset transfer, court-supervised liquidation or sale. Based on this assessment and other considerations, the authorities assign a bank an MREL, or Minimum Requirement for Own Funds and Eligible Liabilities,  ratio. This ratio is similar to a capital ratio and includes other types of liabilities. It effectively attempts to ensure that the banks’ liabilities have sufficient loss-absorbing capacity to prevent taxpayer bailouts.  

In addition to adding higher cost liabilities to absorb losses, banks under the Single Resolution Fund of the EU and various national funds have been paying levies to build up funds that will be used in a manner equivalent to the deposit insurance of the FDIC in the USA.  

The concept is noble, but they are building this buffer right when banks are least profitable.  Such levies currently amount to 4-6% of total income and are not an insignificant expense, especially since each bank’s levy is not linked to profitability but rather more to size.

Finally, and related to capital adequacy, Europe has upgraded its rules regarding asset quality.  Like most of the world, Europe adopted IFRS 9 towards the end of the last decade. This international accounting rule governs how companies provision financial assets. Before IFRS 9, provisions on financial assets were largely retroactive. You only provisioned an asset after non-performance.  

IFRS 9 changes this, requiring institutions to adjust provisioning based on forecasts. It also adjusts how banks can accrue interest on such assets and how much provisioning is required at a time. Broadly speaking, it is much more conservative.

Europe has added incremental rules on top of this for Non-Performing Exposures, or NPE’s.  These are assets that are impaired. In the old days, a bank could restructure a loan and leave this classification. Now, there is a probationary period of a year before loans can be removed from this category. A bank in Europe must also classify a loan as an NPE if it believes it will have to realize any associated collateral to get its money back.  

Why is this important? Because banks have to set aside more capital for NPE’s than regular loans, which eats away at profitability.

Bringing It All Together – True Wards of the State

For European banks in the last decade, capital requirements have risen, spreads have collapsed, taxes have increased, and tech investments have gone up. In contrast, legacy costs have been tough to cut, and new regulations restrict how any bank can manage its balance sheet. Except for costs, all of these elements are managed exclusively by the state.  

Using the COVID response as a template, we’ll see how dependent banks are on regulators’ arbitrary decisions and how this can lead to the gross mispricing of financial institutions’ risk.  

What a European Banking Crisis Now Looks Like

The COVID pandemic led to a financial crisis that rivaled the GFC of 2008. How things unfolded gave a clue as to how the market may view such financial institution risks in the future.

The COVID Crisis: A First Test for New EU Banking Rules

Did you hear about the great European COVID banking crisis? No?

I would argue that there was one. Probably trillions of Euros in loans were restructured, and governments guaranteed hundreds of billions in new, fresh loans.

But aside from bank stocks falling out of bed with the rest of the market, there was no peep. Why? Because the regulator had waived the consequences of actions (restructuring loans) that would lead to increased provisioning, loss of capital, and possible permanent losses on equity or hybrid securities under the EU rules now in force. In essence, banks got a hall pass on COVID-related loan problems.

Furthermore, for the loans banks made to customers guaranteed by the state (akin to PPP loans in the US), there was no capital requirement as the state guaranteed such loans. Banks received a double win.

Implications of the COVID Response for Future Crises

For this discussion, whether these actions were appropriate or not is irrelevant. The point I am making is that a crisis was largely averted because of regulators relaxing the rules. So, what’s the problem?

Banks are still highly leveraged institutions, and policy has neutered their profitability, even during the economic recovery in Europe since 2013. Even with strong economic tailwinds, they have not and probably will not return to the profitability levels seen before the GFC. But because they are levered and only modestly profitable, they are MORE susceptible to unforeseen shocks.

COVID provided an invaluable test to see whether the plans the banks had set up to manage losses would work. But, rather than testing the system, the regulators papered over things. Since there were no issues, many market participants now see a regulator that will relax the rules if things get too tough.  The technical term for this is moral hazard.

The European authorities may arbitrarily decide to prevent contractual events from occurring.  This, much like the Fed put in the US, will cause the markets to misprice the risks in owning bank stocks. If you think the rules are not enforced or will be waived, you will worry less about the risk and pay more for something.  

Most troublesome is that the system is now dependent on regulators’ reactive measures in a crisis to maintain the status quo. Rather than relying on the wording of contracts and the elaborate system the EU has built out, the regulators selectively relax the rules. This sets a dangerous precedent.  

Regulators may not always behave the same way even though the market may price risk as if they will. It also makes regulators an arbiter of what “breaches” of the system are overlooked versus enforced. It is messy and a more byzantine version of the bailouts the regulations were supposed to stamp out in the first place.  


In the next post, I will put my concerns into numbers and see how complicated and far-reaching the underlying regulations’ implications can be. We’ll then look at some possible opportunities in the European banking system.

While I do not doubt that my underlying opinion has shone through, this article intends to demonstrate that increased regulations have not eliminated risk, particularly in Europe. Banks, by their nature, are levered institutions, and by more tightly regulating their activities, regulators and politicians have not eliminated risks. The risks have simply changed. 

Under normal and predictable circumstances, banks are now less likely to run into trouble. However, this has greatly eroded their profitability. By doing this, banks are more vulnerable to unplanned or unforeseen events. Ironically, by relaxing rules under COVID (unforeseen event), they have reintroduced the very moral hazard these new regulations sought to address. 

The European authorities are beginning to acknowledge this issue, as noted in this article last week, but the political will to tackle it is another issue.  Let’s hope they can.

To your investing adventure,

The Castaway Capitalist

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