BRRD, NPLs and NIRP are three long-term headwinds for European bank investors.
The EU’s Bank Recovery and Resolution Directive (BRRD) came into force on January 1. This sets out a framework for resolving a troubled or failing bank. The good news is that an individual bank failure, however large, should not constitute a systemic risk. The BRRD forces the ECB, the Eurosystem and governments to prioritize the protection of payment systems, taxpayers and depositors. The bad news for investors is that “other parts may be allowed to fail in the normal way” – meaning the allocation of losses will follow the usual ranking: equity, subordinated debt, senior debt.
Another concern for investors is the size of the non-performing loans (NPLs). These equal 30% of bank equity in Spain and 100% of bank equity in Italy. Rapidly disposing of the NPLs at fire sale prices would be counterproductive as it destroys capital. Meanwhile, the BRRD prevents governments from recapitalizing the banks until investors have first suffered substantial losses. It follows that only with a crisis will the NPL problem be solved quickly; without a crisis, it will be solved very slowly.
Adding insult to injury is the ECB’s misguided negative interest rate policy (NIRP). At the zero bound, lower interest rates do very little to boost lending volumes. Rather, they compress already wafer-thin net lending margins. This pressure on bank profitability and share prices pushes up the cost of capital. And given that a major constraint to new lending is a shortage of capital, NIRP paradoxically tightens monetary conditions.
The next Insight discusses the broad implications of weak banks for investing in European equities.