European Banks: Three Headwinds

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.

Tactically Cautious On Global Equities

A December Fed rate hike, uncertainty regarding the U.S. presidential elections, weak earnings growth, diminished buyback activity and concerns about European banks pose near-term risks to global equities.


The summer rally has left equity valuations looking stretched. The median U.S. stock now trades at a higher P/E ratio than even at the 2000 peak. The Shiller P/E ratio stands at 27, but would be 37 if profit margins over the preceding ten years had been what they were in the 1990s. The fact that interest rates are low gives stocks some support, but with the Fed likely to hike rates in December, that tailwind will begin to fade.

Lackluster earnings growth remains another concern. S&P 500 and economy-wide profit margins have rolled over. Granted, the collapse in profits in the energy sector has been the major culprit, and this headwind should wane if oil prices edge higher over the next 12 months, as we expect. Nevertheless, faster wage growth and a firm U.S. dollar will limit any recovery in margins. A Trump victory could also trigger a trade war, while a Clinton triumph could mean higher taxes and increased regulatory burdens. Both will be headwinds for the corporate sector.

Bottom Line: Our Global Investment Strategy service believes global equities are vulnerable to a near-term correction.