European Banks: Be Mindful of Risks in 2017

European banks seem to be on an upward trajectory – although improvements are likely to come at a slow pace and with some risks. For the time being, European bank CEOs will continue to look enviously at their counterparts across the Atlantic as US bankers enjoy an optimistic outlook on the possibilities of a stronger domestic economy, higher interest rates and some loosening of US financial regulation. Combined, these factors should increase bank profitability and dividends to shareholders.

European economies are looking slightly healthier than before:

  • GDP growth is gradually picking up, which is a bit surprising given the shocks in 2016 from the Brexit vote and the Italian referendum that caused the resignation of Prime Minister Renzi.
  • European government bond yields have picked up slightly from very low or negative levels .
  • However, short-term eurozone interest rates are likely to stay negative for the foreseeable future, which will continue to put pressure on bank profitability.

The best news from European banks is that Italy is finally shrinking its burden of non-performing loans (NPL). Italian banks currently have a worryingly-high 17.6% NPL ratio1, with most of the NPL dating from the 2008-2009 financial crisis. While the new inflow of NPL has been low, until recently Italian banks haven’t managed to reduce their NPL or build adequate reserves.

But now Italy’s second largest bank, Unicredit, is raising €13 billion from private investors. Its third-largest bank, Monte Dei Paschi, is being bailed out by the government. Both banks will be able to use the additional capital to help boost reserves and reduce the size of their NPLs. Unicredit has agreed to securitize €18 billion of its NPL to private equity companies, as part of its plan to reduce non-performing exposures from 15% to 8% of total by 2019.2

Outside Italy, large European banks are currently well capitalized after years of slowly rebuilding capital since the 2008-2009 crisis. In the 2016 European Central Bank (ECB) bank stress test, European Union banks reported aggregate capital ratios of 13%, up from 9% in the 2011 stress test which will ease the biggest vulnerability of European banks.