2016 Stress Test Results. Sources: Bloomberg, EBA

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1 August 5, 2016 Global Economic Research 50 South LaSalle Chicago, Illinois northerntrust.com Carl R. Tannenbaum Chief Economist Asha G. Bangalore Economist Joanna Williams-Lock Vice President, CRM 44 (0) Egill Almar Agustsson Second Vice President, CRM 44 (0) Looking Beyond European Bank Test Result Italy s Banking Troubles Solid U.S. Employment Report The European Banking Authority (EBA) published the latest health check on European banks last Friday. The report did not trigger alarm bells, and a vast majority of banks had adequate capital to withstand macroeconomic shocks. But European banks stocks fared poorly earlier this week, suggesting that investors trust in the banking sector had not been restored by the stress test results. These contradictory events leave us wondering if there is more to read between the lines. A total of 51 banks took part, 37 from euro-area countries and 14 from Denmark, Hungary, Norway, Poland, Sweden and the United Kingdom. The sample was designed to cover 7 of the banking sector in these countries, and took banks with total assets of more than 30 billion. This time there was no Pass/Fail threshold; the test was designed to focus on banks forward-looking capital planning. Instead it allowed a simple comparison with the group s average ratio. Participating banks were subjected to a scenario that included a sudden rise in global bond yields, amplified by low secondary-market liquidity, weak profitability prospects for banks in a low nominal growth environment, rising debt sustainability concerns, and prospective stress in the shadow banking sector. Real gross domestic product (GDP) growth rates over the three years of the exercise were estimated as 1.2%, 1.3% and 0.7%, respectively. The stress test s objective was to determine whether banks had adequate capital as the hypothetical scenario evolved. The EBA s report broadly suggested that European banks were in a stronger position today than the test held in the fall of Banks started the adverse scenario, on average, with a 12.6% capital ratio and ended it with 9.2%. The chart below indicates how banks across major economies fared, with Austrian, Italian and Irish banks as the weakest Stress Test Results Average capital ratio in stress test (%) Average capital ratio lost in stress test (%) Sources: Bloomberg, EBA

2 All banks, excluding Monte dei Paschi of Italy and Allied Irish, had capital ratios above the last stress test s 5.5% threshold. Monte dei Paschi was the only bank with a negative capital ratio, implying that it would go bankrupt under severe stress. To reassure markets, the bank announced a fresh infusion of capital prior to the EBA s announcement. The report was published after markets closed on July 29. The appetite for bank stocks evaporated and they fell 7.5% during the next two trading days. The outcome of the Brexit referendum had intensified investor fears about European banks and lowered bank stock prices. This trend continued after the stress test results. There is a great deal of uncertainty in the marketplace, with geopolitical developments adding to the list of worries about European banks. In his last press conference, Mario Draghi, president of European Central Bank (ECB), outlined the importance of banks in the eurozone. As a bank-based economy, a significant part of the eurozone s credit intermediation takes place through banks. Draghi noted that if bank equity prices continue to decline, the cost of capital would increase. In turn, the net return on lending would suffer and bankers would adopt a conservative lending strategy. If this chain of events prevails, the transmission of the central bank s easy monetary policy would be less successful. Bank lending in the eurozone has yet to gather pace comparable to the period before the financial crisis. Europe: Equity Prices 15% Eurozone Lending Trend The lending outlook is tied to bank fundamentals. -5% -1-15% Year-to-date 8/1-8/2 12% 9% 6% -2 3% -25% -3-3% -35% Euro Stoxx 600 Bank Index Euro Stoxx 600 Index -6% The stress test results confirm that European banks are solvent and are in a better position than in The key to bank lending now is not solvency, but bank profitability. There are important hurdles in Europe holding back profit growth. The ECB s negative deposit rate and the overall low interest rates trim net interest income. Bankers have passed on costs of negative rates to only a select set of customers. Monetary policy is expected to remain accommodative for a while. In other words, low growth and low interest rates lead to a gradual erosion of bank profits. 2 Sources: Bloomberg, Haver Analytics

3 Analysts estimate that about three quarters of bad loans are corporate loans. The European Union (EU) average of nonperforming loans (NPLs), at 5.9% as of late last year, is far above that of other major economies. The World Bank placed NPLs in Japan and the United States at less than 2%. NPLs restrain bank resources; banks with high NPLs face higher funding costs and margin pressure. Draghi outlined a plan to address Europe s NPL challenge at the last press conference. Until these plans are executed, investor interest in European banks stock is likely to be weak. New EU rules that entail shareholders and depositors taking losses before taxpayers can rescue banks also are contributing to pessimism about EU bank stocks. So while stress test results are useful guides to European bank stability, they aren t enough for investors to view European banks in positive light. The year-to-date stock price trends of European banks points to a bearish view about this sector. On the other hand, economic growth continues to advance in the eurozone, which suggests a low likelihood for loans turning bad. Therefore, the slump in bank stocks is not a signal of a wider economic malaise, but is confined only to the banking sector. Italy is the only major problematic center (see comment on Italian banking below). It remains to be seen if this less worrisome view holds in the months ahead. Some European bank stocks turned around mid-week as their earnings numbers showed progress. The Euro Stoxx bank index gained a bit of ground during the latter part of the week. Despite these developments, the unease about European banks will not fade in the near term as their potential earnings trajectory is weak and a sustained turnaround could be difficult. Italian Banks Need Fresh Capital to Support Economic Recovery The financial crisis and years of economic underperformance in Italy have reduced the ability of households and businesses to service debt, which has left the banking system in dire straits. A quick resolution is unlikely for these long-standing problems. The country s $4.9 trillion banking system is burdened by a vast amount of nonperforming loans. The bad debts add up to perhaps $400 billion, 45% of which banks have already written off. This leaves $220 billion of bad debt in a country with a $2 trillion economy. Italian bankers would contend that they are constrained in their capacity to timely collect underlying collateral by Italian law, which provides for an extremely long and tedious recovery process. While the banks eventually will be able to collect the underlying collateral, which can then be used to cover a portion of the bad debts, the market is suggesting that the Italians are underestimating their need for new capital. An Italian bank was the only one that was left with a negative capital ratio as per the EBA stress test. Italian banks are hampered in their lending capacity by balance sheets filled with bad debt that consumes capital, be it human or monetary, leaving little room to use either for new lending. Consequently, the overhang of bad debts is not just a theoretical balance sheet problem, but a very serious impediment to a broad-based economic recovery. Despite years of unprecedented loose monetary policy in the eurozone, credit conditions have been tight in Italy. From 2011 to the end of 2015, Italy had a wide spread in the rates being 3

4 offered on new bank loans compared with France or Germany. French and German borrowers are seeing rates that were upward of 2% lower than their Italian counterparts. While recent ECB policies have drastically reduced the spread, new lending to businesses remains lackluster. 2 Banks: Problem Loans Germany France Italy Typical Interest Rates to Businesses Solutions for problem loans are critical for fixing the Italian banking system. As a Percent of Gross Customer Loans 15% 1 5% Sources: SNL, Oxford Economics, ECB With a debt-to-gdp ratio of 132% and high NPLs, the Italian government is not in a strong position to provide a capital injection and its existing bank-backed (private) rescue fund is largely used up. In addition, eurozone rules say banks cannot be bailed out by the state unless their bondholders take losses first. Bailing in bondholders is an unusually contentious issue in Italy because retail investors hold more than $230 billion in bank bonds. Italy s prime minister Matteo Renzi noted he would like to provide a capital injection to the system to restore confidence, strengthen balance sheets and boost lending. To do this, he would need to convince the rest of the eurozone that no other option exists, finding a compromise that can at once follow and bypass the rules. Renzi has also floated the idea of bailing out the banks without regard for what the rest of the eurozone thinks. Renzi may have an ally in his fellow countryman, ECB President Draghi, who backed a public bailout of Italy s banks in his latest ECB press conference, citing the exceptional circumstances. Italy is perhaps the most extreme example of a weak banking system constraining the eurozone, but it is a weak system that is, as of yet, unable to support a full and broad-based economic recovery. Renzi is right to point out that bold action is needed across the eurozone. The U.S. Employment Report: As Good as it Gets The headlines and details of the July employment report paint a picture of strength. Concerns of weakness in hiring seen in May are dispelled with two consecutive months of meaningful gains in hiring. The unemployment rate held steady at 4.9% in July. The participation rate increased as 420,000 entered the labor force. On net, this number captures a return of discouraged workers and retiring baby boomers. It is worthwhile to note that the share of discouraged workers (based on 4

5 the percent of those would like to work but are not in the labor force) is not very different from the average that prevailed in the last expansion. Unemployment Trends Nonfarm Payrolls Monthly Change 3-Month Moving Average Percent 8 6 Thousands Unemployment Rate Currently Want a Job/Not in the Labor Force Source: Haver Analytics Nonfarm payrolls increased 255,000 in July, taking the three-month average to 190,000 versus 118,000 in May. There were minor upwards revisions to estimates of May and June payrolls, adding 18,000 more jobs. Hiring was widespread in July, with both the goods and service sectors adding to the overall improvement in payrolls. The highlights of the gains in employment are: factory (+9,000), construction (+14,000), retail (+14,700), health care (+43,200) and government (+38,000). The payrolls diffusion index, which stands for percentage of industries with rising employment, increased to 63.7% the highest since early The workweek was longer in July (34.5 hours, up a tenth). Hourly earnings increased 8 cents to $25.69, putting the year-to-year change at 2.6%. This represents a mild upward trend from 2.3% in July 2015 and 2.5% at the beginning of this year. The nature of today s employment report raises the odds of monetary policy tightening and it has reduced the near-term risk of a significant downswing in economic activity. Earlier in the week, President Dudley of the New York Federal Reserve Bank noted that Brexit-related developments need to be monitored. The Bank of England s comprehensive package to mitigate risks from Brexit addresses this concern. But, global headwinds remain worrisome, which makes a rate increase in December more likely than September. 5