[Mark Gilbert] New reasons to worry about Europe’s banks

European banks have lost their mojo. A toxic combination of negative interest rates, comatose economies and a regulatory backdrop that might euphemistically be described as challenging is wreaking havoc with bank business models. Their collective market value has dropped by a quarter so far this year.

The smoke signals emanating from the European Central Bank in recent weeks suggest regulators aren’t blind to this. Daniele Nouy, who chairs the ECB’s bank supervisory board, said earlier this week that the central bank “is aware that the low-interest-rate environment is putting pressure on the profitability of European banks.” Regulators may respond by going easier when drafting new rules.

Bank-failure rules to prescribe how banks design their balance sheets to absorb potential losses may be eased, according to a European Commission discussion paper prepared last month. Meanwhile, a global panel of regulators will hold a meeting in London this month to let banks give additional feedback on proposed rules about how much capital they must set aside to back their trading activities.

This comes none too soon. The drop in industry capitalization, which reflects investor unease about future profitability, is rearranging the pecking order in European finance. Deutsche Bank, for example, was the most active manager of European bond sales in 2014 with a market share approaching 6.5 percent; last year it slipped to third, and so far this year it ranks fourth. At the end of 2015 the German lender was Europe’s 14th biggest bank; now it’s 20th.

Deutsche Bank chief executive John Cryan said last month that, burdened by restructuring and legal costs, he doesn’t expect his firm to be profitable this year. It’s far from the only one struggling; on Tuesday, Barclays warned that its first-quarter investment banking income will be worse than it was last year. In Italy, officials are scrambling to create a state-backed fund to prop up an industry burdened by more than 200 billion euros ($228 billion) of the 1.2 trillion euros of bad loans hampering the euro zone’s recovery.

No wonder ECB president Mario Draghi spent much of his press conference a month ago answering questions about the damage negative interest rates are doing to banks. They have to pay for the privilege of holding cash on deposit at the central bank, but can’t pass those costs onto their own depositors.

The current structure of the banking system is “unfeasible,” and 90 percent of the world’s banks will have disappeared in the next 20 years, Banco Bilbao Vizcaya Argentaria chairman Francisco Gonzalez said in an interview published by El Pais newspaper last week. Banks that can’t cover their cost of capital aren’t viable, making industry consolidation inevitable, he said.

The conundrum facing Europe is that regulators want to solve the too-big-to-fail problem -- and take revenge for the financial crisis -- by shrinking the banks. At the same time, they need the banks to be more active than ever to help resuscitate the economy.

A drop in market capitalization inhibits banking’s efficacy in serving the wishes of central banks. In a speech Thursday to an ECB conference, Hyun Song Shin, head of research at the Bank for International Settlements, said that while the function of the financial industry in macroeconomics is not well understood, it’s clear that the sector does play an important role:

“Having soundly capitalized banks turns out to be vital for the transmission of monetary policy, also. In this sense, bank capitalization ought to be a key concern for central banks in fulfilling their monetary policy mandate, as well as for their financial stability mandate.”

The growing regulator concern is sensible, if late. There’s no question that the financial crisis exposed the need for tighter regulations and higher capital standards, and that some trading activities come with unreasonable risks and are of no benefit to the wider economy. But unconventional monetary policies and a phalanx of new rules risk destroying the ability of banks to perform their basic role of taking deposits and funding commercial activity. As finance chiefs ponder what a healthy bank should look like, now is a good time for regulators to pause and ponder what kind of industry they want and need in the future.

By Mark Gilbert
Bloomberg

Mark Gilbert is a Bloomberg View columnist and a member of the Bloomberg View editorial board. He has worked at Bloomberg News since 1991, most recently as London bureau chief. He is the author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable.” -- Ed.