LEADIING VIEW: Andreas Dombret
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LEADIING VIEW: Andreas Dombret

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Less regulation is not answer to bank stocks volatility

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Over the course of the last 365 days, European bank stocks have been under massive pressure. While the overall European stock market, as represented by the Euro Stoxx 50 index, has more or less held steady, the Euro Stoxx Banks bank index has dropped by over 30%. This marked spread has fuelled rumours about the banking sector and even lead to comparisons with 2008. 

But in fact, the situation is markedly different: EU banks have strengthened their capital positions, which now stand at 15% on average, exceeding the aggregate tier one capital ratio prior to the crisis in early 2008 by six percentage points. The improved resilience of the EU banking sector is also reflected in the common equity to total assets ratio. Before the financial crisis, European banks held around 3.6% of unweighted common equity; today, the average is 5.5%. Also, the supervisory architecture in Europe has gained capacity through the far-reaching banking union.

So how can we explain market sentiment instead? The recent developments are less indicative of solvency issues and more a reflection of a decline in earnings prospects and a raft of structural challenges. And, furthermore, a closer look reveals that, to a significant extent, bank share decline can be explained by issues specific to certain banks.

Of the many factors influencing bank stock movements, uncertainty appears to be merely a minor element in the grand scheme of things. Volatility indicators have only recently decreased from their peak in July, which is certainly understandable given the outcome of the UK referendum in June. The vote to leave the EU was immediately followed by large price changes on financial markets, but did not trigger turmoil in the European financial system. Quite the contrary: the system proved its resilience to such shocks. In some cases, the consequences have been even less severe than expected by experts. The global outlook for growth, the situation in the emerging markets, and the interest rate turnaround in the US likewise seem to be manageable sources of uncertainty. Nevertheless, investors exhibit a lower risk appetite in uncertain times and therefore tend to steer their money towards banks with a lower risk profile.

Earnings prospects are probably a more robust explanation. For European banks, earnings per share forecasts have been in decline since the beginning of this year. Multiple structural factors have to be taken into account. Most prominently, the very low interest rate environment has been putting pressure on margins. Furthermore, nearly eight years after the financial crisis broke out in 2008, many banks in Europe continue to be plagued by large holdings of non-performing loans on their books.

To some degree, it seems as if global financial markets have given up European bank stocks — at least for the time being. But this sentiment will change again with a further strengthening of the European economy. Confidence in the European banking sector will grow again, and prospects of viable business models will return, partially also pursued by consolidation. Times will come when simply shorting European bank stocks will no longer be a promising strategy for earning fast money— but through solid investing. 

LOOPHOLES MENDED

While stronger regulation does indeed affect the profit and loss account of banks, tagging regulation as an impediment to earnings prospects is misleading and even hazardous. Although, in a global perspective, regulation is costly, it must be weighed against the benefits of a stable banking system. With respect to stock price movements, causes and effects have to be distinguished carefully. The financial crisis demonstrated that high stock prices may plummet if banks lack the ability to cover their risks.

Thus, regulation is actually a precondition for reliably assessing earnings. So it should be about time for those who repeatedly attack ongoing financial reform efforts as “over-regulation” and those who question banks’ fundamental stamina to approach one another on the subject of financial soundness indicators and to achieve some common sense. The legacy of regulatory and supervisory amendments is not meant to reach only regulatory offices in banks, but equally markets and investors. Regulation after the financial crisis was an arduous task for everyone involved. But it resulted in not only greater capital requirements but also higher quality capital instruments. Also, loopholes were mended. This is by and large what made regulation more complex than ever before.

From that perspective, especially considering the enhanced capital and liquidity buffers in the European banking system, the market movement seems over the top. Also supervisory reforms in Europe — a project of unmatched magnitude in financial supervision — aim at a more reliable and effective stability framework. They not only target confidence but also transparency regarding the financial sector in Europe. Stakeholders therefore should not spend too much of their time searching for as yet unknown threats as long as there are known challenges that need to be addressed. 

Andreas Dombret is a member of the Executive Board of the Deutsche Bundesbank with responsibility for banking and financial supervision, risk controlling and the Bundesbank’s representative offices abroad.

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