The Future of European Banks is extremely uncertain. Beaten down heavily after the financial crisis, the banking sector is one of the cheapest in the stock market. However, the interest rate hikes of the early 2020s could spur a recovery.
- 6 Reasons to be cautious about the future of European Banks
The banking sector was one of the top performers in the first decade of the 21st century, with growing profits and rising stock prices. However, the bankruptcy of Lehman Brothers in 2008 and the ensuing crisis would change things for the worse.
If we look at the Stoxx 600 Banks index, which tracks major European banks, we will realize that the number of stock within the index declined from 67 in 2007 to 40 in 2020.
This index is composed of international banks such as HSBC, Barclays, BNP Paribas, Credit Agricole, Deutsche Bank, Commerzbank, UBS, Credit Suisse, Santander, BBVA, Caixabank, and Dankse Bank.
The Stoxx 600 Banks index reached its highest level on April 20th, 2007, at 541.27 points. It then started a long phase of declining prices which culminated in an accumulated crash of almost 85%. If we take only those banks in the Eurozone, the drawdown was close to 90%.
Valuations are extremely low, with the index’s price-to-book ratio at around 0.5. This means the market is only willing to pay 50% of the value at which their assets are booked. Similarly, its dividend yield is surprisingly high.
While we could quickly conclude that such valuations mean that we should be investing in these stocks, the question remains as to what the future of European banks is. There are many reasons to be cautious about it:
6 Reasons to be cautious about the future of European Banks
1) Low Interest Rates
While negative interest rates seem to be a thing of the past, there is no doubt they caused massive damage to the profitability of the European banking sector.
The official reason for negative interest rate policy was to encourage banks to lend money to businesses and households, and therefore stimulate the economy. However, it turned out to be a means for European government to go further into debt without having to worry about getting financing.
This led to banks missing out on a stable source of profits, that is, arbitraging being savers and borrowers. Because negative interest rates were very difficult to pass on to savers, banks ended up losing money for holdings savers’ cash.
Additionally, those policies led to a flat interest rate curve, which meant banks were no longer able to profit from borrowing short-term money from savers and making long-term loans to borrowers.
While the interest rate increases of 2022 and 2023 have put an end to negative interest rates, it will take time for European banks to adjust to the future realities of the market.
2) Aging Population
A bank’s main business is to make loans. Whenever businesses or households want to finance an investment or a purchase, they can go to a bank and ask for credit.
Thanks to that, a bank can make a new loan and get paid interest for that. As long as the borrower does not default, that loan will lead to bank profits. Therefore, we should ask ourselves what segment of the population borrows the most.
It turns out it is people aged 30-50 who tend to borrow the most. These people want to finance the purchase of homes, home renovations, cars, holidays, and a long etcetera. Additionally, these people tend to start businesses, increasing demand for business credit.
However, the European population is aging at a rapid pace. The number of people within this age group is shrinking dramatically and will further shrink in the coming decades. This means the demand for loans in the future will decrease, and that is likely to negatively affect the profitability of European banks.
3) High Debt Levels
Europe’s economies are highly indebted. If we add up the debts of governments, households and corporations, we will realize that the ratio between total debt and GDP hovers around 300% in most countries. That trend has been going up since the early 1980s as interest rates have been going down, and the economy has become more financialized.
One of the consequences of having a very indebted society is that the appetite for new debt is much lower. Companies and families do not want to be in debt forever. After all, debt comes at a cost in the form of interest payments and financial risk.
In fact, it is likely that, in aggregate, corporations and households would prefer to pay debt back. This will lead to a reduction in the banking sector’s assets and, consequently, fewer income sources.
4) Little Credit Demand from Creditworthy Borrowers
Related to the two previous points is the fact that there is very little demand for credit from solvent borrowers nowadays. Younger generations in Europe tend to have a more precarious financial situation than their parents, with lower incomes and less assets.
As a result, the pool of solvent borrowers is much smaller. As an example, the following chart from Idealista, prepared with data from the Spanish INE, shows the number of mortgages granted in Spain over the last couple of decades:
5) Competition from Fintech Companies
Technological advances have made it possible to add competition and transparency to the market. Over the last few years, many technology companies have started to compete with traditional financial institutions for a share of their market share. This sector is often referred to as fintech, because they offer financial services in combination with technology.
These services are very varied. They include simple products such as bank accounts, multi-currency accounts, the ability to buy and sell foreign currencies at low cost at any time, and even the option to invest in stocks, gold or cryptocurrencies. This can all be done from our cell phone.
In addition, fintech companies usually provide better customer experience, making it difficult for banks to compete.
This has led to significant losses for banks in terms of revenue sources. Many of these services tended to be high-margin and low-cost, which is why competition has been fierce.
6) Financial Regulation
Finally, we should touch on the increasing levels of financial regulation which have been put in place for the European banking sector. While new regulations aim to ensure that banks have sufficient capital to withstand adverse macroeconomic and financial conditions, they lead to a decline in profitability.
On the one hand, higher levels of capital mean more capital has to be used to generate the same return. At some point, it becomes uneconomical to pursue certain business opportunities. On the other hand, the cost of complying with such regulations is significant.
One of the reasons why the number of banks in Europe has decreased so much since 2008 has been the increasing costs associated with running a bank business.
As you can see, there are many reasons to be cautious about the future of European banks. While recent interest rate hikes could be the beginning of a new era, the experience of Japanese banks since the end of the Japanese financial bubble can be used as a warning.
As investors, it is important to consider that market pricing is often one of the best metrics to understand the state of the economy or of a specific sector. Cheap valuations often imply significant risks.
Finally, we can ask ourselves how the future of European banks is likely to affect the economy. Banks are very important for the economy. The channeling of credit toward productive endeveaurs creates jobs and innovation, leading ultimately to a higher standard of living.
A weak and smaller banking sector will make the corporate sector less competitive, lead to lower economic growth, and more inequality. It is therefore important to have the proper environment to encourage banks to grow and do well.
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