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Banking on Europe

Europe is beginning to recover but many investors still fear European banks could derail the economy. Tim Rocks, Head of Market Research & Strategy, considers the challenges for European banks and support from policymakers.

A question of profit

European banks are struggling with profitability and this has been a key concern for investors. Two main themes have affected their profitability.

+ High numbers of non-performing loans (NPLs)

These are loans where repayments have not been made and the likelihood that the loan will be repaid in full is very low. Some European countries have a particularly large number of NPLs, for example in Italy NPLs account for 18% of all loans (Source: Datastream). This is a result of country-specific factors like Italy’s lengthy judicial processes, complex system of corporate restructuring and insolvency and a tax system that discouraged write-offs until recently. These have made it difficult for banks to sell on these loans.

+ Negative interest rates

The European Central Bank (ECB) moved its policy rates below zero in June 2014. While European banks have decreased the rates on loans, they have been unwilling to move interest rates on deposits below zero. This has made it harder to generate returns. On the positive side though, negative interest rates have increased the value of banks’ security holdings, lowered funding costs, raised credit quality and boosted loan volumes.

Still in the black

So while profit may be a challenge, European banks have actually improved their solvency levels in recent years. Overall, capital ratios (that is, the proportion of capital a bank holds compared to riskier holdings like loans) are actually higher for Europe than Australia or the US (Source: Datastream).

The banking sector is also being supported by policymakers.

+ Europe is in the process of relaxing bail-in rules (which forced bank investors like depositors to bail out the bank in a crisis by having part of their deposits written off). Italy is currently negotiating for a bail-out of its banks (where the State or another investor would support a company financially to prevent it from failing).

+ The Italian Government has implemented reforms aimed at speeding up bankruptcy and foreclosure proceedings, fostering bank provisioning and easing NPL disposals. Over the past year, Italy and the European Commission agreed on a mechanism that provides government guarantees for the securitisation of bad loans, while Italy’s largest banks created a fund to purchase non-investment grade tranches of NPL securitisations.

Although there are challenges for the banks, support from increased solvency and policymakers mean they are unlikely to derail recovery in Europe. As it continues its recovery, there may be growth opportunities for investors in European share markets with negative interest rates and low inflation continuing to support and encourage business investment and spending.

For more information on the impact of European banks on your investments, please contact your financial adviser.

This document has been created by Westpac Financial Services Limited (ABN 20 000 241 127, AFSL 233716). It provides an overview or summary only and it should not be considered a comprehensive statement on any matter or relied upon as such. This information has been prepared without taking account of your objectives, financial situation or needs. Because of this, you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation and needs. Projections given above are predicative in character. Whilst every effort has been taken to ensure that the assumptions on which the projections are based are reasonable, the projections may be based on incorrect assumptions or may not take into account known or unknown risks and uncertainties. The results ultimately achieved may differ materially from these projections. Information in this document that has been provided by third parties has not been independently verified and Westpac Financial Services Limited is not in any way responsible for such information. Past performance is not a reliable indicator of future performance.

Information current as at 10 August 2016. © Westpac Financial Services Limited 2016.

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