European Banking Crisis Season 2 Is At Hand

Series: Global Financial Crisis Act II

With Brexit serving as the catalyst, Season 2 of the European banking crisis may be about to unfold.

The commercial break at the close of the opening act of the global financial crisis in 2008 is finished. Here comes Act 2 with the globe’s most risky bank as featured guest.

Part 2 of the series describes the sequence of a typical bank failure and explores the list of options available to Deutsche Bank and the likely outcomes.

What was the most significant global financial news which took place in the past week?

Your most likely answer is Brexit and the financial market turmoil which resulted in the immediate aftermath of the triumphant Leave vote and its subsequent recovery. If that indeed is your answer, you can be forgiven for missing something which is far more immediate and impactful – an evolving event which was scantly, if at all, covered by the vast majority of the corporate media.

Granted, the short to intermediate term uncertainties Brexit brings to the UK is significant, and more importantly, the implication of Brexit putting into motion the centrifugal force pulling apart a failed experiment otherwise known as the EU is even more far-reaching.

But those are problems for another day. There is clear and present danger which is happening right here and now.

In case you missed it, the EU and Italy, under the cover of chaos and confusion within hours of the Brexit victory, are scrambling and fighting to cobble together a scheme to bail out the Italian banking system – without calling it a bail-out – before it turns into full blown European Banking Crisis Season 2.

Before getting into the nuts and bolts of the Italian dilemma, here’s Italy’s banking system as it stands.

  • The bad loan problems which existed during the 2008 global financial crisis and the subsequent sovereign debt crisis never went away and, if anything, have gotten worse since. Depending on who and what day you ask, the banking sector is saddled with between €200 billion and €360 billion of non-performing loans (NPL). That’s four times the size of their bad loans back in 2008. And the aggregate common equity among Italian publicly-listed banks: €125bn.
  • 17% of all loans are sour. For comparison purposes, at the height of the global financial crisis, the bad loans in the US stood at 5%. As with the bad loans in Spain, the amount of NPLs continues to escalate.
  • One way to understand the banking crisis there is through the lens of the Texas ratio, which measures the amount of non-performing assets and loans (including loans delinquent for more than 90 days) divided by the bank’s tangible equity plus its loan loss reserve. Courtesy of ZeroHedge (link), 7 out of the 47 banks in the Euro STOXX 600 Banks Index are currently above the 100% threshold with three of those being Italian banks. But just below the threshold two Italian banks – UniCredit and Intesa – follow, showing the magnitude of the Italian banking crisis.


Texas ratios

Texas ratio of European banks. 100 or higher means bad loans exceed bank’s tangible equity.

  • Ordinary Italians buy significant amounts of bank shares and bonds as part of their retirement savings, and own roughly a third of Italian banks’ debt. Last year, more than 100,000 investors in four small banks saw their savings wiped out when the banks were wound up and creditors got bailed in. When an Italian bank collapses, it is not only foreign investors and hedge funds who get burnt. Just about every grandmother will be affected. The impact will go deep into the lowest rungs of the Italian society.

The newly enacted bail-in regime across the EU in 2016 stipulates that shareholders and creditors (read bondholders and depositors) would be bailed in to resolve a failed bank before public money is used.  The rules further disallow a sovereign government from using taxpayers’ money (i.e. issuing more debt) to bail out its domestic banks.

Which makes this ZeroHedge assessment (link), made as far back as 2013, as it relates to NPLs and bail-in induced haircuts for European banks in general, all the more relevant.

the bottom line is that at its core, it is all simply a bad-debt problem, and the more the bad debt, the greater the ultimate liability impairments become, including deposits. As we answered at the time – the real question in Europe is: how much impairment capacity is there in the various European nations before deposits have to be haircut? With Periphery non-performing loans totaling EUR 720bn across the whole of the Euro area in 2012 and EUR 500bn of which were with Peripheral banks, it seems the Cyprus deposit haircut non-template may indeed become the key template.

Earlier this year, the Renzi was given the go-ahead to set up a bad bank (similar to what they did in Spain and Portugal) in which to bury some of the most toxic financial waste (link), in what amounts to a €5bn Band-Aid applied to a €360bn gushing wound. Needless to say, the scheme did not fly and they did not take long to find out, either.

Unfolding Crisis

As evident from the above factoids, the banking crisis in Italy is long in coming, and Brexit is merely a catalytic event which shifted the simmering pot of troubles back to the front burner and brings the burning fuse into sharp focus.

In the immediate aftermath of and two days following the Brexit vote, the bank shares across all of Europe got totally clobbered. Among the carnage:

Shares in Italy’s two largest banks Intesa Sanpaolo and UniCredit, closed down almost 23% and almost 24%, respectively, within 24 hours of the Brexit vote. Italian bank shares are down 56% this year alone.

Monte Paschi, Italy’s third largest bank, lost 45% since Brexit. Its credit default swap (CDS) is implying a 60% probability of default.

Sensing imminent danger of a full blown banking crisis and sector-wide bank run, the Renzi government is tussling with the ECB to make use of ‘extraordinary circumstances’ caused by Brexit to suspend the newly enacted banking rules and inject emergency capital to resuscitate the failing banking sector – the latest scheme calls for an injection of €40bn in direct capital and €150bn in government guarantees into the banking sector.

In the face of opposition to such a rule bending scheme from the ECB and Germany, the Renzi government is threatening to do it unilaterally and act on its own if it does not get the ECB green light. Whether the ECB or Italy will fold remains to be seen. But the bail-in regime, introduced by the ECB forcing depositors to rescue failed banks, might backfire and unleash the mother of bank runs not only in Italy but also the rest of the European periphery.

Elsewhere in Europe

Italy’s banking woes are by no means an isolated case. Rather, it is the norm across Europe and Italy just happens to be the sickest of the patients. Since the ECB’s foray into negative interest rate and doubling down on QE in July 2015, the stock market, and especially bank stocks, started to sell off instead of the usual Pavlovian exuberance. The Brexit shock merely accelerated the downtrend.

For example, major investment bank Credit Suisse has lost 63% of its value since last July and smashed multi-decade lows.


Credit Suisse

Credit Suisse hits multi-decade lows (source: ZeroHedge)


But the scariest one of all has to go Deutsche Bank, deemed the most ‘global systemically important bank’ (GSIB, a euphemism for too-big-to-fail) in Europe. Having lost 48% of its value since last July, its stocks, at €11 plus change as of this writing and heading towards single digit just about any day now, follow an eerily similar trajectory as Lehman in its final days.

Deutsche Bank

Deutsche Bank stock price chart vs LEH


So why should you care if you don’t own Deutsche shares and do not bank there?

Because of its derivatives books.

At $75 trillion (yes, that’s trillion with a T), it’s 20 times Germany’s GDP and 5 times bigger than the entire output of the Eurozone. As the following oh-what-a-tangled-web-we-weave chart shows, courtesy of the IMF, the linkages among these banks through derivatives and other counter-party arrangements reach wide and deep. Should this sucker ever wobbles, the derivative time bomb will set off a tsunami of cascading failures which would make 2008 feel like a walk in the park. (see Bail-in at your local bank Part 2: the derivatives time bomb for a refresher on derivatives)

DB interconnect

Should you worry?

Remember the First Rules of Panic:

Rule #1.      Do not panic.

Rule #2.      If you have to panic, panic before everyone else does.

Monetary reset

This article is part of the Monetary reset in-depth topic. Get a crash course and read the latest developments on this topic.


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