European bank stocks were very weak on Friday. The catalyst was the fact that the U.S. Department of Justice wants Deutsche Bank to cough up a $14 billion fine, which is going to be rather difficult since the company only has a market cap of about $17 billion. But the problems go much deeper than one bank. The biggest issue is in Italy.
The FTSE Italian Bank Index tells the tale, down 53.9% over the past year as the chart below shows:
Italian banking has been in a crisis for at least eight months, although mainstream media did not recognize it until July. A spectacularly high level of non-performing loans (NPLs) is the problem. Only a dramatic improvement in the economy would make it possible to repay these loans and there is no conceivable way that is going to happen.
Since 2008, Italian banks have been waiting for an economic miracle or a bail-out, both of which never came. There has been no recognition of the damage from the Financial Crisis. The banks have been carrying loans classified as non-performing that were actually in default, discounting the NPLs rather than writing them off. Local regulators went along with the deception. Analysts estimate that as much as 17 percent of Italy’s loans will never be repaid, an amount that’s at least five times banking system capital. Attempts to recapitalize the banks have failed; private money has run the other way. Eventually, the NPLs will bankrupt the Italian banks.
The problem does not end at national boundaries. Italy is the fourth largest economy in Europe. Italian loans have been packaged and resold. Italian banks have taken loans from other European banks using Italian debt as collateral. George Friedman of Stratfor concludes that Italian banking could be the mother of all systemic financial threats. The only way to prevent this is a government bailout. The problem is that Italy is part of the Eurozone and as such, its ability to print its way out of the crisis is strictly limited. In addition, EU regulations make it impossible for national governments to bail out their banks.
The EU has a concept called a bail-in, which means the depositors and creditors of a failing bank lose their money first. This is what the EU imposed on Cyprus. In Cyprus, deposits greater than 100,000 euros ($111,000) were seized to cover Cypriot bank debts. While some of the money was returned, most was not.
The bail-in rule exists because Berlin doesn’t want to bail out the banking systems of other countries using German money. Anti-European sentiment in Germany is growing rapidly and the German government’s hands are tied. It cannot accept a Europe-wide deposit insurance system, as it would put German money at risk for the benefit of less responsible non-German banks and depositors. Nor will Germany permit overprinting of the euro. The Italians can only try to manage the problem by ignoring EU rules, which is what they are now doing. This is gridlock that rivals the U.S. congress.
So, here we sit, waiting for a major Italian bank to fail, followed by the threat of a bail-in to fund it. And that, dear reader, suggests the very real possibility of a bank-run. Why would you leave your money in the bank?
Below is what the leading ETF of European bank stocks looks like…a perfect picture of lower highs and lower lows since mid-2014. It’s enough to make a depositor want to keep some cash at home in a safe. Or maybe some physical gold?