In 2007 the global financial system collapsed, leading to the bankruptcy of several major firms and triggering the Great Recession. Now, eight years later, the major banks of Europe still carry a staggering $1.2 trillion in worthless loans. Lackluster economic growth has led to a situation where banks are unable to unload these toxic assets.
Profitability in this sector remains at recession levels.
Challenges Facing the Sector
Regulation adds another element to the woes of the European banking sector. The Basel IV, a stricter set of rules adopted after the recession, is expected to make it even harder for the banks to profit. The regulation adds 0.5 percent to the cost of funding in an industry where every basis point can mean millions in lost revenue. Challenges also come from the growth of non-performing loans (NPLs) on bank balances sheets; these have gone from 1.5 percent to 5 percent and may go further still.
Compared to banks in the United States and Canada, European banks are uniquely unprofitable. The cost of capital in the sector is over 10 percent while return on equity can fall below 1 percent. Net interest margins (NIM) average only 1.2 percent – less than half the NIM in the U.S.
Deutsche Bank Controversy
The plight of the European banking system is not helped by controversy and litigation; this is another significant risk faced by the sector. The controversy with Deutsche Bank and the United States Department of Justice (DOJ), highlights these concerns.
The bank was ordered to pay $14 billion in fines for its role in selling mortgage-backed securities during the financial crisis.
Other European banks have had similar problems. This includes RBS, UBS, Credit Suisse, HSBC and Barclays; they are pending settlement numbers. Many U.S banks have also seen litigation, the most severe of which targeted Bank of America - the firm paid a staggering $16.7 billion. Deutsche Bank’s legal team claims the case can settle at under $3 billion – it is unlikely they will get their way.
All of these constant pressures have had negative impacts on the stock prices of European banks. Deutsche Bank’s stock is pictured below.
Weakness in the European banking system reflects - and causes- lackluster economic growth on the continent. The industry has been unable to escape the shadows of the Great Recession in 2007. If the problem continues at this rate or gets worse, it could result in the weakening of the euro and pound vs other currencies.
Dollar strength is bearish for gold; however, weakness in the Eurozone may delay the U.S Federal Reserve from raising interest rates – the fear of which has been suppressing gold prices for the fourth quarter of 2016. As for physical gold, the market remains as strong as ever for European investors who want to preserve purchasing power in the midst of weak economies and dovish ECB policies.