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The European banking sector restructuring continues By Antonis Vidakis* Over the last few years, the European Union (EU) has been struggling with the effects of the global recession, and the threats from the financial sector that have yet to be fully addressed. In large part, they reflected weaknesses in the public, household, and corporate sectors, but the banks themselves contributed to the problems as the financial sector constituted a feedback channel that reinforced negative tendencies elsewhere. 1 Banks have been found to be insolvent as the rate of Nonperforming Loans (NPLs) to the Total Loans has been increasing dramatically. The financial market is already in the process of restructuring albeit transparency and trustworthiness has not yet been fully recovered, especially in the countries under financial aid (e.g. Greece, Spain, Cyprus). While Europe’s troubled financial sector challenges the decision making of companies and investors, global weak economic conditions, such as the growth slowdown in emerging markets, remains a serious concern. Nevertheless, a financial collapse has been averted from the core Eurozone and 36 of the most important banks; However 8,000 other European banks have made little progress in restructuring. Funding remains a large challenge, especially for banks in the peripheral countries, where tax payer patience diminishes. Many such banks are heavily dependent on European Central Bank (ECB) funding (Cypriot banks are no exemption) with challenges on asset burden and collateral eligibility due to, for instance, rating downgrades, valuation effects on their collateral and overall loss of market confidence. The rising levels of NPLs are placing pressure on banking systems, especially in Central and South Eastern Europe (CSE) where NPLs rates are higher, and the failure to move to sustainable capital structures and business models means these might well go up further. The graph on the left-hand site below represents the growth path of NPLs from September 2007 to September 2012, from a sample of banks obtained from the European Banking Authority (EBA). The upward trend is quite clear. For comparison, the graph on the right-hand side presents the percentage of NPLs from the largest domestic banks and Cooperative Banks in Cyprus. As of September 2013, NPLs of domestic banks in Cyprus reached 46 percent of the gross loans, a rate in line with the PIMCO projections. An upward concerning trend as well. The one-third of the total NPLs is credited to corporate and SME loans in the construction and real estate sector. While the NPL ratio has been increasing, the profitability of the domestic banks has been declining; Bank of Cyprus reported losses of ₏1.8 billion through June 2013, and Hellenic Bank posted losses of ₏90 million through September 2013. 1 IMF (March 2013) European Union: Publication of Financial Sector Assessment Program: Technical Note on Progress with Bank Restructuring and Resolution in Europe

Source: IMF, Dec .2013

So what is out there to expect for the banking sector in EU? At the macro level, gradual and cautious decisions are likely through the EU’s incremental adjustments to the debt crisis, with avoidance of taxpayer burdening and continued low interest rates. While a bailout for countries like Slovenia and/or a revived bailout for Greece and Portugal seem likely with further mini-crises still possible, it seems that further bank bail-ins are expected, especially in tier-2 capital, to limit the direct burden on the taxpayer. A long-drawn-out process of change and restructuring is still to come in banking with up to $2.5 trillion left in deleveraging European banks. Management of NPL assets remains at the heart of the agenda, possibly allowing them to be picked up by Non-European banks and large private equity (PE) funds. Consolidation, capital raising and further pullback to core geographies and products will increasingly become evident. Regulation will remain the primary driver of reform for the foreseeable future. EU bank resolution tools need to be strengthened, while the legal framework should not

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slow down restructuring and maximize asset recovery. In addition to this, further development of the General Directorate for Competition’s (DG COMP) practices will be needed in systemic cases to ensure consistency with a country’s macro-financial framework and support viability of weak banks, recovery of market access, and credit provision. Increased transparency would give added credibility and accountability. In order to restore market confidence, disclosures should be significantly enhanced and harmonised by EBA. All things considered, the financial sector restructuring in EU would divide banks into winners and losers; while a few could become ‘too big to fail’, only local and regional specialists will survive.

Antonis Vidakis CFA ,CBA Valuation and Business Modelling Leader | Transaction Advisory Services (TAS), EY Cyrpus. Opinions presented are personal

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European banking restructuring