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EUROPE BANKS WEAKER THAN WAS THOUGHT

JANE FOLEY<br /><strong>RESEARCH DIRECTOR, FOREX.COM</strong><br />THE American banking sector once again hogged the headlines last week, when 10 of the 19 banks that borrowed money from the US government under the Tarp plan were authorised to pay back a combined $68bn. The US government was quick to make the point that it (meaning the taxpayer and the electorate) has turned a profit as a result of the Tarp arrangements.<br /><br />The banks that have freed themselves will be untied from the stigma associated with government funds and relieved that they will no longer be subjected to strict rules on employee compensation, though they will not escape broad-based pay reform. On the surface this appears to be a happy ending, but in all likelihood the banks have only just cleared a large hurdle in what is likely to be a long and rocky process in moving to a more robust and efficient banking sector.<br /><br />The attitude towards banks in Europe has not been so positive. There has been an increased nervousness about potential bad news emerging, and this is one of the reasons that the euro failed to make ground this week. Less than two months ago the IMF warned that US and European banks needed to raise $875bn in equity by 2010 to return to levels similar to the years before the financial crisis and twice that amount to return to the levels that existed in the mid 1990s. Despite the progress made by some major banks this year, the persistence of recessionary conditions suggests that many banks will struggle.<br /><br />The US is still home to 8,000 banks, a number that suggests that a period of consolidation in the sector is inevitable. While the story of the US banking sector&rsquo;s rebuilding is set to rattle on for months, if not years, perhaps the more interesting story this summer will be the fate of the Eurozone banks, specifically Germany&rsquo;s.<br /><br /><strong>LARGE EXPOSURE</strong><br />Eurozone banks did not have the large exposure to US sub-prime debt that undermined US and UK banks at the start and height of the financial crisis. However, recessionary conditions mean that bad debts are rising closer to home. The IMF estimated in April that Eurozone banks would face $750bn in write-downs relative to $550bn in the US. Last week, the Daily Telegraph reported Dejan Krusec, the ECB&rsquo;s financial stability expert, as warning that Eurozone banks are only strong enough to weather a V-shaped recovery. Despite evidence in many countries that the downturn may be bottoming, there is a strong probability of a U shaped recovery and indeed there are no guarantees that conditions will not deteriorate again before growth rates return to trend. Last week the Fed&rsquo;s Beige Book &ndash; which lays the groundwork for the June Federal Open Market Committee (FOMC), the group which sets interest rates in the US &ndash; suggested that economic conditions remained weak or deteriorated further between mid-April and through May in 12 districts.<br /><br /><strong>V-SHAPED</strong><br />The Reserve Bank of Australia and the Reserve Bank of New Zealand have both recently warned that rates could go lower, while the European Central Bank has been keen to emphasise that the current 1.0 per cent on rates may not be the floor. By and large G10 central banks remain very cautious, implying the continuation of loose monetary conditions well into 2010 and also implying that central bankers in general do not subscribe to the view that the recovery will be V-shaped.<br /><br />Germany is an export led economy, meaning that its economic performance is tied to consumption rates of other countries (not an attractive feature in a global downturn). The German government estimates that its economy will contract by 6.0 per cent this year. The Economist Intelligence Unit is a little kinder with a forecast of -5.5 per cent, but this compares with a US forecast of -2.8 per cent.<br /><br />Clearly, the extent of the bad news that will come out of the banks in the coming months is uncertain, perhaps all the more so because the German government may have an interest in holding back transparency at least until after the September general election. The US dollar is laced with its fair share of negative factors (in particular the issue of financing linked to the surging budget deficit), but with the US likely to benefit from earlier signs of economic stabilisation, the combination of economic weakness and an inefficient banking sector in Germany suggests it could be the Euro that suffers more from bad news this summer.<br /><br />Please send questions or comments to ResearchEmea@forex.com