Banks in turmoil

Sector Focus

The scale of the derating among the western world's banks has been truly breathtaking. All US bank shares have tumbled in recent weeks with, for example, shares in Bank of America - the least well capitalised of the big US lenders - having dropped 26 per cent since the start of August.

France's banks have been hammered, too, with Société Générale having come under especially intense pressure. Its shares have slumped 30 per cent since 1 August, helped by wild rumours, vehemently denied by management, of imminent collapse. Bank shares across Europe have headed south - including those of UK, German, Spanish and Italian lenders. Regulators in France, Spain, Italy and Belgium have responded with a 15-day ban on short-selling shares in banks on those exchanges.

Spotting a clear catalyst for this bank sentiment crisis isn't easy, but one event stands out - the US debt rating downgrade. Certainly, the eurozone sovereign debt burden is a huge factor, but that has been festering for months. The unexpected emergence of a US debt crisis, however, may have been the final trigger that left bank shares as the hardest hit in the current market turmoil.

American nightmare

Given the importance of the US to the global economy, and banks' dependence on economic growth, the collapse in sentiment towards banks isn't entirely surprising. The US boasts the world's largest economy - demand there largely drives global growth, including in fast-growth Asian markets. When the US struggles, the world - and those that lend to it - struggle, too.

So news last month that first-quarter US economic growth had been revised down to just 0.4 per cent thoroughly spooked investors. Add in the spectacle of the White House and Congress sparring over setting a debt ceiling - risking default in the process - and the sense of crisis grew. Then came the seemingly unthinkable: rating agency Standard & Poor 's downgraded US long-term debt.

That decision could make US borrowing more expensive, worsening the debt problem and forcing tough austerity measures - further hampering the already feeble US recovery. And it's not clear that undertakings by Federal Reserve Bank chairman Ben Bernanke to keep interest rates "exceptionally low" until 2013, while possibly pursuing more quantitative easing, will be enough to avoid a recession. Goldman Sachs rates the chances of a US recession in the next six to nine months as one in three. Unfortunately, most of the world is likely to follow the US back into recession - meaning bad news for the world's banks, as bad debts rise and credit demand slides.

Eurozone misery

US problems might not have been enough alone to trigger this meltdown. When added to Europe's own debt crisis, however, sentiment towards the banks has slipped uncontrollably. European bank exposure to the sovereign debt of more troubled eurozone economies is certainly large. According to figures from the Bank for International Settlements (BIS), the German and French banks are exposed to a combined 41 per cent of all bank claims against the 'PIGS' nations (Portugal, Ireland, Greece and Spain). That's hurting individual lenders - Commerzbank , for instance, was forced to write-off €760m (£668m) against its Greek bonds in the second quarter.

And it's the absence of a solution that's the real worry. "US funds are very worried about knowing very little," remarked one UK-based banking analyst - leaving them unclear as to the counterparty risk their funds are exposed to. He adds that there's "very little faith in European politicians to sort it out".

Indeed, the sense that the situation is slipping uncontrollably appears partly responsible for the collapse in French bank shares after rumours circulated that France could also suffer a sovereign debt downgrade - even though all three main rating agencies denied this. "As long as EU peripheral debt issues remain in the headlines, despite the best efforts of the European Central Bank (ECB), banks are likely to remain a focal point for negative risk appetite," think analysts at Bank of America Merrill Lynch.

Healthier fundamentals

Ironically, individual banks look better placed to survive than they did during 2008's crisis. Capital ratios are more robust, for instance, and should strengthen further as bank regulators implement new Basel III capital rules. Credit quality, after 2009's recession, is firmly on the mend, too, with most banks reporting falling impairment charges.

But liquidity worries can't be ruled out. The cost of longer-term euro interbank funding is rising and rumours are circulating that some Asian banks are growing uncomfortable with their exposure to European lenders. Some Italian and French banks look particularly reliant on short-term funding and there's also evidence that European banks are increasingly turning to the European Central Bank (ECB) for funds.

Growing regulatory hurdles won't help sentiment, either. In the UK, next month's final report from the Independent Commission on Banking is expected to recommend ring-fencing retail and investment banking operations. That means uncertainty and possibly greater costs for banks such as Barclays or HSBC , which have big investment banking units. And, even though the Basel III process will leave banks better able to absorb shocks, bolstering capital means less funds to support lending and, ultimately, lower bank returns. The austerity measures being pursued around the world is bad news for credit demand, too.

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