Country risk: The safest and riskiest European banking sectors


Jeremy Weltman
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Bank stability has deteriorated this year in 15 European countries, improved in 13 and is unchanged for nine, according to Euromoney Country Risk

Five years on from the first eruptions of the global financial crisis – and as policymakers ponder the role of a new European banking union and financial system regulator – bank stability remains a key concern for risk managers, not only in the eurozone but right across Europe.

A mid-year annual assessment by the European Banking Authority, Report on risks and vulnerabilities of the European banking system 2012, notes: “The situation remains extremely fragile with increasing uncertainty on asset quality, funding capacity and concerns over the possibility of extreme events. Banks and supervisors are considering and putting in place relevant emergency actions as a rapid deterioration of events could lead to further significant change in the banking landscape.”

However, based on the latest, November, bank-stability scores from Euromoney’s Country Risk Survey (one of 15 economic, political and structural risk factors constituting the overall risk score), considerable variation exists in perceptions of bank stability. Some countries are still showing worrisome fault lines, while others are becoming more stable, according to economists and country-risk experts.

The indicator seeks to assess banking system strength, where 10 would indicate a perfectly functioning system with all possible exposures comfortably covered and zero a complete breakdown in the banking system. 

Wide variation in bank risk

Presently, 4.4 points separate the top 10 countries from the worst 10 when comparing the average bank stability scores between each group. Norway, with its comparatively low-risk banking sector, commands a score of 8.6 out of 10, and remains just above the other four countries perceived to be similarly safe (with scores of 8 or above). They are Finland, Switzerland, Sweden and Luxembourg, which head a list of European countries in ECR’s survey.
Norway’s banks might be still vulnerable, perhaps to a bursting of the credit boom, but were less exposed than those in some other European countries to syndicated financial products during the global financial crisis, and remain to this day well regulated and profitable as a result of a strong economy and risk-averse management practices.

The Norwegian bank-stability indicator is 6.1 points better than either Bosnia-Herzegovina’s or Montenegro’s – the two worst performers in the European segment of ECR’s survey, on scores of just 2.5 out of 10 each. Their underdeveloped financial systems might be as much to blame as credit-supply constraints and contagion fears.

Similar arguments of robustness can be made about Swiss, Swedish and Finnish banks, and even those in Luxembourg, despite the latter country being at the heart of the eurozone.

Wealthy private banks and low sovereign exposures help to minimize the Grand Duchy’s risks, which mostly stem from cross-border ownership structures. The failures of Icelandic bank subsidiaries and the problems incurred by Dexia and Fortis highlighted the vulnerabilities in Luxembourg-based banking during the crisis, but a resilient housing market and only moderate household debts minimized the reverberations in domestic credit markets.

And note, too, the comparative strengths of the banking sectors in the Czech Republic, Slovakia and Poland. These countries are vulnerable to a deepening of the eurozone crisis; their economies are unavoidably contracting as a result. However, they have also corrected excessive fiscal vulnerabilities and current-account imbalances by implementing tough austerity programmes more rapidly than in the distressed eurozone sovereigns.

Miroslav Frayer, an economist at Komercni Banka, says: “The situation in the banking sectors of the Czech Republic and Slovakia is much better than in many of the core eurozone countries, largely due to low loan-to-deposit ratios, meaning the banks in these countries are not dependent on external financing as they have enough internal sources for their lending activities.” 

How has bank-stability risk altered?

However, while current scores are extremely useful for assessing the relative strengths of the region’s banking sectors, they say little about changing risk perceptions, which can only be obtained from historical comparisons.

Looking first at the trend so far last year, three distinct groups emerge: a total of 13 European countries registered improved scores in 2012, 15 have deteriorated and nine show no change.

Among the risers – surprisingly perhaps – are Portugal and Italy, but only a modest improvement is evident. With the countries on scores of 4.3 and 5.5, respectively, risk experts still harbour deep-seated concerns about their financial-system health. Albania also stands out. Its bank-stability score had fallen to just 3.6 out of 10 by January – highlighting links to Greece as well as the spread of banking-sector contagion from west to east – but had recovered to 4.6 by the end of last year.

Careful interpretation

Albania’s bounce might be partly linked to a $30 billion central and southeastern Europe action plan, agreed jointly by the European Investment Bank, the European Bank for Reconstruction and Development and the World Bank, to underpin credit expansion. That might also help to explain the improvements in bank-stability scores for Latvia, Lithuania and Croatia, three other improvers since January 2012 – and ultimately the resilience of the Czech Republic, Slovakia and Poland.

However, absolute scores still need to be taken into consideration. Despite these evident improvements, Albania has the 11th-riskiest banking sector in Europe, according to ECR experts. Croatia and Latvia each have scores that are still below 6 out of 10 – hardly a measure of safety – and Lithuania, the best performing of those four, on a score of 6.6, is sandwiched between France (on 6.4) and Denmark (6.7), both of which have had their fair share of banking-sector problems lately.

Danish defaults yield sector consolidation

The scores of Denmark and France for the bank-stability indicator have fallen by 1.3 points each since January 2012, as confidence in the robustness of their respective financial systems has declined. The problems in Denmark have been evident for some time and have also led to bank credit-rating downgrades, most recently to Danske Bank – the country’s largest – by Standard & Poor’s and Moody’s in May 2012, as well as lower ratings for other, smaller lenders. This has occurred in spite of Denmark’s perceived fiscal strengths underpinning an unchanged triple-A sovereign rating.

Danish banks are vulnerable to weak economic growth and contagion from the eurozone crisis, as well as to changes in regulation aimed at ultimately strengthening the sector, but which have now removed state support – protecting the sovereign from liability. The government has introduced a series of bank resolution programmes since the freeze on interbank lending in 2008 and has surprisingly made a profit on its bankruptcy resolution programme by ensuring intra-sector contributions.

Initially, the changes focused on providing system-wide financial support (liquidity) and stability, but ultimately led to the withdrawal of state guarantees with the introduction of a bail-in package: haircuts for senior creditors in the event of default.

This forms part of an overt managed policy of consolidation in the fragmented Danish banking sector, which is characterized by a small number of large cross-border operators and more than 100 small and medium-sized – mostly regional-based – lenders. Several of these have either folded or been acquired by larger organizations since the crisis began, and several more are expected to do so.

Worryingly, the latest to fold, Tønder Bank, in early November appeared to have hidden bad loans on its books until Finanstilsynet (Denmark’s financial supervisory authority) took a closer look. Around 10 to 15 more might be similarly at risk, but little is known until on-site inspections take place.

French banks, too, have come under the spotlight lately after Moody’s removed the sovereign’s triple-A status by downgrading to Aa1 (negative) in November. S&P had lowered its own rating from Aaa to AA+ in January 2012, while Fitch is still maintaining its top rating, despite retaining the sovereign on a negative outlook.

Moody’s noted that, alongside the sovereign downgrade: “French banks have sizeable exposures to some weaker euro-area countries. As a result, despite their good loss-absorption capacity, French banks remain vulnerable to a further deepening of the crisis due to these exposures and their significant – albeit reduced – reliance on wholesale market funding.”

The report goes on to mention that France might not have the same access to eurozone support mechanisms should they become necessary, that it would bear a high burden of the costs involved in supporting weaker sovereigns, and that additional sovereign and bank credit shocks might undermine French financial stability.

Some of the more well-known banking institutions, such as Société Générale and Crédit Agricole, might be at risk from a ratings downgrade, according to various commentators, though perhaps not BNP Paribas, which boasts stronger capitalization. Moody’s decision to warn of banking sector concerns has been strongly criticized by the French government, which believes that not only has capitalization improved but that banks’ balance sheets have been overhauled by reducing staffing, other operating costs and dividends.

The government is also planning to introduce a new bank-reform law aimed at clamping down on risky trading activities, but which is also expected to affect lending. The new rules would be separate from additional taxes on financial transactions and the Basle III regulatory requirements governing liquidity and capitalization.

Still, the warnings come after a trend decline in the French ECR bank-stability score – a fall of 1.3 points during the past two years or so. Indeed, the downgrades that occurred in the fallers group in 2012 were in many cases merely the continuation of a longer-term trend, preceding market concerns and ratings actions.

Sylvain Broyer, head of economics at Natixis, says: “There are two main consequences to the rising banking sector instability in the G10 European economies. First, deleveraging will be a major concern – without liquidity injections by the ECB you would have seen further diminishment in the balance sheet size of European banks.

“The more worrisome development is the renationalization of the banking system in Europe. Given the higher risks in the banking sector, banks are lending less and less money to non-domestic markets. Everything is going in the direction of renationalization of the bank balance sheets, to the detriment of the eurozone and European financial markets.”

A two-year trend

Although some commentators had expected that Europe’s banks would stabilize and perhaps improve after the initial shock-impact of the global crisis, it is clear that during the past two years or so bank stability has deteriorated right across Europe, according to ECR’s survey, with the exceptions of Sweden – with an unchanged bank stability score – and Switzerland, which improved marginally over the period.

Banking systems in danger have been regularly documented by Euromoney Country Risk and its survey contributors. The problems in Slovenia, Ireland, Italy, Greece and Hungary – those registering the largest falls in their bank-stability scores since September 2010 – were picked up early by ECR experts.

An ECR survey contributor for Slovenia notes: “The banking sector in Slovenia has a different history to other eurozone indebted countries. The majority of problems were raised in the process of privatization as opposed to the NPLs associated with the construction sector, like those in Spain. So there are different causes of the problems in the banking sector in Slovenia when compared with the other peripheral economies.

“Slovenian banks are urgently seeking new capital. However, due to the ownership structure of Slovenian banks it is quite difficult to raise new capital, because most large banks are owned by the state, which means there is little interest from private investors to invest in the Slovenian banking sector.”

These risks have manifested themselves in substantial declines in the aggregate asset base of the banking sectors in question. In 2011 alone, the Irish banks’ asset base declined by 14% on average – the most of any EU country. Hungary’s bank asset base shrank by 8.7%, Greece’s by 7.4% and Estonia’s by 6.6% to name the four worst examples, according to European banking sector facts and figures 2012 from the European Banking Federation. However, in addition, note the relatively large falls in scores, not only for Italy, Spain, Denmark and France, but also for two other large banking systems: Belgium and the UK.

Belgium’s bank-stability score has stabilized this year, but at 6 it is 1.3 points below its level two years ago.

The UK, also on 6, is down by 1.2 points over the same period and by 0.6 this year. Improved regulation and reduced leverage and exposures have so far failed to impress risk experts.

Problems in the UK banking sector were alluded to recently by Bank of England governor Mervyn King, who stated: “There is a great deal of adjustment to be made in the financial sector,” part of which involves absorbing the financial penalties incurred from the mis-selling of mortgage payment protection insurance.

Against the backdrop of a weak economy, continuing problems in the neighbouring eurozone and doubts about the sustainability of the US expansion, boosting bank reserves and dealing with problem loans are of paramount importance.

It seems that, for now, bank stability remains a key area of risk for many European countries.