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European Financials – Out of favour or not quite yet?

The year ahead has the task of easing the strain that numerous global sectors have faced throughout 2016. Financials, notably in the Eurozone have upside potential as a number of geopolitical and economic factors unfold.

European financials were one of the weaker sectors in 2016 as Tier 1 capital requirements, coupled with persistently low borrowing rates and the non-performing loan crisis affecting Italian banks offered little to entice investors on the sector.

The year ahead however, with the ECB’s tone of tapering its asset purchasing program come April has ignited optimism that banks could see profit margins improve, through higher interest rates, currently constricted as a result of Basel III requirements and loose monetary policy measures.

Banks, which make up the vast majority of the financial sector make money predominantly through lending cash at interest rates higher than the cost of acquiring it. Banks usually borrow money through a nation’s Central Bank.

Large customer cash deposits are often loaned out for the purpose of generating interest revenue rather than kept as reserves. The more deposits are loaned out, the higher revenue streams banks can generate. However, restriction requirements imposed by Basel III regulations enforce banks to keep a percentage of customer deposits in reserve.

Such regulations are in place to act as a layer of protection against a run on banks as seen post the 2008 financial crisis and following the Greek debt crisis.

You may ask why a bank would take risks and want to lend most of its customer deposits out, despite numerous risk factors (such as a run on banks). Well, there is such an effect called the Money multiplier.

The money multiplier increases the money supply in an economy when reserve requirements are low, through Banks lending to one another and/or to third parties. A 100 euro initial customer deposit can be loaned numerous times by the loan beneficiaries, in this case banks, so long as they abide by the reserve ratio requirements set by regulators. Banks then benefit off the interest income from these loans whilst the economy benefits off increased money supply in circulation.

Currently the reserve ratio requirement stands at 1% in the Euro area, significantly low and for the purpose of encouraging banks to lend out most of their reserves in the hope of boosting the Eurozone economy.

The rejection of the constitutional reform vote in Italy has prolonged uncertainty around a resolution to the numerous non-performing loans affecting Italian banks, though the optimism around the ECB’s tapering tone enhances the coping mechanisms that Eurozone banks possess as a result of higher interest rates. (Higher Interest rates leads to the potential for higher profit margins)

Financials, notably the deeply subordinated bond issues, showed marked signs of weakness in 2016. Deutsche Bank’s troubles with the US Department of Justice were the highlight as the bank settlement of a multibillion dollar fine, triggered investor fears that a government bailout was on the horizon.

Should the ECB go ahead with reducing its asset purchasing program, subordinated financials could rebound and gain on the upside. Valuations in European financials have been relatively low, and deteriorated following the crisis faced by Banco Monte de Paschi di Siena towards the end of last year.

Caution should set the tone for the year ahead, regardless of the ECB’s tapering actions, as geopolitical risks in the form of numerous general elections and Brexit negotiations have the potential to prolong volatility and trigger unexpected market movements in an already fragile economic environment.

 

This article was issued by Mathieu Ganado, Junior Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. 

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