Real Vision CEO Raoul Pal has called the Eurostoxx Bank Index “probably THE most important level of ANY chart pattern in the history of equity markets.”

The Eurostoxx Banks Index is made up of 25 of the biggest banks in the eurozone. AIB and Bank of Ireland are part of the mix. It’s a barometer of the health of the European banking system.

Raoul Pal is wound up about the Eurostoxx Bank Index because it’s at 80, just above the lowest level in its 33 year history, which was set in 1988. 

So the European banks are less valuable today than they were 33 years ago. By comparison, in the same time period the Eurostoxx 50 index of European stocks is up 421 per cent and the S&P 500 index of US stocks is up 972 per cent. Over a 33 year period, that’s what stocks are meant to do.

European banks are a third less valuable today than they were even at the lowest point of the financial crisis in early 2009. A lot has happened since then. Property markets have long since recovered and the economy is, for the most part, reasonably healthy. Even in Germany, whose economy has performed exceptionally well in the last decade, the banks are in a terrible state. 

Bank profitability matters. If banks can’t lend profitably, as they can’t now, that’s bad news for shareholders, the economy and eventually for taxpayers. Bailing out the banks in 2009 cost around €11,000 per taxpayer. And dysfunctional banks are part of the reason Irish borrowers pay such high interest rates. For an 80 per cent mortgage on an average house, Irish borrowers pay more than three times as much interest over the course of a loan than borrowers in Germany. 

What’s gone wrong? 

Never again

The story starts with the creation of the euro. The euro led to a massive banking boom in Europe. European banks got much bigger and much more international. It’s around this time for example that Deutsche Bank decided to become a global investment bank. In 2005, European banks (excluding the UK) were worth more than twice as much as American ones. 

The Irish property boom was a part of that. German and French banks handed Irish banks like Anglo hundreds of billions of euro at at dirt-cheap interest rates. The Irish banks were happy to put the money to work. 

Banks in Europe were thinly capitalised before the crash in 2007. What this means is that they barely had more assets than they had liabilities. This made them highly profitable per share, but also vulnerable to any change in the value of their assets. The bond markets were happy to lend to these vulnerable, highly-leveraged banks because they knew that if the system ever blew up, the banks were too big to fail. Bond investors knew they’d get their money back either way. 

After the crash, bank regulators resolved that taxpayers would never bail out banks again. So they started putting strict limits on the amount of lending the banks could do. That was the end of the old problem, and the start of the new one.

Quantity, and also quality

Through its subsidiary the European Banking Authority (EBA), the European Central Bank (ECB) regulates banking in Europe. The ECB is part of a bigger global group of central banks called the Bank for International Settlements (BIS). In the world of central banking, there are many acronyms.

The ECB got a clear mandate after the crash — no more bailouts. So, in its bureaucratic way, it set about its task. 

The ECB regulates banks in two ways: by limiting the quantity of loans, and by adjusting for the quality of them. 

Limiting the quantity of loans is (relatively) straightforward. European banks have to hold about 13 per cent of their loans in liquid capital (ie cash or easily sold securities), varying slightly from bank to bank.

The 13 per cent equity cushion is made up of seven components, each with their own acronym. Each component is meant to do a slightly different job. You can see them listed on the chart below for AIB. These are specific to AIB, though they’re fairly representative of requirements for Bank of Ireland and of all European banks. 

The following seven capital buffers are basically different justifications for limiting the amount of lending a bank can do, relative to its liquid assets.

The first component is what’s called pillar 1. Pillar 1 capital is a legally prescribed minimum requirements for capital which applies to all banks.

The second component is pillar 2. This is a capital requirement tailored to the individual bank. The ECB sends teams around the banks to assess their credit quality, management structure etc, and then the team assigns a pillar 2 requirement. AIB’s Pillar 2 requirement of 3.15 per cent is higher than Bank of Ireland’s of 2.25 per cent, for example. 

Next is the capital conservation buffer. The purpose of this one is to conserve capital when things start to go bad. If a bank breaches the buffer, it’s forced to limit dividends and bonus payouts.

Next is the other systemically important institutions buffer. This is an extra capital buffer for big banks which are important enough to drag down the economy with them. 

Next is the countercyclical buffer. This one changes depending on the strength of the overall economy. It forces banks to hold extra capital in good times. 

These five buffers added together get to 11.55 per cent, which is the legal minimum amount of capital Goodbody stockbrokers estimate AIB needs. 

The last two capital buffers are not legally required, but the ECB strongly suggests the banks comply with them. Pillar 2 guidance is another slug of extra capital prescribed on a bank-by-bank basis. And the management buffer is a one per cent buffer to give the bank a bit of extra leeway, so it has the capital space to try new business lines and made the odd mistake. 

Taken together, all these buffers basically limit the quantity of loans a bank can make. But they have nothing to say about the quality of loans. That’s the ECB’s other tool. 

The crash tax

Not all loans are created equal. From a bank’s perspective, a loan to the government is less risky than a mortgage, which is less risky than a credit card. 

The ECB gets around this by applying a specific risk weighting to bank loans. The risk weighting takes into account how likely the borrower is to default, how much of the asset is lost when the borrower defaults, and how much the bank is likely to lose if a default happens.

The ECB has decided that Irish loans are much riskier than European loans. This is where the rules really start to chafe the Irish banks. 

The ECB applies weights to each loan in accordance with how risky it is. So an Irish commercial property loan might come with a risk weight of 60 per cent, an Irish home loan with a risk weight of 38 per cent, and a Dutch home loan with a risk weighting of 11 per cent. 

When making a new loan, the calculation which shows how much capital banks have to set aside is: the size of the loan, times the risk weighting, times the capital ratio. The higher the risk weighting, and the higher the capital ratio, the more capital a bank has to set aside. And the less profitable the loan will be.

This is critically important for the Irish banks. Irish banks have an advantage over European banks in that they charge their customers more for loans. But that advantage is more than cancelled out by their risk weighted asset requirements. 

The most important number for judging banks’ profitability is return on equity (RoE). This number tells you how much profit the bank is able to make for its shareholders from the business of making loans. The bare minimum RoE a bank needs to stay in business for the long run is 10 per cent. It would hope for a number between 10 and 20 per cent. In AIB’s most recent results, it had a RoE of eight per cent; Bank of Ireland made 6.8 per cent.

In making the banking system more robust to shocks, the ECB has damaged its ability to regenerate itself through either organic growth or acquisitions. 

The following simple calculation shows how important the risk weighting is to AIB’s return on equity — and therefore, to its viability as a going concern. If AIB lends €500,000 for a mortgage, it first applies the risk weighting of 38 per cent. That comes to €190,000. Then it multiplies €190,000 by its capital requirements — which we’ve just seen, are 13.3 per cent. That’s €25,270. Once interest from the borrowers, interest to the funder, costs, fees and tax are taken into account, AIB is left with a profit of around €3,000 per year. In this example its return on equity would be 3000/25270, or 11 per cent. 

If you run that same calculation with a Dutch or German risk weighting — ie 15 per cent — the return on equity jumps to 30 per cent. And bear in mind that in real life, the Irish banks are making return on equity in the region of eight per cent. 

So the Irish banks are struggling to get their return on equity above 10 per cent, the threshold they need to get over in order to survive in the long run. The main reason they’re struggling is the ECB’s capital requirement regime which penalises Irish banks. Why does the ECB penalise Ireland? And how are the risk weightings decided?

The risk weightings are modelled by the banks under the supervision of the Irish Central Bank. The modelling process is opaque (the Central Bank couldn’t find me someone willing to talk about it). One element is non-performing or impaired loans — the proportion of the loans which have gone bad. Irish banks have improved a lot in this respect. Bank of Ireland’s non performing loans, for example, are down from 12.5 per cent in 2011 to 4.4 per cent last year. This is only slightly higher than the eurozone average of 3.8 per cent. 

We do know the risk weightings are strongly influenced by historical losses. As time moves on, and as the huge losses from 2009-2013 drop out the back of the models, you’d expect Irish banks’ risk weightings to fall and their return on equity to go up quite a lot.

Wasting away

When returns on equity are below 10 per cent, as they are in Ireland and across Europe, the bank is slowly wasting away. Each loan is destroying shareholder value. That’s not good for bank shareholders or for the economy.

The capital requirements, then, are making the banks less risky in the sense that they’re forced to lend less aggressively. But they’re also helping create a situation where banks can’t lend profitably. Which is part of the reason why we‘ve got Raoul Pal’s scary chart, above. The European banks are wasting away. 

The ECB’s job is to regulate the financial system. How does it answer the criticism that the banks aren’t able to make money? 

The ECB would say banks need to cut costs and get more efficient. They need to merge, if necessary, to create economies of scale. Like the national banks in the US. 

The problem is that the European banking system is still not properly integrated. It’s not possible for an Irish borrower to borrow from a German bank. And if a German bank sets up in Ireland, it has to live with Irish risk weightings. Plus if a German bank buys an Irish bank, it doesn’t know whether it’s going to get hit with extra capital requirements.

In making the banking system more robust to shocks, the ECB has damaged its ability to regenerate itself through either organic growth or acquisitions. 

Of course, capital requirements are not the whole story. They’re the biggest part of the story in Ireland, where risk weightings are so big. But in the rest of Europe, the banks have a different problem — one which is also of the ECB’s making. Mainland European banks’ problem is that they can’t make money on loans when interest rates are so low. Like the average German mortgage we saw earlier, whose interest cost is only a third that of an Irish one. 

How a different department of the ECB is responsible for dragging down interest rates across Europe, making it very difficult for banks to make money, is a story for another day.