Will Europe face financial turmoil in 2017? What MNC executives need to know

Europe continues to be a key region within multinationals’ EMEA market portfolios, despite its slow economic growth. MNCs should continue expecting sluggish economic performance in Europe as the region’s financial sector weakness is depressing investment. Beyond low growth, however, Europe’s financial sector also poses a greater risk, which could materialize during 2017 and requires proactive planning by multinationals. Italy and Portugal, in particular, could see deteriorating bank health, which would spill over into markets including in CEE and North Africa. Should a downside of a banking crisis in Europe materialize, consumer sentiment and B2B demand will drop, hurting MNCs and their local partners and customers, and causing prolonged uncertainty. MNCs should have contingency plans in place to protect their businesses from this possibility while monitoring key signposts.

Where does the biggest banking risk come from?

Policymakers have failed to proactively pursue a permanent solution for the European banking system, which is struggling from the severe losses incurred during the 2007/8 financial crisis. In July, the European Banking Authority (EBA) stress tested 51 banks across Europe, revealing continued widespread vulnerability of the banking sector. According to the tests, Italy’s banks (followed by Ireland’s) would be the first to urgently need recapitalization after a major adverse economic shock. Italy’s Monte dei Paschi di Siena, the financially weakest bank in Europe, performed the worst in the stress test.

European Stress Test Divide

While many markets in Europe have vulnerable financial sectors, most of them are ring-fenced and are addressing their weaknesses, and thus do not pose a broader systemic threat to the Europe’s financial system. An exception to this is Portugal. Despite an EU and IMF loan in 2011, reforms have been sidetracked and economic growth derailed. Because of high external debt, sluggish growth, and an anti-reformist government, the IMF and several banks have repeatedly warned of the systemic threat Portugal’s banking sector poses to Europe. Nonetheless, the systemic risk from the Portuguese banking sector is lower than that posed by Italian banks due to its smaller size and less interconnectedness to the rest of Europe.

The vulnerable Italian banking sector represents the highest systemic risk for a potential banking crisis in Europe as the unique size, interconnectedness, and problems in Italy’s banking sector pose a real threat to Europe’s banking sector. Italy’s banks are the core of the European banking system and its largest bank (Unicredit) is more than twice the size of the entire Portuguese banking sector in total assets. The Italian banking sector is the fourth-largest banking sector in the Eurozone and has non-performing loans (NPLs) amounting to 18% of total loans. Furthermore, Italy is not under a fiscal adjustment program – public debt is 133% of GDP – and its economy is weak and slowing further, further raising the burden on the banking sector. Lack of reform to boost low employment and productivity means accelerating growth is a serious challenge for Italy. A weak banking sector contributes to low growth; and low growth, in turn, makes it impossible for Italian banks to improve the quality of their portfolios and boost lending.

European debt

What’s next? 

Base case scenario: Anticipate Brexit pressures and mergers & recapitalizations

In our base case scenario, one or more small vulnerable banks in Italy and/or Portugal would likely be merged or acquired by larger, healthier banks and will require additional capital by next year. After Monte dei Paschi di Siena, the Italian Banco Carige, Banco di Sardegna, and Banco Popolare are the most vulnerable banks that will most likely require recapitalization next. While Portugal has already injected €10 billion in four of its banks since the financial crisis, Banco Comercial Português SA will require a €2 billion capital injection after losing 60% of its share value since January. Brexit will keep on putting an additional strain on Italian banks until the completion of Brexit negotiations. Italy’s five largest banks lost 60% of their share price since January (20% since Brexit), with Monte dei Paschi di Siena losing 72% of its share price (45% since Brexit). In the first half of next year, a potential second Scottish referendum could see Scotland to leave the UK, shaking up further Brexit negotiations and the economic sentiment. As banks’ mergers are expected to be slow with unions continuing blocking redundancies, each countries’ government together with the ECB will once again likely step in to save the failing banks by injecting money – failing to provide a sustainable solution for the European banking system.

Downside scenario: Hedge Portuguese and Italian risk

Portugal’s potential downgrade and the Italian constitutional referendum could trigger a downside systemic scenario, making selective recapitalizations insufficient to deal with the problem. In October, Canada’s DBRS is expected to downgrade the credit capacity of Portugal after the release of poor recent economic data, which would exclude Portugal from the quantitative easing program and push the country toward a second bail-out, causing deposit flight from its weak banks. Additionally, the ruling left coalition is unlikely to agree with the harsh austerity demands by the EU and IMF in exchange for loans, without which the banks will suffer massively. Like Greece earlier, ultimately the ECB will require a commitment from Portugal to adopt reforms to participate in the EU’s Emergency Liquidity Assistance (ELA) mechanism and return the country to financial stability.

A NO vote at the Italian constitutional referendum on December 4 represents the highest risk that could trigger a downside scenario and a domino effect to the banking sector in Europe. Prime Minister Matteo Renzi has threatened to step down should Italians decide to vote against limiting the powers of the upper chamber of the parliament in the referendum with latest polls estimating a 52% NO to 48% YES result, decelerating the necessary reforms. Political instability would upset the banking sector, with Italian bank shares collapsing. As Italy is ‘too big to fall’, the ECB would guarantee banks’ liquidity and the new government would likely agree to a rescue umbrella by the European Stability Mechanism. However, it is likely that only bank deposits up to €100K would be protected, and small and medium investors would be hit by this rescue plan, delaying the recovery of the Italian economy.

This downside scenario would spread panic in financial markets, hurting sentiment and limiting bank lending.

Business and consumers’ confidence is expected to drop notably, and the weak and indebted housing market to be badly hit by this scenario. The euro would depreciate by at least 10% against the dollar and bank lending would contract by 6% YOY coming down to 2007/8 financial crisis levels. The political uncertainty could trigger a chain of downside events. Beppe Grillo’s Five Star Movement (M5S) populist, anti-euro party is most likely to make gains in new elections, as the center-right Silvio Berlusconi’s coalition is unlikely to come to power representing an outdated status quo. The M5S could potentially ask for a euro referendum, which will spread turbulence in European and global markets and hurt firms’ partners and customers.

Adjust your strategy to the new business normal

Policymakers failing to provide an effective solution for Europe’s banking sector hinder growth prospects of the region and make such downside scenarios more likely. Although the ECB can endlessly print money and recapitalize the banking system, selective injections of capital to the weak banks in Europe fail to address the greater problem – slow economic growth in the region, low interest rates by the European Central Bank (ECB) and stricter banking regulations suppressing banking profits and lending capacity – and don’t prevent new banks from failing and downside scenarios from materializing. A prerequisite to provide a solution for the banking system is for Eurozone members to agree on a strategic European-wide plan for the banks. Fundamentally, initiatives to effectively deal with Europe’s intrinsic problems hit a wall due to the incomplete political and fiscal nature of the union – the ultimate reason the region is unable to fully recover since the 2007/2008 financial crisis. As the muted economic outlook for Europe will be the new normal for multinational firms, firms should closely monitor the downside risks emerging from the European banking sector and plan their strategies accordingly keeping business targets moderate.

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