The Effect of Sovereign Debt and Regulation on Banks
As well as affecting bond and currency markets, the European debt crisis has impacted heavily on the FTSE’s banking sector, keeping bank shares under sustained selling pressure.
On the flipside, there was some upbeat news for banks when calls for a worldwide banking levy were rejected during heated discussions between finance ministers last weekend. This will allow national governments greater flexibility in dealing with nationalised or part-nationalised banks. However, the sector now faces the prospect of stringent regulation on a national level, and the new UK chancellor, George Osborne, is expected to outline plans for a British bank tax as part of his first Budget.
We examine these issues and discuss what the future may hold for the FTSE’s banks.
The link between banks and sovereign debt
The relationship between sovereign debt and the major FTSE-listed banks is significant, but fairly loosely defined.
One key factor is that a large number of banks have significant exposure to institutions in European nations, including those countries with poor credit ratings where there is a risk of default. The other noteworthy issue is the UK government’s controlling stake in major financial institutions, including Royal Bank of Scotland Group and Lloyds Banking Group. While the UK’s balance sheet is in far better shape than those of many of its EU counterparts, there has nevertheless been persistent speculation that the UK’s triple-A credit rating may be at risk. This would, in effect, reduce the credit-worthiness of the part-nationalised banks.
In other words, investor risk aversion towards the banking sector is largely triggered by the perception that sovereign risk – in one form or another – translates into risk for the banks themselves. The damage of this cross-pollination between sovereign risk and risk for the banks is amplified in the climate of fear that has gripped markets over the past month and kept equities under the cosh.
Time to be bullish on banks?
Bullish investors point to the €750 billion safety-net underpinning eurozone nations as reason enough to plough cash back into risk assets, including banking shares. The rescue package certainly seems to have stemmed the torrent of panicked headlines that were fuelling fears across Europe a month ago.
On the other hand, despite the somewhat calmer economic climate, banking share prices have barely improved during the past month. On 6 May, share prices in the FTSE’s banking sector were hit by a report from Moody’s, a major credit ratings agency, which suggested UK banks were vulnerable to the debt crisis. Barclays subsequently closed the day down 6% at 301p. As the graph above indicates, the bank has failed to make any significant inroads since the warning from Moody’s and has in fact lost further ground – a pattern repeated across the sector.
Banking levy and increased regulation
While the sovereign debt crisis impacts a wide range of markets and sectors, the FTSE’s banks face a far more localised threat to their share prices. British banks that received taxpayer money to support them through the financial crisis are under scrutiny and it seems likely they will face some form of levy.
However, initial plans for a global levy have been scrapped due to opposition from Canada and Australia, who felt the levy would unfairly punish those banks that did not need bail-out funds. George Osborne is nevertheless planning to implement a levy on UK banks, but it is likely the chancellor will want to ensure the international competitiveness of the FTSE’s banks and that the tax will therefore be a less significant dent to the banks’ balance sheets than if it had been part of a global levy.
The extent of the bank tax is likely to be announced on 22 June during the Budget and may determine the next key direction for this important sector.
Governments across the world are also currently mulling over some major regulatory overhauls to prevent another financial meltdown. The centrepiece of the reforms is an increase in the amount of capital banks are required to hold. These new capital rules – which are known as Basel III – are expected to knock an estimated 1-3% off world economic growth, an indication both of how large the global banking industry is and how hard they may be hit by the rules.
However, governments will be keen to avoid slamming banks too hard and may aim to phase in the new regulation as painlessly as possible.
Either way, the way in which Basel III is finally implemented will no doubt have a significant effect on banks worldwide and on the FTSE’s banking sector in particular.
Take a position
Whether you believe the sovereign debt will continue to hit the banking sector, or think that the worst is over in terms of the EU crisis and that the new regulations will be phased in gently enough not to have a significant negative impact on the banks, you can take a position with IG Index.
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Updated: 11/06/10
The above comments do not constitute investment advice and IG Index accepts no responsibility for any use that may be made of them.