Mounting concerns over the potential fallout of Europe's debt crisis and the prospect of squeezed profits from low interest rates are slamming the shares of the world's banks.
Not only are there fears of the potential impact of the debt troubles, but also the new reality of at least two more years of low rates in the United States, which will further pressure thinning lending margins. Investors are looking ahead to 2012, when a slowing economy is expected to take a deep toll on profits in the financial sector.
As the debt woes in the 17-member euro zone spread beyond just the smaller countries, some of the world's major banks have tried to calm concerns about contagion by emphasizing how much better capitalized they are today as compared with the crisis of three years ago. But investors have instead focused on weak economic readings in the United States and Europe.
"The markets are responding the way the are because of legitimate concerns over the profit outlook for the [sector] which to begin with wasn't that stellar," Canadian Imperial Bank of Commerce analyst Robert Sedran said Wednesday as banks stocks in Europe, the United States and Canada fell.
"The European debt crisis isn't particularly new. The U.S. debt crisis isn't particularly new. But if it's against a backdrop of soft economic growth, it becomes a lot more concerning."
Speculation over the situation in the French financial sector sent European bank stocks plummeting Wednesday. Shares in French bank Société Générale SA hit their lowest point in two and a half years, sinking 15 per cent. Bank executives moved to quell rumours that its operations were potentially threatened by exposure to European debt, but the efforts helped slow the selloff only slightly.
The selloff was just as pronounced in the U.S., where Bank of America executives also sought to ease investor worries that the country's largest retail bank could be in serious trouble if the U.S. economy falters. Bank of America shares fell 10 per cent in afternoon trading – part of a 36-per-cent drop in the last month – due to concerns about its large exposure to the U.S. mortgage market, its exposure to Europe and questions about whether it has sufficient capital on hand.
Chief financial officer Bruce Thompson said Bank of America is on more stable footing than in 2008, with significantly higher capital buffers to backstop its operations. However, he said the bank is in "a heightened state of readiness," given the debt crisis in Europe, to contain any damage stemming from a default. "We obviously monitor every night the amount of counter-party risk that we have," Mr. Thompson said on a conference call.
Large financial institutions around the world have spent the past three years cleaning up their balance sheets and adding excess capital to buffer themselves against another credit crisis. But the selloff in bank shares has less to do with fears over a failure of the banking system as it does with a general bleak outlook for bank shares in the year ahead and what that means for the stocks.
It hasn't taken investors long to figure out that with no clear solution to the U.S. economic woes, and ongoing troubles in Europe, those factors will take a toll on financial sector profits. Banks in Canada and elsewhere have already seen their lending margins – the difference between what they pay out on deposits and what they make on interest from loans – shrink as interest rates stay low. Should the economy lapse into another recession, higher losses from bad loans would eat further into earnings.
Canadian banks have dropped 10 per cent since early July. After mounting a slight rally on Tuesday, they shed most of those gains on Wednesday. In the past month, shares in National Bank of Canada have fallen nearly 12 per cent, followed by Laurentian Bank (down 11 per cent), Bank of Nova Scotia (down 9.3 per cent), Royal Bank of Canada (down 8.9 per cent) and Toronto-Dominion Bank (down 8 per cent).
The selloff has been the deepest in Europe, where shares in Credit Suisse Group of Switzerland, Commerzbank AG of Germany, Britain's Barclays PLC and Royal Bank of Scotland have each tumbled about 34 per cent in the past month.
In the United States, Bank of America has fallen the most, but it is far from alone. Shares in Citigroup Inc. have lost 32 per cent, while SunTrust Banks has lost 31 per cent from its shares, and stock in Wells Fargo has fallen nearly 20 per cent. The slide is a concern for the financial sector, since falling share prices make it harder for banks to raise capital.
"The markets continue to reflect tremendous uncertainty in demand for products and economic growth prospects for companies and economies, and uncertainty about the debt burdens of the U.S. and other nations," Brian Moynihan, chief executive officer of Bank of America, said. "However, If you think about it, the fundamentals are so much better … in our industry than they were four years ago when last the financial crisis hit. There's a lot less leverage."
Canadian banks will report third-quarter earnings at the end of this month, but the number will contain very little evidence of the worry that investors have over bank profits in future quarters. Instead, analysts have already started looking ahead to future quarters to gauge the impact of an economic downturn on the sector.
TD Newcrest analyst Jason Bilodeau said in a research note that the onset of another recession would impact bank earnings in Canada by 15 to 20 per cent.
"Given the recent weakness and reduced expectations, the bar seems to be set fairly low heading into reporting season," Mr. Bilodeau said.