© Reuters.
© Reuters.

By Geoffrey Smith 

Investing.com — The European Central Bank poured some cold water on the violent rally in Eurozone banking stocks, warning that loan losses from the pandemic could be larger than the banks expect and voicing skepticism about plans for an early resumption of dividend payments.

The index reacted by falling 1.5% by mid-morning in Frankfurt, a move that, while big in normal times, has to be viewed against a rally of 33% in the last month.

Those gains have been largely due to reports from three pharmaceutical companies that their experimental vaccines for treating Covid-19 are safe and effective, fostering hopes that their distribution next year will allow the world economy to bounce back strongly from its worst year since the Great Depression.

For long-suffering investors in European banks, such an outlook means an early lifting of the ban on dividends and buybacks that regulators announced in the spring to ensure that bank balance sheets are strong enough to survive the crisis. In their recent third-quarter updates, Unicredit (MI:), BNP Paribas (OTC:) and others (notably UBS Group (SIX:), which is not ECB-supervised) all stressed that they had more than enough capital to absorb all the loan losses they expect and still pay something out to shareholders.

However, in its semi-annual Financial Stability Review, the ECB took a markedly more skeptical view, noting that the banks have only avoided booking bigger provisions by making use of the government-backed debt moratoria and guarantees and the regulatory loopholes granted them earlier in the year.

“Provisions have increased but look optimistic in some cases,” ECB Vice President Luis de Guindos said in the review. “Guarantees and moratoria may have lengthened the time it takes for weak economic performance to translate into loan losses.”

In addition, the ECB warned in its review that the risk of a sharp asset price correction had risen, while weak underlying profitability remained a concern, especially in view of elevated levels of debt at the sovereign, corporate and household level.

Loan guarantees, debt-repayment holidays and tax deferrals have all helped banks to report surprisingly low levels of provisions, creating an appearance of profitability at a time when many businesses are on the verge of disappearing.

Importantly, since the end of the third quarter, when the banks were able to present relatively tidy books, the economy has turned south again: IHSMarkit’s flash PMIs for November showed the Eurozone clearly in recessionary territory, and with Germany, the region’s biggest economy, set to tighten its restrictions on economic and social life at a meeting Thursday, the risk is that December will go the same way.

“Overall, it would not be surprising if after a very bad month of November we had zero or even negative growth” for the current quarter, outgoing ECB board member Yves Mersch told the Financial Times in an interview published on Wednesday, although he added it would be “premature” to predict another quarter of negative growth at the start of next year.

“We have relaxed some of our standards, creating additional capital available for the banking system to an amount about three to four times the intended distribution of dividends,” Mersch said, adding that it would be “spurious or surprising if the banks were to use the public subsidies to enrich the shareholders.”

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