Deutsche Bank's 7 step guide to how Brexit could cause a systemic crisis in Europe
Mark Wall, chief economist at Deutsche Bank, has put together a little guide to Brexit-related-systemtic doom for any pessismists out there. Here's our redacted version...
1. Brexit means lower growth and more uncertainty
Brexit is not happening in a vacuum: "It is a shock to an already vulnerable system," says Wall. "The situation is extremely unstable and if not taken seriously quickly enough could end up setting the European recovery back substantially, threatening the political sustainability of the single currency project," he adds cheerily. "Doubts about euro-area institutional integrity would put further pressure on banks."
2. Lower growth and more uncertainty will have an impact on banks
"Banks are an inherently cyclical business," says Wall. "Brexit is a negative shock for the economy and hence for banks. Lower growth prospects means QE for longer, which implies lower and flatter yields curves for longer, at least for core countries."
This will exert, "downward pressure" on banks' profits.
3. Banks' stock falls
As banks' profits fall, so does their share price.
"So far this year, euro-area banks have underperformed the market by 27%," notes Wall. "Banks are now trading at the lowest Price-to-Book ratio relative to the market since the beginning of our series in 2004."
Worse: "Expectations for bank earnings are likely to deteriorate further following the Brexit vote."
4. As banks' earnings fall, they lend less and the downturn becomes self-perpetuating
As European banks' earnings and share prices fall, they are less likely to provide credit to the economy at large. This is a problem given that companies in Europe have traditionally financed expansion using bank loans. As bank credit dries up, European growth is likely to shrink further.
5. Banks struggle to raise more capital just as capital requirements increase
Just as this is happening, Wall points out that banks are likely to need to raise new capital externally. He points out that proposed new regulations could increase capital ratios by about 1% on average in the EU between now and 2019. Banks have two options for achieving this: they can raise new capital by going to shareholders or they can sell some risk weighted assets (RWAs).
6. Banks will sell risk weighted assets instead of raising new equity
Given the unpopularity of banks' equity, Wall suggests they're more likely to sell RWAs. The trouble is that if all European banks try to meet capital targets by reducing the loan books, credit available to European companies will shrink further (Wall estimates a 2% annual credit contraction every year until 2019). In this situation, economic growth will shrink and unemployment will fall, and banks' profits will be hit further (see 2).
7. And then, Italy....
Into this storm, wanders the horror that is the bank of Italy. Wall points out that Italian banks have gross non-performing loans of €200bn. He notes that there has already been, "a major loss of market confidence in Italian banks," and that, "any major macro stresses, from worries on China at the beginning of the year to Brexit, disproportionally weigh on Italian banks regardless of the direct channels of contagion."
In an ideal world, the Italian banking sector needs to be recapitalized but the European Union prohibits this under new rules which place the burden for bank bailouts on private creditors instead of governments. In Italy, €200bn+ of banking debt is held by households, which means Italian households would be burned by a private creditor recapitalization. This will make Italians unhappy, which in turn will encourage them to vote against prime minister Matteo Renzi in a referendum in late October, which in turn will boost Italy's euro-skeptic and populist parties, which in turn could make the situation even worse...