The scariest chart since the June 23 Brexit referendum was not the plunge in sterling, the European stock markets or oil; it was the impact of Brexit – Britain's exit from the European Union – on the banks in Britain and continental Europe. Ugly is an understatement.
As bank shares everywhere lost 20 per cent to 30 per cent, a common measure of the value and health of banks – the share price to the net value of their assets, known as book value – got slaughtered. The price-to-book values of some of the weakest banks is so low that bailouts, mergers or outright collapses seems inevitable, with predictable knock-on effects on the wider economy.
To be sure, the banks were having a rough go before Britons voted 52-48 in favour of ditching Britain's EU membership. Blame the weak economic recovery in Europe, the falling net interest margin (the difference between the rates at which banks borrow and lend) as central banks pushed rates to zero and into negative territory, and rising capital requirements.
Then came Brexit. The chart paints a clear picture of the damage done to price-to-book values. Barclays and Royal Bank of Scotland traded at an already lousy 0.55 times book value (p/bv) on June 23. By Tuesday, the figure for both had dropped below 0.4 times. The already weak German and Italian banks fell into oh-my-God territory. The p/bv of once mighty Deutsche Bank went to 0.28 from 0.35 and Italy's UniCredit, one of the biggest banks in Europe, went to a cringe-worthy 0.22 from 0.32.
What is a respectable price-to-book value? Royal Bank of Canada's is now about 1.9 and has been higher. The p/bv of the Euro Stoxx Bank index was 1.6 to 2 during the glory years before the 2008 financial crisis. Its value has been in rapid decline since them. Last year it was just above 0.7. Various forecasts put the figure at 0.4 or less this year and in 2017. That would put the European banks p/bv at the lowest level since the start of the last decade.
Why are the banks' price-to-book values plunging so much and why is the damage worse in Italy and other countries on the EU's Mediterranean flank? I'm just guessing here, but it appears that bank investors are pricing in the potential breakup of the entire EU, which would mean the European Central Bank, the regulator of the banks in the euro zone and the lender of last resort to the weakest banks, would be out of business too. In other words, bank investors fear the Brexit vote will trigger a domino effect.
The banks in Italy, the euro zone's third-largest economy, are the ones to watch as share prices sink sharply. UniCredit shares have lost 25 per cent in a week and 63 per cent over a year. Monster capital injections may be coming, which would amount to a wholesale bailout of the Italian banking sector. The gross value of the Italian banks' non-performing loans is an astounding €200-billion.
The problem is, the injections may not be legal under new EU banking regulations, which require investors, such as bondholders, to take the bailout hit, not taxpayers through government-sponsored rescues. The Italian government of Prime Minister Matteo Renzi wants the EU's agreement for a €40-billion capital-injection plan by the state, not investors, many of whom are families and small businesses who would get wiped off the map were the banks to fail. Mr. Renzi may get his wish, but only because of the financial instability unleashed by Brexit. He will claim that Italy's financial stability is threatened unless he gets a waiver to allow the state to do the rescuing.
But for banks everywhere, Brexit is a nightmare. Banks that have lost the confidence of investors are zombies. They don't lend, which means companies don't get the loans they need. If the Brexit scare continues, the banks will keep retreating and the already weak recovery will take a hit. British Prime Minister David Cameron's reckless Brexit gamble plunged Britain into uncertainty. It did the same for the banks.