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Brexit is a Lehman Moment for European Banks - Bloomberg

European banks are undergoing a real-life stress test in the wake of Britain's vote to leave the European Union. Their share prices were already down 20 percent this year; since the referendum result was announced, they've doubled that decline. If the rot isn't stopped soon, Europe will have found a novel solution to the too-big-to-fail problem -- by allowing its banks to shrink until they're too small to be fit for purpose. The answer is found in the adage never let a good crisis go to waste.

The current situation should be both a motivation and an excuse to do what Europe failed to do after the 2008 collapse of Lehman Brothers brought the financial world to its knees: fix its banking system. Here's a snapshot of this year's drop in value of some of the region's biggest institutions:

Deutsche Bank, which once had pretensions to be Europe's contender on the global investment banking stage, is now worth just 17 billion euros ($18 billion). When the biggest bank in Europe's biggest economy, with annual revenue of about 37 billion euros, is worth about the same as Snapchat -- a messaging app that generated just $59 million of revenue last year -- you know something's wrong. No wonder the billionaire investor George Soros was betting against Deutsche Bank shares this month.

Greece has recapitalized its banks three times, to almost no effect. Piraeus Bank, for example, is worth less than 1.5 billion euros, down from 4 billion euros in December after the last cash injection, and as much as 11 billion euros just two years ago.

UniCredit, Italy's biggest bank, has suffered particularly badly this year. It has a market capitalization of just 12 billion euros, dwarfed by its non-performing loans worth 51 billion euros. Italian banks as a whole have non-performing debts worth 198 billion euros, a total that's been rising ever since the financial crisis and is illustrative of Europe's failure to tackle its banking problems:

Add in so-called "sofferenze," Italian for doubtful loans, and the total value of Italian debt at risk of non-payment rises to about 360 billion euros. That explains why Italy has seized upon Brexit to justify trying to shovel 40 billion euros of state aid into its banking system, much to the annoyance of Germany, which views the move as contravening rules on state aid. 

Rather than risk a messy fight at a time when the EU needs to at least pretend to be united, Europe's regulators should acknowledge that the region needs a functioning banking system more than it needs the hobgoblin of regulatory consistency. Otherwise, all of the European Central Bank's efforts to stimulate growth using monetary policy are doomed to failure.

So the authorities need to backtrack. To save face, Brexit can be classified as a force majeure event, echoing the legal clauses in many contracts that allow transactions to be suspended or standards ignored in the event of a game-changing catastrophe.

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A looser architecture for letting governments bail out their banks is needed. And while it would be a mistake to scrap the bail-in rules designed to safeguard taxpayers by requiring bondholders and shareholders to share in the losses when financial companies get into trouble, some leeway in how those regulations are applied would seem to be sensible in the current febrile environment. In the U.K., the Bank of England is already drawing up plans to cut capital requirements for British institutions.

Jonathan Tyce, a senior banking analyst at Bloomberg Intelligence, argues that the collapse in bank capital may give banking supervisors the justification they need to roll back regulations and relax the rules on state aid, especially if the ECB takes the lead:

"It remains unlikely that Italy, in isolation, will be able to evoke exceptional circumstances to directly bolster the capital bases of its banks. Yet the ECB may look to liquidity conditions and dwindling capital build across the region as a catalyst to reassess its regulatory approach."

America sorted its banks out swiftly after the 2008 credit crisis. Balance sheets were recapitalized, the value of distressed assets was written down and the new regulatory framework was put in place. Europe didn't do the same. It should now seize this second chance that fortune has dropped into its lap -- otherwise, it risks turning the Brexit crisis into a financial catastrophe.

(Corrects fourth paragraph to show market capitalization of Piraeus Bank reached 11 billion euros two years ago, not 40 billion euros.)

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story: Mark Gilbert at magilbert@bloomberg.net

    To contact the editor responsible for this story: Therese Raphael at traphael4@bloomberg.net

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