“Europe is caught in a trap.”

By Don Quijones, Spain & Mexico, editor at WOLF STREET .

In Europe, banks are beginning to feel the side effects from the ECB’s negative interest rate policy (NIRP), which (among other things) is meant to weaken the euro, fuel inflation, force banks into riskier lending, and prevent Eurozone economies from buckling under the sheer weight of their sovereign debt.

But it doesn’t work. Inflation remains much lower than the ECB’s target headline rate of 2%, European sovereign debt continues to grow at an alarming rate, and bank lending remains anemic in most countries. And it could actually end up killing the patient, Europe’s biggest banks.

That’s what Francisco González, Executive Chairman of Spain’s number-two financial institution, BBVA, just warned in a speech at the Spring Membership Meeting of the world’s most powerful financial lobby organization, the Institute of International Finance (IIF).

“Europe is caught in a trap,” he said. “It has to do something to boost its growth potential. But expansive monetary policy has led to negative interest rates, which are killing us.”

For BBVA, like most other European banks, the main problem with NIRP is the shrinking effect it has on its operating margins, which in turn puts unbearable pressure on its balance sheets. For example, when the Euribor is at zero, interest rates on variable rate mortgages are at next to zero. And these variable-rate Euribor-linked mortgages predominate in Spain’s mortgage market.

Until not so long ago, Spanish banks were insulated from this problem by the floor clauses they discreetly inserted into their mortgage contracts. These set a minimum interest rate — typically of between 3% and 4.5% — for variable-rate mortgages, even if the Euribor dropped far below that figure. That meant the banks enjoyed all the benefits of low-interest rate living with none of the drawbacks, which were exclusively reserved for Spanish mortgage holders.

All that changed in April when a Spanish judge ruled that the clauses were both abusive and lack transparency. The 40 banks implicated, including BBVA, now must reimburse clients all the money they’ve overcharged them since May 2013, and perhaps even since 2009. That could be as much as €10 billion. Also, as WOLF STREET reported at the time, in a delicious irony, all the banks that applied the floor clauses will now have to learn to survive without the one mechanism that protected them from the profit-shrinking effects of the ECB’s NIRP — just when the Euribor goes negative!

Cue Gonzalez’s public meltdown!

But BBVA’s problems are not just a result of ECB policy. The bank also has an unwieldy €16 billion exposure to the beleaguered global energy industry, making it the 8th most exposed bank to the sector in Europe after BNP, ING, HSBC, Credit Agricole, Barclays, Société Générale and Deutsche Bank. Unlike BBVA, however, these banks are all global systemically important financial institutions, meaning they’ll get bailed out (assuming they can get bailed out), and perhaps their stockholders and some of their creditors get bailed in, if things get really sticky.

Just as ominous for BBVA is the fact that 43% of its current reported exposure to the energy sector is in the form of junk bonds — compared to just 11% for Spain’s biggest bank, Santander.

BBVA obtains 68% of its profits from countries where oil and other commodities are vital for the economy. Through its subsidiary BBVA Bancomer, BBVA is the second biggest bank operating in Mexico, which accounts for 40% of the group’s profits. And in Mexico, things are looking decidedly grim for the state-owned, debt-laden oil giant Pemex. Bank of America-Merrill Lynch points out that BBVA has not divulged how much of the €30 billion it holds in Mexican corporate bonds or the €11 billion it holds in U.S. corporate bonds are concentrated in the energy industry.

Besides its acute exposure to the energy industry, BBVA has other problems to contend with, including heavy presence in emerging markets with struggling currencies, in particular Latin America and Turkey. Another serious threat it and most other Spanish banks face is the planned introduction of new rules in Europe that would set a limit on the sovereign bonds some banks can hold as eligible “risk-free” capital.

According to European Central Bank data, euro-area sovereign bonds accounted for just over 10% of banks’ assets in the Eurozone, or €2.73 trillion at the end of 2015 — over €300 billion more than at the end of 2014, on the eve of the ECB’s launch of its negative interest rate policy. This trend is particularly acute in countries on the periphery, where banks’ balance sheets are overflowing with bonds of their individual sovereigns.

The rule change is being demanded by fiscally hawkish Eurozone countries such as the Netherlands, Finland and Germany, which want the system overhauled before forging ahead with a closer banking union, to the barely concealed horror of southern European bankers and politicians.

They include Santiago Fernandez de Liz, the chief economist for financial systems and regulation at BBVA, who cautioned earlier this year that applying a proposal of this kind in the Eurozone would risk “reigniting the fragmentation” of Europe’s financial markets, which just a few years ago almost put an end to the single currency.

Clearly BBVA has serious issues. But now its Executive Chairman has come out publicly against NIRP. Other bankers have also mumbled things to that effect. From a German banker, it’s one thing. But from a Spanish banker, whose bank is supposed to be one of the ECB’s prime constituency, it’s quite another. Banks like BBVA are the reason for QE, LTRO, and all the rest of the ECB’s alphabet soup creations. But now they are unhappy that they too — not just consumers, savers, and taxpayers — are having to pay the price for Europe’s failing financial system. By Don Quijones, Raging Bull-Shit

“Markets say the ECB is done, their box is empty. But we are magic people,” said ECB Governing Council Member Vitas Vasiliauskas. “Each time we take something and give to the markets — a rabbit out of the hat.” Read… ECB Prepares to Expand its Racket, Markets Salivate

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