DB Deutsche Bank Aktiengesellschaft

By Jenny Strasburg and Max Colchester 

Just a few years ago, Europe's banks managed to stagger out of crisis brought on by the Continent's debt woes. Britain's looming exit from the European Union, analysts and investors fear, could push them back in.

A wide swath of European financial institutions are at risk: Hobbled behemoths like Deutsche Bank AG and Credit Suisse Group AG that are limping through difficult turnarounds, clusters of regional banks pressured by negative interest rates, and banks across Europe's weak periphery that are reeling under piles of bad loans.

Still wounded from the eurozone debt crisis, European banks need investor confidence and steady economic growth to prosper. Brexit risks both.

Perhaps most acutely, Britain's breakaway calls into question the durability of the European Union and the euro. All of a sudden, the prospects of Europe's political framework disintegrating at its core, considered far-fetched just days ago, have edged up.

"This event could be discombobulating for eurozone banks if the market fears tail risk of a eurozone break up," Huw van Steenis, Morgan Stanley's lead European banking analyst, wrote in a note Friday.

And the medicine may not help.

The market could be expecting central banks to step in with lower interest rates or debt buybacks, Mr. van Steenis added. But cuts to interest rates, already negative in many European markets, bode worse business conditions for lenders, not better.

That helps explain why investors sold European bank stocks somewhat indiscriminately Friday. Spain's Bankia SA dropped 21% and Italy's UniCredit SpA 24%. Yet France's BNP Paribas, seen as one of Europe's stronger, better-run banks, also fell 17%.

Many banks will face questions about how much work they have done in the years since the eurozone crisis to raise additional capital, reduce their use of borrowed money and shed risky assets. Investors have taken a dim view: Valuations of scores of banks, big and small, are very low.

Even if European policy makers managed to stamp out existential concerns, the economy is likely to take a hit. Ratings firm Standard & Poor's Global Ratings says "Brexit" could knock 0.5 percentage point off the entire eurozone's economic growth next year. That is a considerable amount: Before the Brexit vote, the European Commission had forecast growth to be 1.8% in 2017.

Growth is vital to banks' viability equations. In countries like Italy and Greece, where bad loans are endemic, banks need their troubled borrowers to hang on so they can repay their debts. That is vastly harder if the economy slumps, house prices fall and unemployment rises.

Brexit further fuels concerns that European banks' capital cushions are too thin. Germany's biggest lender, Deutsche Bank, and Swiss rival Credit Suisse have pledged to boost capital levels by selling assets, cutting costs and hoarding earnings.

But a slowdown in deals, and companies' anticipated reluctance to issue new shares and debt, could punch holes in their investment-banking and trading-profit engines. Deutsche Bank and Credit Suisse shares have declined 41% and 48% this year, respectively.

That compares with a 22% year-to-date decline in the Stoxx Europe 600 Banks index. The index fell 14.5% on Friday.

While a 2008 style funding crunch seems unlikely, British banks face a wave of longer-term uncertainty.

The Brexit outcome raises questions about whether Lloyds Banking Group PLC and Royal Bank of Scotland Group PLC will keep their headquarters in Scotland. Scottish leaders have said they are pushing for independence from the U.K. to remain in the EU.

Shares of London-based Barclays PLC fell 30% Friday morning before ending the day down around 18%.

On Friday, Citigroup Inc. banking analysts led by Andrew Coombs downgraded Barclays to "sell" from their previous "buy" rating, forecasting sharply higher funding costs and lower profit.

One concern is how Barclays and other banks with big London-based trading divisions might navigate regulatory agreements that require a legal base in the EU. That question, which involves what are known as "passporting" rights for securities trading, is central to broader worries about London's ability to maintain its massive financial-services workforce.

"Given that this is going to be a slow-burning downturn, do regulators force banks to raise capital now, or wait for six months?" said Chirantan Barua, a banks analyst at Bernstein Research.

London-based investment-banking operations will likely again swing the ax in coming months, potentially eliminating thousands more jobs, Mr. Barua said.

The mood on London's trading floors and among its investment bankers is downbeat, bank employees said. "My team has a lot of different nationalities, and they are worrying about their jobs and their ability to stay in the country," said a senior banker at an American investment bank in London.

Italy's banking sector has been roiled by soured loans, insufficient capital and management upheaval. Analysts have warned that the country's biggest bank, UniCredit, is ill-positioned to manage Brexit fallout.

UniCredit shares have lost 47% this year as investors fretted about its thin capital buffer. Its embattled chief executive, Federico Ghizzoni, agreed to step down in late May, but the bank has so far failed to find a successor.

The Brexit vote is creating "a lot of uncertainties which will compound the issues of Italian and Spanish banks," said Filippo Alloatti, a Hermes Credit senior analyst in London.

Spain's biggest lender, Banco Santander SA, relies on mortgages and other products it sells in the U.K. to generate about a quarter of its total net profit.

On Friday, Santander dragged Spain's benchmark stock index to its biggest one-day drop ever. Shares of the bank fell 20%.

Executive Chairman Ana Botín, who ran the British unit before taking the helm of Santander, tried to reassure investors, noting in a statement that the bank's focus on retail banking provides stability. That was a nod to investor concerns that investment banks in particular could be hard hit by post-Brexit market volatility.

Santander's commitment "to British businesses, customers and our people remains as strong as ever," she said.

But J.P. Morgan European bank analyst Kian Abouhossein included Santander on Friday in his list of "most-impacted banks" exposed to potential U.K. credit weakness.

In Portugal, analysts say while banks have almost no direct exposure to the U.K., they will suffer from investors' risk aversion at a time when the system is already struggling with low profitability and a big portfolio of souring loans.

Analysts say banks are undercapitalized. Portugal's economy is grappling with low growth and high levels of debt weighing down the government and Portuguese companies. Lenders have also invested in Portuguese government debt, which stands to lose value amid the uncertainty.

--Giovanni Legorano, Patricia Kowsmann and Jeannette Neumann contributed to this article.

(END) Dow Jones Newswires

June 26, 2016 16:47 ET (20:47 GMT)

Copyright (c) 2016 Dow Jones & Company, Inc.