The decline in European financials does not represent a systemic risk

"There have been several high profile disappointments this earnings season such as Deutsche Bank, Credit Suisse and Royal Bank of Scotland and there are well-founded worries around future profitability. Most notably, ECB action, rising non-performing loans and emerging market exposure are weighing on the sector.”

The banking system is not a systemic risk; supportive role of the ECB

“While there is cause for concern with respect to the outlook for European financials, the banking system does not represent a systemic risk for the Eurozone as a whole."

“The worry regarding ECB action is that a further decline in interest rates will suppress the interest margin of Eurozone banks, hurting their profitability. This is indeed likely to happen but the ECB will bear this negative feedback loop into consideration when deciding its policy mix. As a result, the ECB will move gradually and will take mitigating action when necessary. The last thing the ECB wants is a banking crisis."

“While the market is rightly concerned about non-performing loans and the Eurozone banking system does have fairly chunky exposures to stressed emerging markets, it is at the same time clear that these exposures should be manageable given their size as a percentage of capital. The banking system is well capitalized and well-regulated now that the ECB has taken on its supervisory role."

“The problem is that although individually the concerns look both genuine and manageable they become a lot more dangerous from an investor’s point of view when combined with the newly enacted Eurozone bail-in regime. The risk of potential losses at an individual bank causing a bank run from either bond holders or deposit holders and thereby creating a vicious cycle across the banking system is real. However, at the same time at the moment there is plenty of scope to deal with individual problem cases without creating a vicious cycle in the system as a whole."

“Finally, the underlying Eurozone economy is also still growing. In a recessionary environment there would be a lot more reason to be more concerned about the sell-off.”

The sell-off is overdone

“Eurozone banks share of total market cap is now at the same level as in the financial crisis and only slightly above the level reached in the Eurozone crisis (see chart). Both these previous cases were much more dangerous than the current situation."

“All in all, there is more than a little bit of fear priced in beyond what the concerns call for and the sell-off does look overdone.”