Lawrence White and Iain Withers

LONDON (Reuters – Europe’s failing banks have entered 2022 with a surge of optimism that they hadn’t seen in more then a decade. Interest rates are set to rise, COVID-19 is receding, profits are rising and interest rates will finally rise. That optimism was quickly shaken by the Ukraine crisis.

Russia’s invasion prompted a exodus from Western companies to the country. It also hammered euro currency and threatened global recession. This happened just as Europe’s creditors were poised for re-enter the growth cycle.

Investors have been returning cautiously to the sector due to cheap valuations, the chance of extra capital saved during the pandemic and potential buybacks and dividends.

However, capital distribution plans of UniCredit in Italy appeared to be on the verge of collapse after the company said that a write off of Russia’s business would run at 7.4 billion Euros ($8.1 billion). This is the most obvious indication of the impact of the crisis on the sector’s appeal.

The STOXXX index for European banks fell 15% after the February 24th invasion, compared to a mere 5% drop in the benchmark STOXX Index. This makes banking one the most underperforming sectors of the region.

RBC Europe calculation shows that the shares of European banks are trading at a discount greater than a third of those in America. The valuations remain above previous crisis troughs.

It is indicative of the dramatic shift in mood that has occurred in recent weeks. The February full-year earnings report of banks showed an optimistic tone with lenders like HSBC. Barclays UBS (LON:), posting record profits and promising increased shareholder payouts, and giving a positive outlook.

Eric Theoret from Manulife Investment Management said that it is difficult to assess the damage potential to banks because they are exposed in so many different ways.

Some hold Russian bonds or shares. Others stake in Russian banks. Other still have sensitivity to secondary impacts on Europe’s economies.

Theoret declared that European growth would be affected by Russian banks being exposed to Russia. This is one of his biggest worries.

Graphic: Russia’s attack on Ukraine a headwind for Europe: https://fingfx.thomsonreuters.com/gfx/mkt/dwvkrlqogpm/banks0803.PNG

According to Citi analysis, the banks with Russia exposure are most exposed to Russia: Austrian, Italian, and French banks.

Analysts said that those with the greatest risk through their holdings in French Societe Generale and UniCredit could still be able to write off all of these assets.

Societe Generale, on March 3, stated that it was able to deal with losing its 15-billion euro share in Rosbank.

Raiffeisen, an Austrian lender, is considering leaving Russia. It is currently the country’s tenth-largest bank in terms of assets.

Longer-term, European banks could be more vulnerable to the risk of delaying central bank rate rises and dwindling chances of returning capital to shareholders. There is also the possibility of stagflation where prices increase as the economy slows.

Markets had predicted that the European Central Bank’s (ECB) deposit rate would rise from -50bps to zero before the conflict. According to Michael Christodoulou, Berenberg analyst and Berenberg spokesperson for Berenberg, they now anticipate a mere 20bp rise.

Banks are hurt by this because they can make more profit on the spread between interest rates on loans and deposits.

Barclays or other banks may also be hit by an impending freeze on corporate funding. Deutsche Bank (DE:), that have substantial capital market businesses.

Maria Rivas (senior vice president, global financial institutions, DBRS Morningstar), stated that clients’ equity and debt issuance will be held off until more certainty is available. This could adversely impact underwriting overall revenue.