It may be ten years since the financial crisis came to end (or at least stock markets bottomed, to use them as crude proxy) but the after-effects continue to linger. This can be seen most clearly in the performance of the banking sector, in the UK but also worldwide.

In 2019, the Banks sector is the ninth-worst performing sector within the FTSE All-Share, with a 4.7% capital gain that lags the index by several percentage points.

But this poor stock market showing is not unique to Britain’s lenders. America’s Philadelphia KBW banks index topped out last summer and Europe’s STOXX banks index is trading at just a 12-month trough but its lowest level since 1995.

The woes of Europe’s banks may be best encapsulated by the grinding drop in Deutsche Bank’s share price, but its problems are in many ways related to its investment bank and that unit’s derivatives book.

Chief executive Christian Sewing is looking to downsize that business by culling 18,000 jobs and the equities operations and that plan is offering some respite, at least temporarily to Deutsche’s share price (something that may make the senior management team at Barclays (BARC) twitch just a little, given their ongoing commitment to the investment bank there).

The real issue is in fact non-performing loans. Worryingly, the FTSE 100’s Big Five banks now seem to be showing a worsening trend here too. And while the good news is they are starting from a low base, the bad news is that loan impairments seem to be past the trough and trending higher.

Investors need to pay attention because if this does become a hard and fast trend then it could have negative implications for the banking sector and also the wider economy, as a real uptick in loan losses would suggest the economy is not in good health. We shall see.

Loan book blues

In Europe, the problem of non-performing loans seems stark. While the situation has improved since 2016, European Central Bank (ECB) data suggests that 44% of banks loans in Greece, 22% in Cyprus, 11% in Portugal and nearly 10% in Italy are non-performing. The ECB also suggests that more than half of these dud loans are over two years old and a quarter are at least five years old.

This is when the Eurozone is still growing. Heaven knows what might happen if the economy turns down and a new recession develops, as the resulting bad loans which presumably knock a big hole in the banks’ balance sheets, further crimping their ability to lend and oil the economy’s wheels.

Investors looking for cheer will see the UK near the bottom of the list with a non-performing loan ratio of just 1.2%.

Those who lean more toward the dark side will be noting with interest a trend toward higher credit losses and impairments. Standard Chartered (STAN) did not see a deterioration in the first half of 2019 relative to a year ago but its fellow Asian heavyweight HSBC (HSBA) did.

So did the more domestically-focused trio of Barclays, Lloyds (LLOY) and Royal Bank of Scotland (RBS).

Early days

There is no need to press the panic button. The loan impairment ratio at the Big Five ranges from 0.17% at Standard Chartered to 0.54% at Barclays.

But the rise in losses does look ominous. It could suggest that the global economy is not in quite the rude health we would like to think it is.

It could explain why central banks are backtracking on interest rate rises and leaning toward cuts, as even a modest tightening of policy looks to be affecting borrowers’ ability to pay coupons and repay principal more difficult. And it could explain why banks stocks are doing badly and why, in the case of the UK names, they trade at barely one times historic book value at best in the case of HSBC and barely 0.5 times book at the lowest at Barclays, as the market remains wary of the quality of the loan books and therefore the official asset valuations.

To reassure on all fronts, it would be nice to see loan losses moderate and the banking stocks offer improved financial and share price performance in the second half of 2019 and beyond.

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