The massive underperformance of European banks during 2018 is one of the stranger market phenomenon of the year. The SX7E index trading at just 8.6 times estimated earnings, and at 63% of book. China Construction Bank, by contrast, is trading at 57% of book.

Evidently, the market has about as much confidence in the book value of European banks as it does in the case of Chinese banks, which is quite a statement. What mines lurk below the surface in European banks?

One good candidate is the $12-$13 trillion in off-balance sheet derivatives obligations related to hedging the foreign exchange risk of portfolio investments. In effect, European banks have to borrow dollars from US (or other) banks in order to provide swap facilities for their customers who wish to buy US securities and hedge them into Euros.

USD-EUR x-currency basis swap

There is a very strong relationship between the credit quality of European financial institutions as reflected in the SUBFIN credit defaults swaps index and the cost of the cross-currency basis swap, which comes down to what banks charge to provide balance sheet.

Although the derivatives lines are reported off balance sheet for European banks, they require interbank credits. As the credit of European banks deteriorates, US banks will ration interbank lines, making dollars scarcer, and European banks in turn ration dollar hedges to their customer by widening the cross-currency basis swap. Seasonal factors, for example, quarter- and especially year-end balance sheet constraints, also move the cross-currency basis swap. But the relationship between the creditworthiness of European banks and the basis swap is quite clear.

Basis swap vs bank sub CDS spread

The scatter graph shows (in the circled areas) that quarter-end effects move the basis swap independently of European banks’ credit spreads, but the overall relationship between the basis swap and bank creditworthiness is clear.

I suspect that European banks are in a vicious cycle, in which the risks associated with their off-balance sheet derivatives exposure widen credit spreads, and wider credit spreads, in turn, make it harder to manage this exposure.

Corrected for serial correlation, the SUBFIN index is highly significant as a predictor for the X-currency basis swap, using the past seven years’ daily data.