Bank sell-off casts shadow on Europe's fragile recovery

FRANKFURT (Reuters) - A protracted selloff in the shares and bonds of euro zone banks has the potential to knock the fragile economic recovery off track by raising financing costs for banks, limiting their ability to lend.

It may also undo some of what the European Central Bank has been trying to do to increase bank lending an pump up inflation via spending.

Euro zone banks <.sx7e> have seen their shares plummet by nearly 30 percent and yields on their bonds surge since the start of the year, as investors worried about thinning profits and uncomfortably high levels of bad loans in some countries.

The selloff makes it more expensive for banks to raise capital on the market by selling shares or bonds.

If this situation were to last, it would dent banks' capacity to grow their balance sheets by extending new loans to companies and households. This would jeopardize a tentative rebound in lending driven by the ECB's ultra-easy monetary policy.

"This can have an impact on the economy, which is bank dependent in Europe," said Sascha Steffen, professor of finance at the University of Mannheim. "And of course it puts more pressure on the ECB because it doesn't help it bring back inflation."

Bank lending in the euro zone started growing again in 2015 after shrinking for three years, but data for December data pointed to a loss of momentum.

Adjusted loans to euro area residents excluding governments rose a meager 0.4 percent in the last month of 2015, the slowest pace in three months.

Large euro zone banks generally hold more capital than demanded by regulators and the ECB gives them access to limit-less cash provided they have sufficient collateral. This makes a banking crisis of the kind seen in 2008 less likely to take place.

But the sheer magnitude of the market rout shows investors are losing confidence in the sector.

A key transmission channel is the market for Additional Tier 1 (AT1) notes - bonds that can be converted into equity under certain conditions and on which the issuer can decide whether or not to make coupon payments.

Banks have relied on issuing these notes over the past few years to shore up their balance sheets and build buffers to absorb future losses.

European banks have been issuing around 30-40 billion euros($33.84 billion-$45.12 billion) worth of AT1 bonds in each of the past two years.

But after a sharp selloff since the beginning of the year, the supply of new issues has dried up, with Italy's Intesa Sanpaolo and France's Credit Agricole the only two European banks to have sold new bonds this year .

If this key market were to remain shut for a long time, banks would be faced with an uncomfortable choice between issuing AT1 bonds at prohibitive yields, selling equity at deep discounts, or shrinking their balance sheet by lending less.

Deutsche Bank , which posted its largest ever annual loss last month, saw yields on its AT1 notes go up by a quarter or more since the start of the year. They now yield between 12.6 percent and 15.7 percent .

The bank sought to calm investors this week by saying it had "sufficient" reserves to make due AT1 payments.

Similar or higher yields are bid on AT1 bonds issued by Italy's biggest bank, UniCredit and Spain's No.3 lender Banco Popular after a sharp rise since the start of the year.

This means that, if these banks were to issue AT1 bonds now, they would need to pay a yield higher than current market prices in order to attract buyers.

Or they could issue equity, which dilutes the value of existing shares and, unlike AT1 bonds, is not tax deductible.

By and large, banks do not need to refinance their AT1 bonds imminently and they can retain capital by foregoing dividends and bonuses if needed, as Deutsche Bank has done.

But sooner or later they have to come back to the market because they need to top up their loss-absorbing buffers to meet regulatory demands.

If market confidence is not restored quickly, a higher cost of capital is likely to act as a drag on bank's willingness to extend new loans, undoing the effect of the ECB's policy and strangling a nascent recovery in bank credit.

"For the past year, ECB easing has been accompanied by private banks' easing of credit conditions," said Marco Troiano, a director at ratings agency Scope. "If market volatility reverses this, banks would tighten lending, negating some of the ECB's efforts."

(Additional reporting by Hélène Durand in London Editing by Jeremy Gaunt)