The European Union has some major issues that will eventually have to be solved, but not by kicking the can down the road, as is being done at present. The problems include the high rate of non-performing bank loans (NPLs), Brexit, and use of a single currency by all EU nations. These issues will ultimately place a great deal of stress on the EU financial system. The proposed pairs trade is intended to take advantage of the messy situation in Europe by going long the Financial Select Sector SPDR ETF (NYSEARCA:XLF) while shorting the iShares MSCI Europe Financials Sector Index ETF (NASDAQ:EUFN).
The weighted average NPL ratio for the EU as a whole was 5.7% in 2016, but with high dispersion across different countries.A cross country comparison suggests that the average NPL ratio is much higher in the EU than in other global jurisdictions.
NPLs are a problem at multiple levels: at a micro prudential level, heightened NPLs are associated with lower profitability and lower efficiency; at a macro level high levels of NPLs are associated with stagnant growth as capital is tied up with NPLs and not funding new lending into the real economy; finally, for consumers, proactive engagement on NPLs by banks can help avoid the situation of paying interest and fees on an asset that they may eventually not own…
…Moreover, a decline of stock prices can negatively affect bank asset quality. Finally, an increase in lending interest rates tends to increase NPL.
While Brexit is still a long way off, the ongoing uncertainty will have an impact on banks, not only in the UK, but also the rest of Europe. US banks have grown relative to European banks for several years.