European banks show no sign of funding stress in tariff sell-off

With the market focus over the last week or so being firmly on equities and credit spreads, it is worth zooming in on developments in the European bank credit default swap (CDS) market.

At time of writing, the Euro Stoxx Banks equity index has dropped 18.9% since the start of last week as the broader S&P 500 and Euro Stoxx 50 indices have dropped 11.4% and 13.6% respectively. Meanwhile, single-name CDS (a proxy for default risk) for the European banking sector has behaved in a relatively orderly manner, with the Markit iTraxx Europe Senior Financial index rising 25bp since the start of last week versus 20bp for the broader Markit iTraxx Europe index that also includes non-financials. Furthermore, we have not observed any clear “weak links” or individual banks which have underperformed the rest of the space. Some European banks have even outperformed their US peers, something rarely seen in past periods of broader market stress. Things can change quickly given the uneasy macro picture, but thus far the signals from the CDS market have been rather positive and reassuring for European banks.

Funding costs are of paramount importance to any bank as they largely determine its competitiveness in the market. Elevated funding spreads can prevent loan origination, reduce the number of counterparties willing to engage with the business and create revenue pressure.

CDS contracts provide a useful way of measuring potential changes in banks’ funding costs and observing any stress, since they effectively provide insurance against the default of the underlying instrument. A CDS contract on a senior unsecured bond, for example, pays compensation when the underlying bonds experience a loss event. CDS offer lower transaction costs and higher liquidity than making multiple bond trades, and thus for some investors they are a useful tool for hedging counterparty risks. As such, CDS spreads are a widely used proxy for the credit risk of the underlying instruments and the issuer. Indeed, given its broad usage, CDS can serve as a “canary in the coal mine” indicator for any funding stress that a bank may observe and would be a metric that any bank treasury would manage carefully.

Going back to the events of the past week, as noted above the move in the banks’ senior CDS index has broadly matched that of the broader European senior index (which includes non-financials). Indeed, as Exhibit 1 shows the differential remains below its longer term average. Clearly, it has been a sharp yet not unprecedented move, but it is nevertheless reassuring to observe that both indices have been moving largely in tandem and the financial sector has not displayed material stress versus broader corporate credit.

In addition to those orderly moves at the index level, we would also note that we have not observed significant deviations to the index widening for individual banks. While higher beta names such as Deutsche Bank and Société Générale have continued to trade wider, their week-on-week moves have not been out of line with peers; this is notable given particular institutions can often be singled out in times of stress (Credit Suisse during the Silicon Valley Bank crisis, Société Générale during the French political crisis in mid-2024; Deutsche Bank on several other occasions). This lack of visible differentiation is important as it highlights to us that there is no single issuer the market is particularly concerned about at the moment.

Finally, we would also note that some European banks have outperformed US peers in the CDS market this past week. As an example, Barclays’ five-year senior CDS has widened by around 38bp from the tights of this year, while BNP Paribas’ has widened by around 40bp. That compares to around 50bp of widening for both Bank of America and Citi. While these moves may appear sensible given the market’s focus on the US economy (European investment grade and high yield bond indices have outperformed the US in the sell-off) it is noteworthy given that historically, European banks have been more volatile than US peers in periods of stress.

Overall, despite material moves in the markets this past week, we have seen relatively calm action and no signs of funding stress for European banks judging by the CDS indices. The individual moves have looked orderly with more subordinated bonds underperforming as one would expect, while at the index level, financials have matched the moves in broader CDS.

As for the impact on Additional Tier 1s (AT1s), we recently noted the importance of staying selective in the market given tighter valuations since the start of the year. The recent spread widening, combined with the relatively calm reaction in the CDS market, may already present some opportunities, though as always we will remain disciplined considering the shifting macro picture.