French Banks Could Suffer Most From Sunday's Vote

 | Apr 20, 2017 | 9:00 AM EDT
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Perhaps surprisingly, French banks have enjoyed some investor love. An index of regional French banks compiled by FactSet that includes largely domestic companies such as Credit Agricole (CRARY) and Credit Industriel et Commercial is up 4.8% year to date and has advanced 19.4% over the past year.

An index of major French banks -- comprising just two, Societe Generale (SCGLY) and BNP Paribas (BNPQY) -- paints a more realistic picture of worries about the sector before the presidential election. It is down 2.7% year to date. However, that's after advancing by more than 20% in a year.

The decisive round of the French presidential election is only three days away. On Sunday, French voters will decide who, among four candidates, will enter the runoff, which is held on May 7. I say the decisive round is this weekend because extreme right leader Marine Le Pen is guaranteed to make it in the runoff.

Opinion polls (as much as you can trust them, after getting Brexit and Donald Trump wrong) show that whoever gets into the second round with Le Pen is likely to beat her. However, the extreme left candidate Jean-Luc Melenchon is not an attractive option as her direct opponent. The two have been dubbed "the twins of ruin" by French media.

If the worst happens on Sunday and the two extremist politicians make it in the runoff, French banks will be in the line of fire -- a situation that could not come at a worse time for them. During the next few years, French banks will need to raise more debt to build their capital cushions in order to adapt to the new European capital requirements, as European rating agency Scope noted in a report on French banks published on Wednesday.

A victory by Le Pen and Melenchon on Sunday likely would push investors out of French assets, as yields on French bonds, including corporate and bank bonds, would increase. "More elevated marginal funding costs are not likely to help French banks' profitability, which is not high to begin with," Sam Theodore, analyst at Scope, said in the report.

If Melenchon makes it to the runoff, he could gain the votes of those who find the prospect of Le Pen too unpalatable. But his victory could be an even worse outcome for French banks. He has been targeting the rich with promises to introduce a 100% top tax and has been criticizing the big banks and their profits. Some observers fear he would opt for nationalizing some, or all, of them.

But even if he doesn't go ahead and nationalize all banks, Melenchon still could hurt their profitability in more subtle ways. As Scope's Theodore noted, the future for banks is financial technology, or fintech -- they need to adapt to customers who prefer to deal with finance in the digital world rather than the real one. The transition means they will need to close branches and fire employees working in them.

A left-wing president would try to prevent French banks from restructuring by reducing their staff. If that happens, "their cost structure and efficiency will continue to suffer, increasingly so as other European and global competitors will be less constrained to do exactly that," Theodore noted.

Under either of the two extremist candidates, France's image on the international business scene would suffer, and therefore the banks could find themselves forced to retreat to their home turf. This could affect Societe Generale and BNP Paribas the most, as they are the ones with global operations in both retail and investment banking.

Another point to note is that the rise in French banking stocks that has taken place since last year partly could be explained by the Brexit vote. International banks will need to move part of their operations into the European Union after Britain leaves, and Paris has lobbied hard to be the place where these banks move. By association, French banks have benefited.

However, as Theodore notes, "a win by either Le Pen or Melenchon could indeed throw a massive monkey wrench into the French establishment's plans to build Paris as a bigger financial center after Brexit."

If you thought of diversifying your portfolio with a few French banks, look but don't touch until this coming Sunday. Or, if you love risk, you always can take the opportunity to buy on what could be just a fear-induced dip.

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