Shares in European banks have had a tumultuous week after concerns began to emerge over whether or not Deutsche Bank AG, Santander and UniCredit would be able to meet the cost of payments to bondholders over the coming months.

Markets became so panic-stricken by the middle of the week that investors actually bought, quite hilariously, into a rumour that the ECB was considering buying European banking stocks. This rumour was the source of Wednesday’s sharp, but temporary, recovery.

The above shares have been hammered hard, along with those of UK banks like Barclays (LSE: BARC), whose shares are down 29% year-to-date.

The bonds in question are AT1 capital securities, commonly referred to as coco’s, which convert from debt into equity when a prescribed trigger point is reached.

However, these bonds also allow the borrower to defer coupon payments when financial conditions make it necessary, in much the same way it would defer or cancel a dividend.

The problem

Legacy conduct costs have driven profitability into the ground for continental banks during recent years.

Just two weeks ago, Deutsche reported a record 6.8bn loss for the 2015 year, after earnings were wiped out by impairment charges and conduct costs. It also warned on the threat of further costs in 2016.

This has prompted analysts to begin looking at Deutsche’s reserves and liabilities for the year ahead.

Inevitably, some have voiced concerns that non-existent economic growth, fragile market conditions and ‘lower for longer’ interest rates could mean that capital quality deteriorates from here and eventually forces Deutsche into deferring coupon payments to bolster its balance sheet.

Your problem

Asides from the implications of another meltdown, Deutsche & Co’s woes are a problem for UK investors because it isn’t just European banks that have developed an appetite for coco bonds while being plagued by legacy conduct issues.

Barclays shareholders were left nursing a £174m loss at the close of 2014 after its £845m in post-tax profits was swallowed by coco bondholders.

Recalling that Deutsche’s current predicament arose from conduct costs, and considering that PPI 2.0 could be just around the corner for UK banks (see here for an explanation), a much more violent run on Barclays share price no longer seems such a distant prospect.

The takeaway

The investment case for bank stocks hinges on the cost-cutting ability of management teams as well as the eventual subsistence of conduct costs. But recent events have called into question whether we’ll see either of these contingents satisfied any time soon.

For an explanation on the cost saga, see this article detailing the most recent debacle at HSBC. For further information on the diminishing prospects of an end to litigation, see this linked article.

Bank valuations are shockingly low at present. Deutsche trades on just 0.35 times tangible book value, while Barclays is valued at 0.56 times. However, I can’t help but feel that sometimes, things are cheap or ‘undervalued’ for a reason.

Looking ahead, I believe many UK banks will struggle to cut costs further, while regulators clearly still have an axe to grind.

The net effect of this is a bleak outlook for earnings and cash returns to shareholders in my view.

It probably isn’t a good idea to still be hanging around when the rest of the crowd wakes up and sees these clouds rolling in.

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James Skinner has no position in any shares mentioned. The Motley Fool UK has recommended Barclays. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.