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Europe’s non-performing banks to delay economic recovery

28 October 2013

Compared with America’s better capitalised banks, the Eurozone still faces massive bad debt problems. Christopher Barrow of Metropolitan Safe Deposits is concerned that European banks’ weak balance sheets will forestall economic recovery.

Under major new powers granted last year, the European Central Bank will shortly start to inspect the balance sheets of the Eurozone’s largest banks. This exercise is in preparation for the ECB to take full responsibility for supervising Eurozone banks in the autumn of 2014. Investors and financial analysts will be anticipating some horror stories lurking within. The process of discovery will no doubt oblige banks to write down substantial amounts of debt as they are forced to recognise the true level of their non-performing loans.

The obvious concern is whether the banks have (or will be able to raise) sufficient capital to cope with the losses. That, in turn, will have a knock-on effect on the banks’ funding costs and, of course, their willingness (or ability) to lend. The big question is what will happen to the weaker banks, especially in the more vulnerable southern European countries. The stronger banks have a greater capacity to raise additional capital and thereby recapitalise their balance sheets. Will the weaker banks, in particular those that are financially unviable, be allowed to fail? Might they be split into good banks and bad banks (such as in Ireland and Spain)? Will they get bailed out by the respective country’s taxpayers or by the region’s European Stability Mechanism fund?

The ECB will have to perform a clever balancing act. Their so-called “asset-quality review” will help to determine the scale of the bad debt problem. Applying tough standards will promote market confidence, but imposing overly harsh rules will crystallise outsize losses that may push banks over the cliff. According to current official statistics, the most indebted banks in terms of non-performing loans (as a percentage of total loans) are located in Ireland, Italy, Portugal and Spain. France and Germany are not without their problems, but their ability to clean up their banks’ balance sheets is much greater.

As this week’s Economist points out, Europe is normally associated with having a sovereign-debt crisis. However, the origins of the Euro disaster lay less with government profligacy than with excessive private borrowing. Whilst Greece’s difficulties did derive from too much government borrowing (and insufficient tax collection), problems elsewhere were mainly created by corporate borrowing and mortgage debt.

The contrast between Europe and the US is striking (the UK sits somewhere in between). America’s six largest banks are now significantly larger than they were before the 2008 crash. They took substantial hits (in terms of write-offs) and recapitalised relatively quickly, helped by an economy that has been growing consistently, albeit slowly, since its low point in 2009. Both US banks and households have been able to deleverage substantially (government debt is another story).

The Eurozone, on the other hand, has remained mired in recession, which has made it much harder for households and corporates to reduce debts. Compounding the problem has been Europe’s weak banking sector, which has been reluctant to recognise (and make provisions for) its huge level of non-performing loans. Another factor disadvantaging Europe has been its decrepit bankruptcy laws and less debtor-friendly markets. America’s Chapter 11 has proved to be an important tool for companies seeking to survive the crisis; and many householders were able to walk away from their “non-recourse” mortgages. America also has much more efficient secondary markets in distressed debt. The net effect (post-crisis) was that US banks were forced to write off their debts more quickly and start the process of restructuring and recapitalising their balance sheets.

The non-performing loan situation in Europe is exacerbated by the close link between the banks’ balance sheets and the Eurozone’s sovereign debt crisis. European banks hold substantial amounts of government debt securities on their balance sheets. The reason is that the Capital Requirements Directive, which translated the Basel Accords into European law, allows for a 0% risk weight to government bonds issued in domestic currency. This special treatment of sovereign debt applies to all debt issued in Euros, resulting in European banks holding large amounts of debt issued by the likes of Greece, Spain, Portugal, Italy and Ireland. Losses on this sovereign debt have impacted negatively on both the banks’ balance sheets and their profitability.

As the ECB undergoes its intensive inspection of the books of Eurozone banks, there will be much speculation as to which banks require fresh capital from investors or state support. Most banks will be subject to ECB scrutiny over the next 12 months. The review will cover about 85% of the Eurozone banking system. The good news is that this will lead to greater transparency of the banking sector’s finances and lending practices. Another healthy development is that ECB President Mario Draghi has been quoted as saying that banks will be allowed to fail. Proper stress tests would certainly restore credibility and strengthen confidence in the banks. The need to sell or restructure their bad loans will ultimately lead to a greater ability to increase bank lending to individuals and businesses. In the short term, however, the painful process of shedding trillions of Euros of assets to improve loan quality and comply with new international capital standards will act as a constraint on Europe’s nascent economic recovery.