Saturday, November 22, 2014

Europe’s Zombie Banks

BRUSSELS – What is wrong with Europe’s banks? The short answer is that the sector is too large, has too little capital, and contains too many players that lack a viable long-term business model. It is the combination of the last two factors – an overabundance of banks with no sustainable way to turn a profit – that constitutes the most serious and most difficult problem.

The banking sector’s size is a cause for concern because, with total liabilities amounting to more than 250% of the eurozone’s GDP, any major problem could over-burden public budgets. In short, the banking sector in Europe might be too big to be saved.

Undercapitalization can be cured by an infusion of new equity. But the larger the banking sector, the more difficult this might become. More important, it makes no sense to put new capital into banks that cannot return profits for the foreseeable future.

The difficulties in southern Europe are well known, but they differ fundamentally from country to country. In Spain, banks have historically issued 30-year mortgages whose interest rates are indexed to interbank rates such as Euribor, with a small spread (often less than 100 basis points) fixed for the lifetime of the mortgage.

This was a profitable model when Spanish banks were able to refinance themselves at a spread much lower than 100 basis points. Today, however, Spanish banks – especially those most heavily engaged in domestic mortgage lending – must pay a much higher spread over interbank rates to secure new funding. Many local Spanish banks can thus stay afloat only because they refinance a large share of their mortgage book via the European Central Bank. But reliance on cheap central bank (re)financing does not represent a viable business model.

In Italy, the difficulties arise from banks’ continued lending to domestic companies, especially small and medium-size enterprises (SMEs), while GDP has stagnated. Even before the eurozone crisis erupted in 2010, the productivity of capital investment in Italy was close to zero.

The onset of the current recession in Europe has exposed this low productivity, with the failure of many SMEs leading to large losses for the banks, whose funding costs, meanwhile, have increased. It is thus difficult to see how Italian banks can return to profitability (and how the country can resume economic growth) unless the allocation of capital is changed radically.

There are problems north of the Alps as well. In Germany, banks earn close to nothing on the hundreds of billions of euros of excess liquidity that they have deposited at the ECB. But their funding costs are not zero. German banks might be able to issue securities at very low rates, but these rates are still higher than what they earn on their ECB deposits. Moreover, they must maintain an extensive – and thus expensive – domestic retail network to collect the savings deposits from which they are not profiting.

Of course, some banks will always do better than others, just as some will suffer more than others from negative trends. It is thus essential to analyze the situation of each bank separately. But it is clear that in an environment of slow growth, low interest rates, and high risk premia, many banks must struggle to survive.

Unfortunately, the problem cannot be left to the markets. A bank without a viable business model does not shrink gradually and then disappear. Its share price might decline toward zero, but its retail customers will be blissfully unaware of its difficulties. Other creditors, too, will continue to provide financing, because they expect that the (national) authorities will intervene – either by providing emergency funding or by arranging a merger with another institution – before the bank fails. Recent official tough talk in the European Union about “bailing in” bank creditors has not impressed markets much, not least because the new rules on potentially imposing losses on creditors are supposed to enter into force only in 2018.

Starting next year, when it takes over authority for bank supervision, the ECB will review the quality of banks’ assets. But it will be unable to review the longer-term viability of banks’ business models. Current owners will resist to the end any dilution of their control; and no national authority is likely to admit that their national “champions” lack a plausible path to financial viability.

Keeping a weak banking system afloat has high economic costs. Banks with too little capital, or those without a viable business model, tend to continue lending to their existing customers, even if these loans are doubtful, and to restrict lending to new companies or projects. This misallocation of capital hampers any recovery and dims longer-term growth prospects.

What should be done is clear enough: recapitalize much of the sector and restructure those parts without a viable business model. But this is unlikely to happen any time soon. Unfortunately, until it does, Europe is unlikely to recover fully from its current slump.

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    1. CommentedR S

      In the end, there is no way around a debt restructuring in the EU periphery and a private sector based transfer union (banking union & debt-to-equity swaps in EU's banking sector) to solve EU's financial crisis. This is why:




    2. Portrait of Christopher T. Mahoney

      CommentedChristopher T. Mahoney

      The challenge is to grow the money supply while shrinking the banking sector. I don't see how you can shrink the banking sector without causing a debt-deflation spiral.

    3. CommentedGerry Hofman

      What needs to be done is clear. Europe must find the courage to do to itself what it did to Cyprus, that is, close the bad banks to save the good ones. It's that easy. Shut down the zombie banks, transfer accounts under 100 k to the good ones, which will instantly become better cashed up and able to provide credit once again, and strike a deal with accounts over 100 k . Halving Europe's banks will just about do it.

    4. CommentedTomas Kurian

      The problem is that there is no viable economic model for banking sector as a whole at the macroeconomic level, without input from CB.

      Banking, as an industry cannot survive longterm without expansionary monetary policy of Central bank.

      Otherwise, interest collected is withdrawing more and more money from real economy until it collapses. Simply, the money to pay all the interest is not there, and unless it is created by CB and distributed through state fiscal policy ( the best option, with best transmission mechanism), some banks will always go bust, no matter what they do.

      As ECB does not have the adequate powers, it is inevitable that banks will collapse one by one, or will need to be constantly recapitalized.
      Construction of Euro as nonexpansionary currency ( equal to some kind of golden standard) does not allow for sustainable growth and prosperity.

      More on that in my theory: Genom of Capitalism

    5. CommentedFrank O'Callaghan

      Neither Europe nor any other community should be a service instrument for banks and the reckless thieves who have run them. This 'crisis' is a scam and a sham.

    6. CommentedJose araujo

      On a micro/firm level, risk pricing is the central piece of the baking industry value creation model. Portfolio management should be the central core competence of a bank, yet we have seen a movement where size was considered that most important competitive advantage.

      Scale economies were made central because all risk pricing mechanisms were rendered obsolete. Portfolio management wasn't considered important, because banks cannot fail. We live in times where lower staff number in a local branch is a better measurement of management skill then risk pricing...

      Banks have emerged locally and small in size, because it is central to the quality of the portfolio they manage. The knowledge of the community, the correct evaluation of the risks they pose, and the price that has to be paid is central on a efficient banking system. This allows a lower default risk, and by consequence a lower operating cost, much lower then any operating efficiency from staff or technology, and a true differentiation between banks.

      We have lived in times where size was all it mattered, mergers between portfolios that no one could value or manage were lauded and applauded.

      Regulators promoted this behaviors, cutting the ties between banks and the portfolio they managed and placing more value on external mechanisms of value creation, considering portfolio management a identical natural human skill. Well, we have proved that this skills are not natural, trust and evaluation of risk and character are central to a healthy bank, but now all banks look alike, manage identical portfolios so we don't have any real alternative.

    7. CommentedJose araujo

      We could trace a major part of the problems of the banking industry to the EU constitution. A big part of them are obvious, namely the relation between ECB and the finance system, the lack of regulation, etc, but I would like to take a closer look to the less obvious problems.

      First, e usually consider 3 major markets in economy. Real Markets, Financial Markets and Currency Markets, and we say that if two of the markets are at equilibrium then the third will also be at equilibrium. With the Euro, by default the currency market isn't at equilibrium, and that by consequence makes that the financial isn't at equilibrium. Interest rates aren't formed in the market has lost its rating power.

      Other less obvious fact is the subsidies policies, that led to bad risk pricing policies, and again the loss of the rating power by interest rates. We spend 20 years promoting projects that under efficient markets were never going to be funded, and now we are paying for it.

      Third and last is the extensive use we make of banks financing corporations, leading to an anemic development of capital markets, namely commercial paper and bonds. We all knew that European banks were inefficient pricing risk, so corporate and individual behavior led to the capture of value from banks by undertaking risk projects at a much lower price.