LONDON – The good news for Europe is that it will not reenact the dramatic collapse of Lehman Brothers. The European Central Bank’s unlimited ability to provide liquidity ensures that. But European leaders have yet to recognize that old bank business models are obsolete, and that reliance on private-sector leverage for balance-sheet repair of both sovereigns and banks is doomed to failure.
Two years into the crisis, the authorities have correctly identified four crucial problems – sovereign debt, bank capital, the risk of a Greek default, and deficient growth. But they have yet to agree on cause and effect. Understanding the obsolescence of most European banks’ business models is absolutely crucial to sorting that out.
In general, the eurozone has outsized banks (assets equivalent to 325% of GDP) that are highly leveraged (the 15 largest banks’ leverage is 28.9 times their equity capital). They are also dependent on large quantities of wholesale debt – totaling €4.9 trillion (27% of total eurozone loans), with €660 billion maturing in the next two years – to fund low-yielding assets. According to Barclays Capital, the 15 largest banks increased their returns on equity by 58% between 1998 and 2007, with 90% of the gain coming from higher leverage. Returns have since collapsed.
This model’s viability depends on large amounts of cheap leverage, supported by implicit government backing. While leverage normally becomes scarce and expensive during recessions, this time declining confidence in sovereign debt also has increased the cost of capital. Government borrowing costs, which anchor banks’ own funding, normally fall during recessions. But, as “risk-free” rates have risen six-fold in the past two years, the cost of bank equity and debt has often surged to levels at which investors balk. No one should be surprised, then, that they are reluctant to recapitalize – or, indeed, lend – to eurozone banks.