Opinion

Euro area banks remain vulnerable

Strengthening the banking system is important to achieve a sustainable recovery, because it will revitalise credit to the healthier segments of the economy. However without restructuring, euro area banks are still vulnerable.

By: , and Date: August 21, 2015 Finance & Financial Regulation Tags & Topics

This article was also published in Expansion, Il Sole 24 Ore, Kathemerini, Handelsblatt, and will be published in Diario Economico.                                       Expansion logoIl Sole logoKathemerinihandelsblatt logodiario economico logo

The euro area’s biggest banks have reported record profits. The stress tests published by the European Central Bank late last year showed that the largest banks—those with assets of more than €500 billion—have been able to cut their non-performing exposures and increase their provisions. But the euro area banking system is not out of the woods. The vulnerabilities lie in the small and medium-sized banks, those with assets below €500 billion. Together these banks own 50% of the euro area banking system assets.

In our research, based on 130 euro area banks directly supervised by the ECB, we find that banks are often superficially well capitalized—their regulatory capital ratios and even their equity capital looks reasonable. Only one in ten small banks has equity less than 3% of its assets; one in six medium-sized banks has an equity/asset ratio below 3%. But banks are vulnerable either because they have a high share of non-performing loans or they have insufficient resources to cover for possible losses on the non-performing loans. This is a widespread problem but one that is especially acute in the countries that have faced high stress since the start of the crisis.

To identify the troubled banks, we asked a crude but simple question. If 65% of non-performing loans have to be written down, how many banks would still have equity that is at least 3% of the bank’s assets? The answer, we find, is that about a third of small banks, with almost 40% of small-bank assets, would fall below the 3% equity threshold. Medium-sized banks would face similarly extensive stress. By comparison, only one of the euro-area’s 13 “large” banks would be considered stressed under our enhanced stress test.

Corroboration for our findings comes from bank share prices. While the stock prices of all banks are still well below their pre-crisis peaks, the small and medium-sized banks that we identify to be stressed have had particularly weak performance. Even this understates the problem since many of the most stressed banks are unlisted. If our scenario were to unfold, the stressed assets of the small and medium banks would add up to about €3.6 trillion, about 38% of small and medium bank assets—and 16% of entire euro-area banking system assets.

 

Evolution of banks’ stock market prices
20150821 banking vulnerability

Source: Bruegel using data from Thomson Reuters Datastream. Note: Number of listed banks: 45 (23 Small, 12 Medium, 10 Large).

 

The troubled banks tend to serve a narrow range of geographically concentrated customers. As the local economy suffers, so do the banks, which, in turn, further hurts local economic prospects. This vicious cycle keeps non-performing loans high—and growing. But despite such localization, their stock price movements were highly synchronized in the early phase of the crisis, as if there were contributing to the broader systemic tensions. In other words, at moments of panic, they add to the panic well beyond the communities they serve.

For dealing with banking vulnerabilities, European policymakers seem wedded to a single response: to pump more capital into the banks. Even after the ECB’s latest asset quality review and stress tests, the entire focus was on how much more capital the banking system needed. Indeed, critics focused mainly on whether the official estimates for recapitalization were too low.

We also believe in well-capitalized banks—with the focus on equity rather than on fuzzy regulatory capital. But the real problem in Europe is that the banks in trouble have had long-standing governance problems. Often they are either government-owned or have links to the government. They have long been the source of patronage and unhealthy lending practices. Even if the new supervisory system helps clean up some of these past pathologies, the question still must be asked: what economic purpose do these banks serve? The continuing problems in Europe’s smaller banks are sending a message: Europe has a problem of overbanking.

The bottom line is that the euro-area’s banking sector needs pruning. In the United States, hundreds of banks have been closed or merged since the start of the crisis—the bulk of such action was taken quickly so that the problems would not fester. In the euro area, after much effort, the authority to resolve banks has now been standardized across the member states. Yet, there has been little action. Despite rules to impose losses on banks’ owners and creditors, there remains a reluctance to do so.

It is well past time to aggressively restructure, consolidate and close the weakest euro area banks. Failure to do so will act as a drag on economic recovery, much as it did in Japan.

 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint.

Due to copyright agreements we ask that you kindly email request to republish opinions that have appeared in print to communication@bruegel.org.

View comments
Read article More on this topic More by this author

Blog Post

DSC_0794

Why was the last TLTRO take-up unexpectedly high?

The final round of TLTRO financing was an unexpected hit with euro area banks. The aim of the programme is to encourage banks to increase lending to the real economy. However, with many now expecting a hike in deposit rates, banks’ enthusiasm might be driven largely by the chance to make a profit from the cheap loans.

By: Justine Feliu Topic: European Macroeconomics & Governance Date: March 27, 2017
Read article More on this topic More by this author

Blog Post

Silvia Merler

The inflation basket case

Inflation in the euro area has finally reached 2%. But Draghi is right to warn that the underlying dynamics do not point to this being a self-sustaining trend. Breaking down the numbers shows that many inflation basket items are still showing weak price growth or even deflation.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: March 17, 2017
Read article Download PDF More on this topic More by this author

Policy Contribution

PC 07 2017 cover

What happened to global banking after the crisis?

The global financial crisis allegedly led to the end of global banking. However, Dirk Schoenmaker finds that reports of the demise of global banking are premature.

By: Dirk Schoenmaker Topic: Finance & Financial Regulation Date: March 14, 2017
Read article More on this topic More by this author

Podcast

Podcast

Banks and borrowers in distress — Europe's NPL crisis

European banks are struggling with high amounts of non-performing loans. We look at the reasons behind this crisis, and how it affects banks, borrowers and the European economy as a whole. Finally, we explore potential solutions.

By: The Sound of Economics Topic: Finance & Financial Regulation Date: March 10, 2017
Read article Download PDF More on this topic

Policy Brief

PB 17 01

Making the best of Brexit for the EU27 financial system

The EU27 needs to upgrade its financial surveillance architecture to minimise the financial market fragmentation resulting from Brexit and the corresponding increase in borrowing costs for firms.

By: André Sapir, Dirk Schoenmaker and Nicolas Véron Topic: Finance & Financial Regulation Date: February 8, 2017
Read article More on this topic

Blog Post

MariaDemertzis1 bw
sd-12177-_0028bea2-web

Bruegel conference discusses strategies to tackle Europe’s NPL crisis

Bad loans and private sector debt distress are widely acknowledged to hold back investment and growth in Europe. It was good, then, to hear ECB Vice-President Vítor Constâncio call for a comprehensive strategy to address the non-performing loans problem at an event hosted by Bruegel last week.

By: Maria Demertzis and Alexander Lehmann Topic: Finance & Financial Regulation Date: February 7, 2017
Read article More on this topic More by this author

Blog Post

Silvia Merler

The strange case of the MPS capital shortfall

Italy's banking saga continues with the announcement that beleaguered MPS may need to find an additional €3bn. What exactly has changed, and what does it say about ECB decision making?

By: Silvia Merler Topic: Finance & Financial Regulation Date: December 27, 2016
Read article More on this topic

Opinion

MariaDemertzis1 bw
Guntram B. Wolff

Eurozone QE and bank profitability: Why it is too early to taper

In the eyes of the critics, the quantitative easing programs have been of little help to growth and inflation and have instead been an attack on savers, undermining the profitability of banks and insurances. Do these arguments stand scrutiny?

By: Maria Demertzis and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: December 8, 2016
Read article Download PDF More by this author

Policy Contribution

pc-23-12European Parliament

The impact of the legal and operational structures of euro-area banks on their resolvability

Following the financial crisis, the question of how to handle a big bank’s collapse has come to the fore. This Policy Contribution evaluates the obstacles to resolvability that the legal and operational structures of the large euro-area banks could pose to the European Union’s new resolution regime.

By: Dirk Schoenmaker Topic: European Parliament, Finance & Financial Regulation, Parliamentary Testimonies Date: December 6, 2016
Read article Download PDF More on this topic More by this author

External Publication

cover-ep

The impact of the legal and operational structures of euro-area banks on their resolvability

This paper evaluates the obstacles to resolvability that the legal and operational structures of the large euro-area banks could present, assuming that it is possible to liquidate smaller and medium-sized banks through a transfer of the relevant activities to other banks.

By: Dirk Schoenmaker Topic: Finance & Financial Regulation Date: December 6, 2016
Read article Download PDF

Working Paper

cover

Reform of the European Union financial supervisory and regulatory architecture and its implications for Asia

This Working Paper reviews recent developments in the EU’s financial supervisory and regulatory architecture with a view to draw out lessons for regional financial regulatory architecture in Asia.

By: Zsolt Darvas, Dirk Schoenmaker and Nicolas Véron Topic: Finance & Financial Regulation, Global Economics & Governance Date: November 17, 2016
Read article More on this topic More by this author

Opinion

Silvia Merler

An Italian take on banking crisis

The year 2016 has not been good to Italian banks. While resilient to the first wave of financial crisis in 2008, due to their low exposure to US sub-prime products and to the fact that Italy did not have a pre-crisis housing bubble, they have been suffering much from the euro sovereign crisis and the ensuing deteriorating economic conditions.

By: Silvia Merler Topic: Finance & Financial Regulation Date: October 27, 2016
Load more posts