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 Topic: Finance & Financial Regulation

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

Blog Post

Talking about Europe: Le Monde 1944-2018

An ongoing research project is seeking to quantify and analyse national printed media discourses about Europe over the decades since the end of the second world war. A first snapshot screened more than 2.8 million articles in Le Monde, out of which 750,000 speak about “Europe”.

By: Enrico Bergamini, Emmanuel Mourlon-Druol, Francesco Papadia and Giuseppe Porcaro Topic: European Macroeconomics & Governance Date: March 20, 2019
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: The case for a legislative remedy for recessions

Bruegel's Maria Demertzis welcomes Yale Law School professor Yair Listokin to this Director's Cut of 'The Sound of Economics', to discuss how law might be deployed as a macroeconomic tool to counter financial crisis.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: March 12, 2019
Read article More on this topic

Blog Post

The European Union must change its supervisory architecture to fight money laundering

Money laundering scandals at EU banks have become pervasive. The authors here detail the weaknesses the current AML architecture's fundamental weaknesses and propose a new framework.

By: Joshua Kirschenbaum and Nicolas Véron Topic: European Macroeconomics & Governance Date: February 26, 2019
Read article More on this topic More by this author

Blog Post

Greening monetary policy: An alternative to the ECB’s market-neutral approach

The ECB’s market-neutral approach to monetary policy undermines the general aim of the EU to achieve a low-carbon economy. An alternative tilting approach would foster low-carbon production, accelerating the transition of the EU to a low-carbon economy, and could be implemented without undue interference with the chief aim of price stability.

By: Dirk Schoenmaker Topic: European Macroeconomics & Governance Date: February 21, 2019
Read article More on this topic More by this author

Podcast

Podcast

Deep Focus: A greener monetary policy approach for the ECB

Bruegel fellow Dirk Schoenmaker walks Sean Gibson and 'The Sound of Economics' listeners through his latest working paper, focusing on how to make monetary policy in Europe more climate-friendly

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: February 21, 2019
Read about event

Past Event

Past Event

Is the European automotive industry ready for the global electric vehicle revolution?

How can Europe catch up on the global electric vehicle race?

Speakers: Eric Feunteun, Jacques Pieraerts, Julia Poliscanova, Simone Tagliapietra and Reinhilde Veugelers Topic: Energy & Climate, Innovation & Competition Policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: February 12, 2019
Read article Download PDF More on this topic

Policy Contribution

Russia's growth problem

After the 2014-2016 currency crisis, Russia’s economy has returned to growth, albeit at a slow pace. In this Policy Contribution, the authors analyse the potential causes of mediocre growth performance, as well as its impact on Russia's economic and political relationships. They also include their recommendations for the future.

By: Marek Dabrowski and Antoine Mathieu Collin Topic: Global Economics & Governance Date: February 7, 2019
Read article More on this topic

Blog Post

Whose (fiscal) debt is it anyway?

The authors map how much fiscal debt is in the hands of domestic and foreign holders in the euro area. While the market for debt was much more international prior to the crisis, this trend has since been reversed. At the same time, central banks have become important holders of fiscal debt.

By: Maria Demertzis and David Pichler Topic: European Macroeconomics & Governance Date: February 6, 2019
Read article More on this topic

Blog Post

The higher yield on Italian government securities is becoming a burden for the real economy

Francesco Papadia and Inês Gonçalves Raposo have recently written on Italian fiscal policy and the increase in the spread between Italian (BTP) and German (Bund) government. Since then, two developments have taken place: one good, and one bad. This blog post reviews them.

By: Francesco Papadia and Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: February 5, 2019
Read article More by this author

Blog Post

What 2019 could bring: A look inside the crystal ball

Economic performance prospects in Europe, the US and Asia in 2019. We start off by reviewing commentaries and predictions about the euro zone, which many commentators expect to perform below potential as uncertainties continue to dampen a still robust recovery.

By: Michael Baltensperger Topic: European Macroeconomics & Governance, Global Economics & Governance Date: January 14, 2019
Read article Download PDF More on this topic

Policy Contribution

Is the European automotive industry ready for the global electric vehicle revolution?

This Policy Contribution investigates the position of the European automotive industry in a scenario in which electrification substantially progresses. Europe cannot follow China in the adoption of centrally-planned industrial policy measures. But it certainly can and should do more to stimulate the transformation of its automotive industry through more ambitious policies.

By: Gustav Fredriksson, Alexander Roth, Simone Tagliapietra and Reinhilde Veugelers Topic: Innovation & Competition Policy Date: December 20, 2018
Read article Download PDF More on this topic

Policy Contribution

The euro as an international currency

Is a more important international role for the euro worth pursuing? What measures would achieve this result, if it is worth pursuing?

By: Konstantinos Efstathiou and Francesco Papadia Topic: European Macroeconomics & Governance Date: December 18, 2018
Load more posts