Blog Post

Still vulnerable: the euro area’s small and medium-sized banks

In our recent research we show that the small and medium-sized banks (SMBs) – and among them the unlisted banks – remain under considerable stress.

By: and Date: August 14, 2015 Topic: Finance & Financial Regulation

This op-ed was originally published on VOXEU.

The European Central Bank’s 26 October 2014 publication of the results of a comprehensive assessment of 130 banks under its oversight (ECB, 2014) identified problems in terms of non-performing assets and capital shortfalls. Nevertheless, the outcome brought a sense of relief to financial markets. Unlike stress tests conducted in July and December 2011 by the European Banking Authority, the ECB’s assessment was considered broadly credible.

The assessment showed that the largest banks appear to be out of the woods. However, in our recent research we show that the small and medium-sized banks (SMBs) – and among them the unlisted banks – remain under considerable stress (Mody and Wolff, 2015). The ECB data covers 130 banks in 19 countries, which can be divided into three size categories: small (assets below €100bn), medium (assets between €100bn and €500 billion) and large (assets more than €500 billion). Of the €22 trillion in assets in total, the ‘small’ group has 84 banks with €3.1 trillion, the ‘medium’ group has 33 banks with €6.3 trillion, and the ‘large’ group has only 13 banks with aggregate assets of €12.5 trillion. Thus, ‘small’ banks have about 14% and ‘medium’ banks have 29% of total bank assets in the euro area.

SMBs thus control a sizeable share of the euro area’s bank assets. They have also received substantial bail-outs. During recent periods of market pressure, SMBs have become closely interconnected in the market’s perception, thereby posing a broader systemic risk. Though there is no cause to believe that the vulnerabilities of SMBs will lead to widespread banking distress, their weakness could delay the recovery.

To measure the vulnerability of individual banks, we conducted a simple ‘stress test’ which asks the following question: if 65% of a bank’s non-performing loans have to be written off, then after accounting for provisions, what would the bank’s equity/assets ratio be? Contrary to the ECB, we look at non risk-weighted equity. If the ratio falls below 3%, we consider the bank to be ‘under stress’. This, we acknowledge, is very crude. It is intended only to assess where the current trouble spots are without claiming to detect all problems.

Stress tests

In December 2013, euro-area banks had non-performing exposures (NPEs) of €879 billion, representing 4% of the total assets of the directly supervised banks. The banks have provisions that cover 42% of these NPEs, but the distribution of NPEs and coverage varies considerably for different countries and banks. Cyprus and Greece are clear outliers but problems are also serious in other countries. For example, Italian non-performing loans are about 11.4% of assets with about half (45%) provided for.

There is also considerable variation for different sizes of bank. Large banks have relatively low NPE ratios and high rates of coverage for the NPEs. Their relatively low equity-asset ratios are thus not a concern. But the small banks have a relatively high average equity-assets ratio (6.4%), and also a very high NPE ratio (9.8%) and a low coverage ratio (39.2%). The mid-sized banks fall in-between for the NPE ratio but have the lowest coverage and equity ratios.

Figures 1a and 1b show the distribution of equity after this stress is applied. As might be expected, despite their relatively low equity ratios, only one of the large banks is placed under stress under our test. Their NPEs are low and coverage is high. However, several small and medium banks fall below the 3% equity/assets threshold. They have high NPEs and low provisions. Hence, even their relatively high equity ratios could prove insufficient in the event of a shock.

 

Figure 1a: Distribution of banks before and after stress test, number of banks

mody fig1a 12 aug

Figure 1b: Distribution of banks before and after stress test, share of assets, %

mody fig1b 12 aug

Source: Bruegel based on SNL Financial and ECB data. Note: The red histogram shows the distribution after the stress test while the blue before the stress test.

Fewer than one in ten of the small banks currently has an equity ratio below 3%. But after the stress, just over a third of small banks would fall below the 3% equity ratio (Figure 1a). More importantly, the banks that would be stressed are the larger of the small banks, so the share of distressed assets would increase from 12.4% to 39.2% (Figure 1b).

Similarly, the share of medium-sized banks with an equity ratio under 3% would increase from 15.2% to about 40.0%; and the share of stressed assets in this group of banks will increase from about 14.9 to 37.7%.

Applying these ratios to the assets of SMBs, about €1.2 trillion (about 39%) of small bank assets and €2.4 trillion (about 38%) of medium bank assets could come under stress. Together, the questionable assets amount to 38.2% of small and medium banks’ assets and 16.4% of banking system assets. Some countries would be particularly affected. Alongside Cyprus and Greece, Portugal, Finland and Ireland would have about half or more of their assets under stress. Italy and Spain show lower shares of assets under stress mainly because they have large banks that are safe under these metrics. However, their share of small and medium banks’ assets under stress would also be sizeable, 47 and 52% respectively for Italy and Spain. 

Stock price movements of ‘stressed’ and ‘non-stressed’ banks

To corroborate our findings, we examined the stock market performance of the banks in the different groups, though several banks are unlisted. Among SMBs, unlisted banks hold about 68% of total assets. Unlisted banks (in both the small and medium categories) have lower NPE ratios than the listed banks; but they also have lower equity ratios and, for medium-sized banks, they also have lower coverage ratios. For this reason, much of the increase in stress will be in unlisted banks.

Figure 2: Evolution of banks’ stock market pricesAll types of banks have substantially lower stock prices than in the first quarter of 2008. However, the stock prices of unstressed banks, especially the small and the large banks, bottomed-out around mid-2012. In contrast, the banks identified as ‘stressed’ by our simple test have experienced much larger falls in stock prices (down to about one-tenth of the prices at the start of the crisis), and their stock prices have continued to fall even while the healthier banks regained some ground (Figure 2).

Figure 2: Evolution of banks’ stock market prices


mody fig2 12 aug

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

Altogether, the evidence suggests that the most serious vulnerabilities lie in the medium-sized banks. They have experienced a decline in deposits while large banks have reduced their debt and derivatives, and small banks have reduced their debt. On the asset side, the stressed medium-sized banks reduced their net loans much more significantly than other banks, suggesting they have had to adapt their businesses substantially to deal with the pressures they face. This is not to suggest that large banks cannot pose risks. But crisis management has allowed them to emerge from the deep shock the euro area experienced in a healthier way. 

Resolution without delay

In the European policy context, these findings are important for three reasons. First, the SMBs serve domestic markets and their continued stress impedes the flow of credit and limits the potential for economic recovery. The weakness of these banks is one reason why bank lending in Europe remains weak. Second, to the extent that these banks are unable to lend because of lack of demand, they might be subject to a deflationary (or low inflation environment) risk: lenders might struggle to repay their loans. In combination, banks and the corporate sector could (continue) to drag each other down.

Third, the geographical distribution of the banking stress is worrying. Countries that have experienced increased unemployment also have many stressed small and medium-sized banks. While their large banks are healthier and can to some extent compensate for that weakness, the slow resolution of bank problems in the small and medium-sized sector can delay the recovery further.

To tackle these issues, the focus should be on how and when to restructure and resolve banks. The ECB’s comprehensive assessment and stress tests focused on capital shortfalls but so far, under the euro area’s Single Supervisory Mechanism, no banks has been forced into recovery and resolution. We believe it is a pressing requirement to aggressively restructure, consolidate and close the weakest banks. Our analysis suggests that 38% of the assets of SMBs (16% of the assets of the entire banking system) very likely deserve to be subjected to this. The aim would be to remove NPEs from balance sheets as much as possible. In some cases, it would involve closing the banks. In other cases, bad assets might have to be separated and then be transferred to a bad bank or traded in markets for distressed assets. In still other cases, asset separation might have to be followed by consolidation and mergers with stronger banks. EU mechanisms to facilitate bank restructuring and resolution, such as the Bank Recovery and Resolution Directive, should be put to use without delay.

References

Mody, Ashoka and Guntram Wolff, 2015, “The Vulnerability of Europe’s Small and Medium-Sized Banks,” Bruegel Working Paper 2015/07.

 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article Download PDF More on this topic

Policy Contribution

Should we care about central bank profits?

The authors investigate the ECB’s profit-making activity of the last 20 years, assessing how this was achieved and the reasons why we should care more broadly about central banks generating profits.

By: Francesco Chiacchio, Grégory Claeys and Francesco Papadia Topic: European Macroeconomics & Governance Date: August 30, 2018
Read article More on this topic

Opinion

The ECB is compromising the attractiveness of euro-area sovereign bonds

The ECB should refine its collateral framework in order to continue protecting its balance sheet without putting at risk the safe-asset status of sovereign bonds of the euro area.

By: Grégory Claeys and Inês Goncalves Raposo Topic: Finance & Financial Regulation Date: August 29, 2018
Read article More on this topic More by this author

Blog Post

Criteria for entry into the ERMII and the banking union: the precedent from Bulgaria

In its bid to join the single currency Bulgaria has made commitments on financial supervision but also wider structural reform which set a precedent for future applicants for participation in the exchange rate mechanism ERMII. Most conditions, though not all, are justified by the additional demands of the banking union. But the envisaged timeline seems ambitious, and verification will not be straightforward.

By: Alexander Lehmann Topic: European Macroeconomics & Governance Date: August 29, 2018
Read article More on this topic

Blog Post

European bank mergers: domestic or cross-border?

As the European economy recovers from the global financial crisis, bank mergers are back on the agenda. While cross-border mergers have been predicted before, most European bank mergers have been domestic until now. What are the odds of cross-border mergers in the upcoming bank-consolidation wave?

By: Patty Duijm and Dirk Schoenmaker Topic: Finance & Financial Regulation Date: June 21, 2018
Read article More on this topic

Blog Post

Is the ECB collateral framework compromising the safe-asset status of euro-area sovereign bonds?

Central banks’ collateral frameworks play an important role in defining what is considered as a safe asset. However, the ECB’s framework is unsatisfactory because it is overly reliant on pro-cyclical ratings from credit rating agencies, and because the differences in haircuts between the different ECB credit quality steps are not sufficiently gradual. In this note, the authors propose how the ECB could solve these problems and improve its collateral framework to protect its balance sheet without putting at risk the safe status of sovereign bonds of the euro area.

By: Grégory Claeys and Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: June 8, 2018
Read article Download PDF

External Publication

The changing fortunes of central banking

What are the major challenges of central banks today? This book discusses the developing role of central banks and the policies they pursue in seeking monetary and financial stabilisation, while also giving suggestions for model strategies.

By: Philipp Hartmann, Haizhou Huang and Dirk Schoenmaker Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: May 29, 2018
Read article More on this topic More by this author

Blog Post

Are SBBS really the safe asset the euro area is looking for?

The European Commission is pushing to create a synthetic euro-area-wide safe asset in the form of sovereign bond-backed securities (SBBS). However, SBBS do not fully fulfil their original promises. If introduced on a massive scale, they might increase the supply of safe assets in good times and loosen the link between sovereigns and banks. But they will not give governments a means to maintain market access during crises, they might change incentives for governments to default, and they could pose a problem to individual bonds not included in SBBS if, in the end, they are put at a regulatory advantage vis-à-vis individual bonds.

By: Grégory Claeys Topic: Finance & Financial Regulation Date: May 28, 2018
Read article Download PDF

External Publication

Central banking in turbulent times

Central banks came out of the Great Recession with increased power and responsibilities. Indeed, central banks are often now seen as 'the only game in town', and a place to put innumerable problems vastly exceeding their traditional remit. These new powers do not fit well, however, with the independence of central banks, remote from the democratic control of government.

By: Francesco Papadia and Tuomas Valimaki Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: May 22, 2018
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: Post-crisis prognosis for macroeconomics

The global financial crisis prompted the field of macroeconomics to rethink its methods. In this Director's Cut of 'The Sound of Economics', Bruegel deputy director Maria Demertzis addresses the changes made and the problems still unresolved, in conversation with Nicola Viegi, South African Reserve Bank professor of monetary economics at the University of Pretoria, and Frank Smets, director general of economics at the European Central Bank.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: May 15, 2018
Read article More on this topic More by this author

Opinion

The upheaval Italy needs

While Italy remains without a new government, it would be foolish to believe that a country where anti-system parties won 55% of the popular vote will continue to behave as if nothing had happened. But political upheavals sometime provide a unique opportunity for addressing seemingly intractable problems. After its political upheaval, Italy now needs an economic one.

By: Jean Pisani-Ferry Topic: European Macroeconomics & Governance Date: April 30, 2018
Read article More on this topic More by this author

Blog Post

Latvia’s money laundering scandal

Latvia’s third largest bank ABLV sought emergency liquidity from the ECB and eventually voted to start a process of voluntary liquidation, after being accused by US authorities of large-scale money laundering and having failed to produce a survival plan. What does it mean for the ECB?

By: Silvia Merler Topic: Finance & Financial Regulation Date: April 9, 2018
Read article More on this topic More by this author

Opinion

The Lesser Evil for the Eurozone

For three decades, the consensus within the European Commission and the European Central Bank on the need for market reforms and sound public finances has been strong enough to overcome opposition in small countries and outlast procrastination in large ones. Today, however, the Eurozone playing field has become a battleground.

By: Jean Pisani-Ferry Topic: Finance & Financial Regulation Date: April 4, 2018
Load more posts