Europe's Second Banking Crisis?

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by: Carnegie Endowment

The EU-IMF rescue package bought Euro area governments time, and its size and urgency underscored the threats still confronting European banks, even two years after the outbreak of the financial crisis. Though banks have partially rebuilt their capital, loan losses remain high and funding requirements are rising; the European debt crisis greatly adds to the problems. Not only will weak banks stifle credit growth and slow Europe’s already anemic recovery, but they may also further the transmission of Greece’s debt crisis to Spain, Italy, and beyond. European banks have to confront large challenges, and policy makers must act quickly to fix their own fiscal mess.

Four Challenges Facing European Banks

The outbreak of the debt crisis has already hit European banks, halting their recovery and undermining market confidence in them. Since the start of 2010, the value of European bank shares has fallen by 32 percent, compared to only 2.5 percent for U.S. financials. Credit has also continued to contract and is expected to remain depressed: the IMF projects that the European credit shortfall (the difference between credit supply and credit demand as a percentage of credit demand) will be 22 percent in 2010 and 13 percent in 2011, compared to 14 and 2 percent in the United States.



With the recovery in Europe expected to be weak, banks will have difficulty quickly repairing their balance sheets.

Real GDP Growth, %
Quarterly growth is at an annualized rate

2009 Q4 2010 Q1 2010* 2011*
Euro area 0.4 0.8 1.0 1.5
United States 5.6 3.0 3.1 2.6
Japan 4.1 4.9 1.9 2.0
Emerging Markets 7.0 7.7 6.3 6.5
* Forecast from April 2010 WEO.
Sources: IMF, Eurostat, JP Morgan.
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Four other challenges, however, pose an even bigger threat to European banks.

Loss of Confidence in Sovereign Debt

Sovereign debt concerns pose the biggest threat to European banks by eroding the value of government securities on their balance sheets, affecting the quality of all loans in the countries in question and beyond, and elevating the banks’ borrowing costs. German and French banks, which own 61 percent of the Euro area’s total holdings of public and private debt issued by Greece, Ireland, Portugal, and Spain, are particularly exposed, as are banks in the troubled countries.

Usually regarded as a country’s safest asset, sovereign bonds—and their yields—serve as the baseline in national bond markets: as government borrowing costs rise, so do all others across the economy, especially for banks that have received government support. At the end of May, top Spanish banks were already paying over 10 basis points more than their American counterparts for short-term loans and indications have emerged that Spanish banks are finding it increasingly difficult to fund themselves on international markets.

High public borrowing requirements also indirectly increase bank funding costs by crowding out private borrowing. According to the IMF, in 2010 alone, governments in Greece, Ireland, Italy, Portugal, Spain (the GIIPS), Belgium, France, and Germany will need to raise $2.3 trillion, while Euro area banks will need $2.4 trillion over the next three years. Finding these funds will be especially difficult now that a majority of investors rate the EU as the worst market for investment opportunities.

A fall in government bond prices, which move inversely to yields, will erode bank assets directly. For example, the increase in Greece’s 10-year bond yield from 5.3 percent a year ago to 8.2 percent currently implies a market value decline of over 35 percent. With Euro area banks holding 50 percent of outstanding long-term Euro area government bonds, the falling prices impose a significant and direct cost on European banks.

Banks must also prepare for the once unthinkable possibility of outright default by Greece or other troubled economies. The Bank of International Settlements estimates that lending to the GIIPS by European banks (excluding domestic banks) is as high as $3 trillion, or 18 percent of EU GDP.

Finally, significant measures from the financial crisis, including guarantees of liabilities, liquidity support, and asset purchasing programs, continue to support banks. Maintaining these programs, or at least retaining their credibility, will become increasingly difficult if fiscal strain intensifies.

Overhang From the Real Estate Bubble and Other Bad Assets

In addition to sovereign debt, European banks are still dealing with the legacy of bad loans in other sectors, particularly real estate. The ECB estimates that Euro area banks will be required to write off 195 billion euros through 2011; the IMF estimates roughly the same value of write-offs through 2010 alone.

Euro area real estate prices continue to slide, having fallen 3.1 percent (y/y) in the second half of 2009—the sharpest decline since 1982. Commercial property prices fell by 2 percent (y/y) in the first quarter of 2010, prompting the ECB to increase its December estimate for total 2007–2010 write-offs from commercial property mortgages by nearly 50 percent to 55.3 billion euros.

With austerity programs set to cut wages in the troubled countries and European unemployment already at its highest rate since 1998, the quality of household loans—which rose to nearly 5 trillion euros in the Euro area in March—could also deteriorate.



Furthermore, Euro area banking groups exploited an extremely wide net interest margin, the difference between the interest rates at which banks can borrow and lend, in 2009, leading net interest income to rise to 1.17 percent of total assets. The ECB now estimates that the net interest margin is narrowing, suggesting that the share will return to its 2005–2008 average of 0.73 percent.

Regulatory Uncertainty

European banks are growing increasingly anxious about financial regulation, as are banks in other jurisdictions. More stringent capital and liquidity requirements, the cornerstone of the pending update to the Basel recommendations for banking laws (commonly known as Basel 3) will increase the cost of doing business, reduce profit margins, and create new funding demands at a time when equity valuations are low. Furthermore, according to the IIF (which is funded by banks), new regulations could also significantly reduce real GDP growth, particularly in the Euro area: the IIF estimates that if Basel 3 were implemented, Euro area GDP would be 4.3 percent lower in 2015 than if no policy changes are made. In the United States, where capital markets are less dependent on banks, GDP would be 2.6 percent lower.

Low Profitability


Even before the financial crisis, low profitability plagued European banks. From 2001 to 2008, Euro area banks averaged returns on assets of well less than half of those of U.S. banks. Furthermore, banks in Europe adjusted more slowly to the crisis: since the end of 2006, the number of credit institutions in the Euro area has grown by 4.9 percent, despite banking equities losing nearly two-thirds of their value. Over that same period, the number of U.S. commercial banks has fallen by 8.5 percent.

These problems can be traced back, in part, to structural issues—especially in Europe’s large and poorly managed public banking sector. In Germany, for instance, publicly-owned regional banks, or Landenbanken, hold slightly less than half of total bank loans and securities, yet, according to the IMF, they will accrue over 50 percent more in losses than commercial banks from 2007 to 2010. Similarly, Spain’s savings banks, or cajas,1 are expected to repossess 396 billion euros in real assets over the same period, compared to commercial bank repossessions of 285 billion euros, despite savings banks holding roughly half of Spanish financial sector assets.

Policy

As the events of 2008 and 2009 demonstrated, trouble in the banking sector rarely stays in the banking sector. With governments, companies, and individuals in Greece, Ireland, Portugal, and Spain having borrowed $1.6 trillion from banks in the Euro area, it is also likely that further trouble in the GIIPS will not stay in the GIIPS. Policy makers must quickly and forcefully address the challenges outlined above, beginning with taking urgent steps to reassure markets that Europe’s fiscal problems will be managed.

This is not enough, however. A rigorous analysis of the banks’ ability to withstand further losses, including those coming from the default of one or more Euro area government, must be done. Banks that fail this “stress test” should be required to improve their balance sheets or restructure; for those that are deemed too weak, political leaders should take steps to limit contagion effects. Over the medium term, policy makers should push for reforms to reduce the public’s share of the banking sector in order to enhance productivity.

Finally, financial reform should be enacted deliberately, transparently, and in a gradual, coordinated manner. Given the nervousness in Europe’s banking system—half of the eighteen Euro area banking groups rated by Moody’s have been tagged with a negative credit outlook—policy changes could create new, difficult-to-manage shocks. For example, in the week following Germany’s ban on naked short selling, which came as a surprise to many market participants, both German and European equities fell by nearly 8 percent. In today’s jittery market, even the wisest policy action must be implemented carefully.