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Lachman Loan Ratio

Any doubt that Europe is heading towards another round of its sovereign debt crisis should have been dispelled by data compiled last week by the Moody's rating agency on the state of the European banks. For those data reveal a disturbing increase in the non-performing bank loans of a number of key European countries. More disturbing yet is the fact that the increase in European bad loans is occurring at the very time that the weak European economic recovery is already showing signs of running out of steam and that European inflation remains stuck in the deflation danger-zone.

According to the data compiled by Moody's, there has been a troubling rise in non-performing loans to well over 10% of total bank loans in Italy, Portugal, and Spain. It is particularly troubling that this bad loan situation could require further government support to the banking systems of these countries at a time that public sector debt to GDP is already over 130% in both Italy and Portugal. It is also troubling since one has to expect further significant increases in these non-performing loans should the European economic recovery falter and should Europe move further towards deflation.

In considering how big an issue European non-performing loans can become, it is well to remember that the European banks also have on their books very large holdings of their respective country's sovereign debt, which are of dubious quality yet which are treated by the European regulators as risk-free assets. It is also well to recall how large the European banking sector is in relation to that of the United States. Whereas in the US the banks' balance sheet is around 100% of GDP, in Europe the banks' balance sheet is generally in the range of 300% of GDP. This implies that resolving the European bad bank loan problem could add substantially further to the already high sovereign debt levels that characterize countries in the European periphery.

In the context of a faltering European economic recovery and very high public and private debt levels, it would seem to be only a question of time before the European sovereign debt crisis again comes into the market's focus. Among the more obvious factors that might reignite the crisis is a normalization of US interest rates that might change the present ample global liquidity situation, which has helped to mask the very poor state of Europe's public finances.

It would be a mistake, however, to think that an increase in US interest rates is the only factor that might renew the European debt crisis. Rather one would think that any sign that Europe is again moving towards recession or towards deflation might bring home to markets how unsustainable is the European periphery's debt level. Similarly a major political reversal in any of the peripheral countries could raise questions anew in the markets about the political willingness of the highly indebted European countries to persevere with fiscal austerity and structural economic reform. And the forthcoming asset quality review exercise of the European Central Bank scheduled for October could also draw market attention to this issue.

In her recent Congressional testimony Janet Yellen intimated that US interest rates could be raised earlier than expected should the US economic recovery be stronger than anticipated. She also acknowledged that there were pockets of froth in some sectors of the US equity and credit markets. What she did not mention, however, was how frothy are European credit markets and how those markets might be impacted by a rise in US interest rates. This might have been a serious omission on her part considering the impact that a renewal of the European sovereign debt crisis is likely to have on the US and global economic outlook.

Source: Europe's Bad Bank Problem