The European Banking Crisis, Part 2

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Includes: EUFN
by: Peter Newell

Summary

European banks are currently on the hook for 1 trillion euros in non-performing loans. Not including loans to other financial institutions, this represents 10% of their total outstanding loans.

The ECB could put more pressure on banks to make more loans by reducing already negative interest rates.

Italian banks alone hold more than 200 billion euros in bad loans, and 4 of them had to be bailed out last year.

While debt, private and public, is still less than 100% of income and GDP, respectively, there's not a lot more room to grow.

Finally, new regulations prohibit governments from bailing banks out and don't include any form of insurance for depositors.

Last week I wrote about the European banking crisis that is unfolding at the moment. In that article I covered analyzed the default risk to European banks posed by: falling profits caused in part by negative interest rates, and the cost of insuring debt. This article will continue where I left off and cover the risk of non-performing loans in Europe's banking industry. Part 3 of this series will cover the systemic and contagion risk posed by the European situation.

How bad loans come to be

It's probably common knowledge by now that ultra-loose monetary policy forces banks to make bad loans. Lower and lower interest rates create an atmosphere in which banks can't collect meaningful, risk-free interest on cash deposits; and thereby force them to lend. The problem with that is that; in order to find the demand for all the excess capital they wish to disperse, they have to expand their customer base. This expansion often leads some banks to provide loans to customers that they wouldn't have lent to under normal conditions.

In time, banks have to watch as the lower quality customers they were forced to lend to struggle to pay back their loans. I think we can all remember the last time these chickens came home to roost, the global financial system is still dealing with the aftermath.

€1 trillion in non-performing loans

This is what's happening in Europe as we speak. As the ECB has pursued loose monetary policy in the wake of the 2008 financial crisis, European banks have been forced to create demand for money in the hopes of stimulating growth. While the economic benefits haven't materialized, inflation and growth are still anemic; Europe's banks have seen their non-performing loans reach 10% of the total loans and advances, excluding loans to other financial institutions. For comparison, in the U.S. that number is around 3%.

At the end of 2014, Europe's bad loans stood at €932 billion, and reached €1 trillion during the first half of 2015. During the same period, lending in the Eurozone increased by 3.9%. With the growth in new loans last year, and an expectation that negative interest rates will push banks to lend more aggressively this year, we should expect to see more and more European banks' balance sheets become unstable; since the growth to repay all this new debt has yet to materialize.

Italian banks in big trouble

It might come as no surprise that Italy, Greece, Spain, and Portugal account for a significant portion of the non-performing loans; as these countries were hit hardest by the global recession and have yet to recover. However, it might surprise you that Italy's banks hold 20% of the zone's non-performing loans. Italian banks have more than €200 billion in non-performing loans. In a country that has been slow to recover from the financial crisis, this is an unsustainable amount of liabilities; and Italian banks won't simply be able to write these off without causing trouble.

Las year, the Italian government had to implement the Eurozone's new European Bank Recovery and Resolution Directive to bailout four regional banks. The Directive, among other things, forces failing lenders to convert bonds to equity, essentially wiping out bondholders in the process. The efforts helped stave off a desperate situation then, but the country's banks are still holding more than 200 billion euros in non-performing assets. So it's hard to argue the effectiveness of the bailouts, as they seem to have only delayed a major problem.

What's worse, the ECB's negative interest rates will likely push banks to lend more. But how many creditworthy customers are left, and do they have any demand for more debt?

Debt levels in the EU

After 7 years of expansionary monetary policy, there is some good news: EU household debt to income was down to 95.66% in 2014, compared to its high at 98.66 in 2010. But government debt to GDP is still around 93.5% in the EU as a whole, representing the dispersion of risk inherent in the 27 member union. While neither of these statistics is good, they do provide a bright spot: neither number by itself is fatal to the EU economy. But they do shed some light on how little room there is to grow, especially for new loan generation.

Outlook

So for banks, it is a critical time. They are being pushed by the ECB to lend more to stimulate economic growth, while their profits are shrinking and new regulations have come into play that undermine banks' ability to raise debt from investors to finance operations and internal growth.

The outlook is not good for European banks. Share prices have crashed, bondholders have exited stage left, and they could very well see deposits evaporate if the ECB continues deepening already negative interest rates. With governments stripped of the ability to bailout their banks and no FDIC-like deposit insurance thanks to the Directive, any type of shocks to the system could produce chaos.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.