WARNING SIGNALS
Reading Crisis Economics
Focus - Banking risks
Healthy bank balance sheets are crucial to support the economic upswing and long-term growth. This is particularly important in the EU, where reliance on bank credit by enterprises, and in particular small- and medium-sized ones, is large compared, for example, to the United States. A relatively large share of non-performing loans in several banks and further capitalisation needs indicate remaining weaknesses in the banking sector. Banks’ large holdings of government paper may have crowded out private credit. These factors, which are also sources of risk, restrain the banks’ capacity to lend. (OECD)
Introduction
Heading for the end of the credit crunch?
According to the ECB January 2015 bank lending survey:
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Credit standards for all loan categories continued to ease in net terms in the fourth quarter of 2014 (particularly to non financial corporation and households. At the same time, it has to be kept in mind that the level of credit standards is still relatively tight in historical terms.
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Rising net loan demand continued to be reported for the fourth quarter of 2014, in particular for loans to non-financial corporations and for consumer credit.
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Cross-country disparities in lending supply conditions continued to decline in the fourth quarter of 2014.
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Access to funding further for euro-area banks improved in net terms for all main market instruments and for short-term retail deposits, but developments were again heterogeneous across the largest euro area countries.
Low profitability of the Euro Area banks
Low profitability raises concern for EU banks
June 2014 EBA report on risks and vulnerabilities underlined the Euro banks average return on equity (RoE) was significantly lower than international banks average. New regulatory environment combined with the economic downturn, the growing weight of fines and penalties, and the low rate situation continue to pressure banks margins and might be a challenge for the sustainability of some banks’ business models (IMF GFSR, 2014).
According to an article on IMFdirect, high and rising levels of nonperforming loans in the euro area have burdened bank balance sheets and acted as a drag on bank profits. Banks, striving to maintain provisions to cover bad loans, have had fewer earnings to build-up their capital buffers. This combination of weak profits and a decline in the quality of bank assets, resulting in tighter lending standards, has created challenging conditions when it comes to new lending.
Feedback loop between banks and sovereign crisis
A risk of crowding out
According to a study of Columbia Management by Martin Harvey, Euro Area banks balance sheets are devoted increasingly to government debt at the expense of the real economy. There is a risk - illustrated by the Japanese 'lost decades' - that additional government spending eventually becomes a negative influence on growth.
Silvia Merler and Jean Pisani-Ferry come back on the sovereign-bank vicious circle:
"The reason why euro area banks and sovereigns seem to be indissolubly tied together is twofold. On one hand, in the absence of a supranational banking resolution framework, member states keep individual responsibility for the rescue of their national banking system. Given the size of the banking systems across the euro area, this implies that the fiscal consequences of rescuing banks are potentially very large and explains how stress in the banking system can spill over to sovereigns. On the other hand, domestic banks hold on their balance sheets a considerable share of the debt issued by their domestic government. Any doubt about sovereign solvency immediately therefore affects domestic banks. This two-way bank-sovereign interdependence constitutes one of the specific features of the euro area that renders it especially fragile."
Sovereign risk has been mitigated by the implementation of the ECB’s OMT program in September 2012 (Mainly Macro and the November 2014 ECB’s financial stability review). Viral Acharya argues that the solution rests on directly addressing the sovereign excess in the borrowing markets by adjusting the capital charges for sovereign bonds and imposing the highest quality bucket for the government bonds eligibility for liquidity holdings.
For more details: read our Thematic Blogspot (pdf.)
Charts below illustrate the stong correlation between Sovereign and Banks Credit Default Swap.
Premium evolution of banks' CDS
Non performing loans - cleaning the banks' balance sheets
Real-financial linkages from a weak economy
The health of banks in the eurozone is weak. With a weak economy and lowflation affecting companies’ profitability and weighing on borrowers, capacity to repay debt and deleverage is at risk. Non-performing loans might increase substantially, in particular in peripheral countries, where banks are already burdened with large NPLs from the global crisis, making banks more risk-averse, especially with SMEs, and hindering the monetary policy transmission channels (Zerohedge).
Zombie banks
As Nicolas Véron explains, some banks in the eurozone lack a viable business model. Although only 13 banks did not pass the stress tests, German and Italian banks would have fared much worst if Basel III rules were compulsory. He calls for closing these “zombie banks”.
Even Danièle Nouy, the euro area’s new chief supervisor, has acknowledged that some banks must disappear.
Closing dysfunctional zombie banks and restoring wounded ones to health will not be enough to pull the euro area out of its economic and political funk. But the hard work of recognizing bad loans and recapitalizing and restructuring banks will reduce the current drag on growth from banks that squeeze credit even from promising firms, and will contribute to economic expansion and employment. Europe’s policymakers need nerve and clear-sightedness for this opportunity not to be wasted. (Bloomberg)
Read the speach of Benoît Coeuré, Member of the Executive Board of the ECB, on Zombie banks and the risk of a lost decade (5 July 2013) :
"Now, what about the risk of “zombie banks”? The risk that a few undercapitalised banks still operate in the euro area cannot be dismissed. Indeed, the financial crisis of 2008-09 left banks with relatively low capital ratios. In some cases, this problem was tackled by means of interventions that directly sought to restore appropriate capitalisation levels through incentives to restructure bad loans and free up resources for new economic activities. In other cases, governments have reacted by delaying recapitalisation, instead issuing guarantees on bank liabilities. It has been argued that such measures tend to provide banks with an incentive to roll over bad loans and shift risks to depositors or the government."
"Zombie lending is dangerous, as it can stifle the physiological progress of creative destruction which contributes to fostering productivity growth. The adverse consequences on the Japanese real economy are well documented in the literature. The normal process of industrial churning was severely disrupted in sectors populated by “zombie firms”. Under normal conditions, unprofitable enterprises would have lost market value or been driven out of the market, paving the way for profitable new entrants. By guaranteeing the liabilities of banks that supported such zombies, the government effectively kept wages high and prices low, reducing the profits that new productive firms generated and distorting market competition. As a result, even solvent banks had very few good lending opportunities and the economy remained stagnant throughout the 1990s."
(For more details about AQR & Stress test, please read on Special Focus)
For more information about financial risks, read the following focus: