Bad debts hobble any European recovery

December 2013

In Europe, there’s a number that punctures immediate hopes for the region. It is the amount of bad debts that sit on eurozone bank balance sheets. Accounting firm PwC estimates that non-performing loans now exceed 1.2 trillion euros (A$1.8 trillion), a figure that has doubled in four years.[1] Until its banking system is steadied, Europe’s economy will be deprived of the lending it needs to recover, heightening the risk that only years of stupor lie ahead.

Forcing banks to confront their woes ranks among the most onerous tasks confronting policymakers in the eurozone, where non-performing loans will peak this year at 7.6% of gross lending, according to Ernst & Young.[2] The EU in October shifted a chunk of the responsibility for fixing banks to the European Central Bank. Late next year, the central bank will assume from national regulators sole responsibility for supervising large banks. The ECB will thus be in charge of ensuring that eurozone banks shed 3.2 trillion euros in assets (which means reduce their lending to trim their balance sheets by about 7%)[3] to comply with Basel III regulations by 2018, according to an estimate by the Royal Bank of Scotland.[4] While shifting supervisory powers to the ECB marks an achievement for Europe’s policymakers towards the banking union the area needs, they need to take even bigger steps to create the proper infrastructure needed to safely and swiftly restructure Europe’s banks. The challenge for lawmakers is that popular support is working against the formation of a union that is needed to ensure that the common currency survives.

A banking union entails having a uniform rulebook, one supervisor for all banks (rather than palming off smaller banks to national regulators as Europe has done at Germany’s insistence), a well-funded bank-resolution mechanism under central political control and a deposit-guarantee mechanism across an area. The key advantage of a banking union is that it spreads the costs of banking failures across the area under coverage, rather than allowing the pain to devastate the state (in Australia’s case) or country (in the case of the eurozone) where the bank is headquartered.

A banking union is not a cure-all, of course, and dollops of liquidity from the ECB and accounting and other tricks are propping up Europe’s banks anyway for now. A banking union won’t nullify the solvency threats from inadequate capital, a jobless crisis and the deflation taking hold in peripheral Europe. Its formation may prompt banks to over-prioritise boosting capital over lending. It won’t lower the equity and bond crossholdings among European banks that make the region’s banking system so vulnerable. But a banking union is the best way for Europe to cope with the excessive amount of soured loans to households and business that trouble bank balance sheets. It will help diffuse the threat posed to governments by oversized banks – due to excessive lending, eurozone banking assets amount to 3.5 times GDP compared with about two times in Australia, Canada and Japan and less than one times for the US. Perhaps far more significantly for Europe is the political symbolism involved with forming a banking union. Big leaps towards a banking union would verify that European policymakers are serious about creating the political, fiscal and financial integration Europe needs to surmount its crisis. For any banking union involves genuine political entwining and some fiscal sharing.

The credibility test

While the EU-controlled European Banking Authority is working on a single set of rules for European banks, the challenge of securing all the steps needed for a banking union for the euro area became apparent when the ECB in October said it will prepare for its supervisory role by conducting a review of the eurozone’s 130 biggest banks. The aim of the exercise that will cover 85% of the eurozone banking system by assets is “to foster transparency, to repair and to build confidence”, the central bank said announcing the review that will include tests on how resilient balance sheets are to shocks.[5]

When asked on Bloomberg Television whether any exam that aims to build confidence sounds rigged, ECB President Mario Draghi was forced to respond that “banks do need to fail” to uphold the integrity of the review.[6] His attempt to protect the validity of the ECB’s bank assessment rang hollow to many used to eurozone fudges – as if the ECB is going to reignite the eurozone crisis by flunking a bunch of its largest banks. It reminded many of the stress tests in Europe in 2010 and 2011 that quickly lost credibility when banks that passed soon needed rescuing.

The announcement of the ECB’s review served to highlight the inadequacies of the steps Europe has taken towards a banking union. The big failure is to establish a jointly funded mechanism to handle bank failures under central political control. A major barrier to any agreement is agreeing on who bears the cost of managing bank failures and who decides that a bank should be allowed to collapse.

The only sizeable progress Europe has made towards a joint bank-rescue mechanism is to sanction off 60 billion euros within the 500-billion-euro European Stability Mechanism to help banks if a Europe-wide system is ever put in place to cope with bank failures. This is an underwhelming amount of money given the estimated numbers of bad loans to households and businesses on Europe’s bank balance sheets. A further restriction is that the money would only be deployed if national governments agree to as-yet unformulated conditions. Another complication is that the rescue fund is under the political control of the so-called troika, the European Commission, the ECB and the IMF, a setup ripe for squabbling. Until policymakers agree on a centrally controlled authority to handle bank failures, national regulators (governments) will stay the backstop for collapsing banks headquartered in their country. This only reinforces the potential all-fall-down embrace between weak banks and debt-laden governments.

While European leaders have set a deadline of 1 January 2015 to have a common resolution system in place, they are unlikely to meet that timetable if no legislation is passed before European parliamentary elections in May. A meeting of European finance ministers in November failed to make any progress towards a year-end deadline to agree on how to fund a joint banking backstop, in the hope of having a European resolution mechanism in place by the time the ECB takes over supervision.

Fudging

The core reason why a banking union is largely stalled in Europe is politics. Germany is the biggest impediment. Berlin says that treaties governing the EU need to be changed to create a single resolution mechanism, a view that stalls progress because changes to treaties usually mean undertaking the slow and uncertain process of gaining voter assent. Berlin opposes the EC having the power to decide whether to restructure or dissolve a troubled bank and wants to keep this decision with national governments. It is insisting that creditors get wiped out (bailed in) as a condition to bank access to EU rescue money, even though Draghi has warned that such bail-ins risk alienating private investors. It is thwarting a eurozone-wide deposit insurance scheme. It is resisting ECB and EU requests to hand its small banks over to ECB supervision.

Berlin’s motives are more than simply wanting to protect its taxpayers from bank failures in other eurozone countries. It thinks that keeping supervision at the national level is the best way to hide the inadequacies of Germany’s banking system that includes some dodgy multinational and some suspect smaller regional banks. The decision to make the ECB responsible for supervising large banks only was a sop to keeping Germany’s generally small banks under Berlin’s political protection.

While politicians are hamstrung, Europe is experiencing a credit crunch – loans to the private sector fell 2.1% in the year to October.[7] At the same time, European banks are financing wobbly firms to avoid capital losses and are allowing troubled borrowers to technically default in a way that prevents write-offs hitting the balance sheets. (The simplest way to do this is to extend troubled loans and pretend they are sound, a drill that bankers call “forbearance”.) Such practices can’t go on endlessly. Maybe concerns that the eurozone crisis will reignite sooner or later will energise Europe’s politicians into taking leaps towards a leaner, better-capitalised and unified banking system that is capable of providing the financial lifeblood that businesses across Europe needs to thrive. The flawed structure of the euro, Europe’s unemployed and all those bad debts demand nothing less.

by Michael Collins, Investment Commentator at Fidelity

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© 2013. FIL Responsible Entity (Australia) Limited.  Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

Financial information comes from Bloomberg unless stated otherwise.

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