As the European Central Bank prepares to take its first big step toward a banking union, the financial industry in the region remains as fragmented as ever.
Access to credit is choked off in the economies that need it most, banks are more dependent on government bonds of their home countries, and ECB reviews of the region’s biggest lenders, intended to restore investor confidence, may backfire.
ECB supervision alone probably won’t reverse the fracturing of lending along national lines that has driven up borrowing costs in some countries and worsened the co-dependence between indebted governments and their banks. As long as the bill for rescuing or shuttering failing lenders rests with individual states, regulators will be loath to relax their grip, according to current and former banking supervisors and economists.
“Supervision is clearly not enough,” said Guntram Wolff, director of Bruegel, a Brussels-based research firm. “Central resolution is also necessary for national supervisors to stop bullying banks into a nationally fragmented framework.”
The drive for a banking union stems from the trauma of the European debt crisis, when governments were forced to rescue lenders loaded down with bad loans, sparking a run on sovereign debt so severe the euro’s survival was imperiled. The ECB today announced its methodology for reviewing the quality of assets of the area’s biggest banks before taking over supervision next year.
The crisis prompted banks in Germany and France to cut cross-border lending and shun the bonds of Europe’s most indebted nations, including Greece, Ireland, Portugal, Spain and Italy. That and surging public debt levels in those countries drove up borrowing costs, leaving some businesses starved for credit while forcing governments to rely on their own banks, financed with cheap long-term ECB loans, to buy their bonds.
The fragmentation has cut into profits and made cash management harder for lenders across the region.
UniCredit SpA, Italy’s biggest lender, is constrained in moving funds from its German and Austrian units to Milan, where it’s based, because of objections by national regulators, according to a person with knowledge of the firm’s operations who asked not to be identified because the matter isn’t public. The Austrian unit faces similar barriers moving funds to Eastern Europe, where it’s the biggest lender.
Deposits and bonds issued by the bank held by customers in Germany and Austria -- 166 billion euros ($228 billion) at the end of June -- comprise about one-third of UniCredit’s total. Lenders in those countries pay on average 0.5 percent annually to depositors, compared with about 2.5 percent in Italy, ECB data show. Not being able to lend the money it borrows cheaply in Germany and Austria to companies in Italy, Turkey or Russia, where rates are higher, hurts UniCredit’s profitability. It lost money on its Austrian operations in the first half.
“European banks have a competitiveness problem and cannot allocate liquidity in a proper way because they have different regulators and rules and market fragmentation,” UniCredit Chief Executive Officer Federico Ghizzoni told reporters in Milan last month. “This isn’t a problem just affecting UniCredit but the whole European banking industry.”
The rush to cut risks tied to Greece, Ireland, Portugal, Spain and Italy eroded progress made since the euro’s 1999 debut, which helped integrate the region’s banking industry. Lenders that had wagered on an increasingly open financial system hedged those bets by pulling back, while local banks wound up holding more domestic sovereign debt.
Since 2010, the exposure of U.K., German and French banks to the five countries shrank by half, Bank for International Settlements data show. That’s about $1 trillion of loans to the governments, banks and companies evaporating in three years.
BNP Paribas SA, France’s largest lender, reduced the funding it provided to its Rome-based BNL unit to 5.5 billion euros by the end of June from 29 billion euros at the end of 2010, according to company reports. Credit Agricole SA and Societe Generale SA sold their unprofitable Greek banks.
The reduction in cross-border lending has resulted in firms in southern Europe paying more to borrow than those in northern countries -- when they can obtain credit at all. The average rate for new loans to companies in the five peripheral countries was 5.7 percent in the six months through August, while those in Germany and five other northern nations paid 3.1 percent, ECB data show.
As recently as 2009, rates for new corporate loans were lower in Spain and Italy than they were in Germany. Since then, they rose even as the ECB cut its benchmark rate, while borrowing costs in Germany, Austria and the Netherlands fell.
“Higher lending rates have tightened monetary conditions, negating the impact of ECB rate cuts and the euro’s depreciation, and were a major factor behind the deep recession” in Italy, the International Monetary Fund said in a report last month.
The higher rates have led some firms to shift manufacturing out of southern countries, further weakening those economies.
Ficep SpA, a producer of steel-fabrication machinery, makes beam-drilling machines in Camblanes, France, in addition to its main plant in the northern Italian town of Gazzada. While the equipment sells for about 200,000 euros in both countries, buyers in Italy pay more because lending rates are higher, according to Chairman Ezio Colombo. The usual five-year financing package costs 1 percent to 1.5 percent annually in France compared with 4 percent to 5 percent in Italy, he said.
“That means that on average a 500,000-euro sale of the same product costs 60,000 euros more in Italy,” Colombo said. “The higher cost of credit is killing Italian exporters.”
EUSolar Srl, a builder of solar plants in northern Italy, opened a headquarters across the Swiss border in Locarno two months ago to reduce funding costs, said Maurizio Guidi, a co-owner. Switzerland isn’t a member of the European Union.
“Credit conditions in Italy are prohibitive,” he said.
While Italian banks charged annual interest of 4.5 percent to 7 percent, plus fees, for a 100,000-euro credit line, in Switzerland banks are willing to lend at 1.2 percent to 1.9 percent, Guidi said.
The gap in borrowing costs between the euro-area periphery and its core is wider than ECB figures show, based on a recent survey of lenders and borrowers by the Washington-based Institute of International Finance. Small and medium-size companies in Italy, Spain, Portugal and Ireland were offered loans that were 4 to 6 percentage points higher than German firms of similar size, the study found.
One reason ECB figures show a smaller gap is that some businesses end up not borrowing at such high rates, according to the IIF, a trade group for the global financial industry.
The disparity in costs, along with shrinking bank balance sheets, has made credit scarcer in the south. Deleveraging in Spain started in 2009 and credit growth hasn’t returned since, ECB figures show. In August, net corporate loan volumes were 20 percent below a year earlier. In Italy and Portugal, they were between 5 percent and 6 percent lower.
Spain’s unemployment rate is 26 percent, and the jobless rate for people under 25 is 56 percent. In Greece, the figures are 28 percent and 57 percent.
Steps toward a banking union probably won’t lead to easier lending terms soon, and conditions might deteriorate for a time, said Susana Monje, CEO of Grupo Essentium, a Spanish construction company.
“We don’t think that with banking union will come either in the short or medium term the reactivation of credit that European institutions and especially the ECB point to,” Monje said in an e-mail. “Changes in supervision and regulations normally have the effect of withdrawal of credit as the banks try to make their balance sheets look the best they can.”
The push for more unified rules gathered force during the depths of the sovereign-debt crisis. As international investors shunned the bonds of Europe’s most indebted countries following Greece’s default and the bailout of Ireland and Portugal, government borrowing costs jumped to euro-era records along Europe’s southern rim. That worsened an economic contraction in Spain, already reeling from a property-market collapse, and contributed to Italy’s longest recession since World War II.
As banks based in northern European countries retreated to their home countries, lenders in peripheral nations took on increasing amounts of their governments’ debt, helped by the more than 1 trillion euros of low-cost, three-year loans the ECB made available in late 2011 and early 2012.
Banks in Italy have doubled their holdings of Italian government debt since the beginning of 2011, while lenders in Spain increased their portfolios of Spanish sovereign bonds by 60 percent, according to data compiled by Bloomberg. Spanish banks now own about 40 percent of all of Spain’s public debt. For their Italian counterparts, the ratio is about 20 percent.
To stem this splintering within the euro area and prevent a rerun of the region’s debt crisis, policy makers envisioned a banking union that would incorporate a single supervisor, a central system to recapitalize or wind down failed banks and Europe-wide deposit guarantees.
While common oversight by the ECB received approval from EU finance ministers in Luxembourg last week, progress toward a single system for dealing with failing banks has been stymied by Germany’s insistence that using European funds to recapitalize lenders would require changes to EU treaties and German law.
EU leaders last year sought to empower the European Stability Mechanism, the region’s bailout fund, to lend directly to banks. They are now emphasizing national responsibility for stabilizing lenders that need help.
“Without a resolution mechanism, we’re only halfway to resolving the sovereign-bank nexus,” said Lorenzo Bini Smaghi, chairman of Italy’s Snam SpA and a former member of the ECB’s executive board. “The principal factors needed to restore growth in the euro area are the easing of fiscal restrictions and credit contraction -- banking fragmentation is key.”
With the ECB about to begin scrutinizing the balance sheets of the region’s largest lenders, bankers have called for a mechanism to backstop those found to need more capital.
“The question for me is: Who is going to provide that capital,” Jan Hommen, who stepped down this month as CEO of Amsterdam-based ING Groep NV, said in a September interview. “Because I don’t think there is a safety net built yet that makes sure that if a bank needs more capital, it is there.”
Without a common fund to backstop them, some governments may choose not to fill the holes that the ECB’s review finds, said Harald Benink, a banking and finance professor at Tilburg University in the Netherlands.
“We could have the ECB telling governments to shut down or restructure banks, but it won’t have power to force national authorities to do that,” Benink said. “Then we’ll have zombie banks being kept alive.”
Before it takes on supervisory responsibility, the ECB will be combing through the balance sheets of 124 banks to make sure there aren’t hidden losses, it said today. If it finds underreporting of bad loans or mispriced securities, it will ask the lender for further writedowns and an increase in capital to cover them.
While the ECB will require the euro area’s biggest banks to hold a capital buffer of at least 8 percent, what qualifies as capital will change over the course of the three-part assessment, the central bank said in a statement today. The ECB will use stricter rules when stress testing banks’ balance sheets next year than it will to study their assets.
“We’ve got a feasible but safe capital cushion of 8 percent,” Ignazio Angeloni, head of the ECB’s financial stability directorate, said at a press conference in Frankfurt today. “We want the exercise to encompass all the main sources of risk.”
The central bank will have a tough balancing act, according to Alberto Gallo, head of European credit research at Royal Bank of Scotland Group Plc.
“The ECB has to reveal some shortfalls, but it also can’t be too tough,” Gallo said. “There’s a trade-off between maintaining its credibility and harming the banking system. The ECB won’t blow it all up in its face.”
ECB President Mario Draghi has said that banks should be able to access public aid without wiping out junior bondholders if regulators decide a lender needs more capital and isn’t on the brink of failure. He asked the European Commission to be more flexible in allowing such government capital injections as the bloc seeks to improve confidence in its banks, according to a July letter obtained by Bloomberg News. The letter was a response to a commission rule change requiring mandatory bail-ins for all future bank state aid.
The 44-company Bloomberg Europe Banks and Financial Services Index has gained 50 percent since July 2012, when Draghi pledged to do whatever it takes to keep the euro intact, outperforming gains of other European stock indexes.
The recent history of European stress tests isn’t encouraging. Exams in 2010 found Ireland’s banks sound just months before their collapse required an international rescue, while Dexia SA passed 2011 tests run by the European Banking Authority only to fail and be broken up. Both reviews found smaller capital shortages than analysts had predicted.
“It is important that we get a very credible asset-quality review and also credible stress tests, so therefore it is essential that euro countries can set up a backstop,” Swedish Finance Minister Anders Borg said after the Luxembourg meeting.
Germany has insisted that the EU speed up implementation of rules requiring bank creditors to share in losses before public funds can be used. Those are now slated to take effect in 2018. The Netherlands has urged members to pass national legislation immediately requiring creditor bail-ins when the governments have to step in as well.
Junior bondholders in Spain’s banks have contributed 24 percent of the more than 50 billion euros of capital injected into the nation’s lenders, according to a study by Hans-Joachim Duebel for the University of Frankfurt. In Ireland, the private burden-sharing at two banks studied was 12 percent.
Even with the bondholder contribution, the use of taxpayer funds by the two countries to rescue their banks more than tripled the ratio of debt to economic output for each government to more than 100 percent, which could take 15 to 30 years to bring back to reasonable levels, according to Paul De Grauwe, a professor at the London School of Economics.
Banks in Spain, Italy and Portugal face about 250 billion euros in potential losses on their business loans over the next two years, the IMF said in a report earlier this month. That equates to about one-third of the total capital held by the banks in those three countries.
Asking the already highly indebted governments of those countries to recapitalize banks to cover such losses will further increase public debt levels. Sovereign risk is as important as bank risk in determining when cross-border cash flows will resume in the euro area, said Karel Lannoo, CEO of the Brussels-based Centre for European Policy Studies.
“Fragmentation above all results from risk aversion, and that’s not just bank risk but country risk,” Lannoo said. “In addition, banks’ asset quality depends on the economy. So if these countries cannot get out of recessions and indebtedness, their banks will keep bleeding.”