Banks Put The Squeeze On Euro-Zone Growth

Cautious lenders are keeping interest rates up -- and making loans harder to get. That could stall an already slow recovery

After the European Central Bank lopped 75 basis points off interest rates last year, many companies in the slow-growing euro zone breathed a sign of relief. Markus Brachtel, who runs a small Rotterdam trucking business, figured he'd benefit from much lower rates when his company renewed a $312,000 one-year loan on Feb. 26. But his bankers had other ideas, demanding 4.5%, or just 40 basis points less than a year ago. "I'm a bit fed up," says a disappointed Brachtel. "I thought they'd have charged me less, given how far ECB rates have fallen."

Brachtel is just one of hundreds of European entrepreneurs -- mostly small and midsize corporate borrowers -- that aren't getting the full benefit of Europe's low interest-rate policy. And commercial banks are doing more than just keeping interest rates high: According to an ECB report issued Feb. 12, they are also lending smaller amounts for shorter periods, demanding more collateral, and imposing stricter covenants -- all despite the fact that the creditworthiness of most European companies is improving. Critics say that if the banks continue tightening their loan conditions, they could depress growth just as the sluggish euro-zone economy is finally beginning to revive. Bank lending in the euro zone as a whole continues to expand, but slowly, at an annualized rate of 3.1%. The problem is particularly acute in Germany, which is nearing a credit crunch. "Tighter lending is already undermining the economy," says Martin Wambach, a managing partner at Rödl & Partner, a Nuremberg financial-consulting firm. "The banks' policies are holding growth back." Says Citigroup (C ) chief European economist Michael Saunders: "This adds to the likelihood that even with strong global growth, the euro-area recovery will be modest."

LOWER TOLERANCE FOR RISK. Politicians such as German Chancellor Gerhard Schröder and French Prime Minister Jean-Pierre Raffarin have been urging the ECB to cut rates to stimulate growth. But if analysts like Saunders and Wambach are right, the pols' wrath may be misplaced. The banks may not respond to further rate cuts by handing out more and cheaper credit.

What's going on? Experts explain that banks in Europe had to eat billions in bad loans from the roaring '90s and are naturally being more cautious to- day. Germany's four leading banks -- Deutsche Bank, HVB Group, Dresdner Bank, and Commerzbank -- racked up $10 billion in provisions against loan losses in 2002. Now they think twice before handing out loans. "Risks that used to be acceptable are now looked at more carefully by the banks," says Josef Trischler, director of corporate economics at the German Fed- eration of Engineer- ing Industries.

Indeed, the banks are proud to point out that the days of easy credit and pro-forma due diligence are gone. Moreover, they note, the European corporate titans that would qualify for the lowest loan rates today increasingly avoid bank loans by tapping the bond market. Euro-zone banks in general also are tightening the screws in anticipation of new global capital-adequacy rules, known as Basel II, which will go into effect by the end of 2006. The rules will force banks to set aside more capital against riskier loans. That, in turn, means banks will have to charge more for their loans to earn the higher returns they need. "Basel II is making everything more formal," says Hiltrud Nehls, an economist at the Rhine-Westphalia Institute for Economic Research in Essen. "The days when bankers used to lend money on the back of personal relationships are gone."

The tough love is most shocking for companies in Europe's largest economy, Germany, because they have traditionally paid less to borrow than competitors in neighboring countries. Before the launch of the euro in January, 1999, short-term business loans cost some two percentage points less in Germany than in most other European countries. That's because German savings banks, which account for 50% of all lending, benefited from government guarantees that meant they could raise and therefore lend money more cheaply.

German banks also were not under pressure to make big profits because they are city- or state-owned and not subject to the demands of shareholders. But now the guarantees and state support are being phased out. Loans cost more or less the same -- even though inflation is lower and the economy weaker in Germany than elsewhere in the euro zone.

SMALLER POTS OF CASH. Many smaller German companies have been reared on cheap credit from formerly lenient lenders. And statistics show those businesses depend on bank borrowing for a larger share of their financing needs than counterparts elsewhere in the euro zone. Bank loans accounted for 42% of total corporate liabilities in Germany last year, compared with around 32% in Italy and just over 10% in France. Worse, many of the small and midsize companies that make up the Mittelstand, the heart of the German economy, are terminally undercapitalized. "German companies aren't exactly overflowing with capital but as compensation have had stable house-bank relationships," says Trischler. "When this constellation isn't there any more, the companies suffer."

German banks are not only charging more for the privilege of borrowing but also extending much less money. The Bundesbank, the German central bank, says private banks cut back on their lending to companies through credit lines by 8.5% between January and November last year. Other types of lending were cut even further. According to the German government's development bank, KfW, 45% of small and midsize companies now have trouble getting loans, up sharply from 32% in 2002. "There's a real danger of a credit crunch," says Reinhard Kudiss, a financing expert at the Federation of German Industries in Berlin. "Many of our members, especially the smaller ones, are very concerned." According to economists at Goldman, Sachs & Co. (GS ). in London and Frankfurt, German investment has fallen sharply in recent years as a percentage of gross domestic product, in part because companies are having to pay comparatively more to borrow.

Banks in Germany and elsewhere deny they are discriminating against small and medium-size companies in their lending policies. On the contrary, Hans-Peter Müller, the CEO of Commerzbank, recently launched a "Mezzanine for the Mittelstand" program that will provide a token $375 million in capital to such companies. And Deutsche Bank Chief Executive Josef Ackermann insists that Germany's largest private bank "has been sensitive to the needs of its clients in Germany, faced by weak economic conditions." Yet Deutsche's loan book now stands at around $185 billion, 14% less than a year ago.

Of course, what's bad for borrowers is great for bank profits, which need help in most euro-zone countries. But as they strive to improve their earnings, Europe's banks are exacting a high price from the small and midsize businesses that make up Europe Inc. Unless those outfits are given room to run, there is reason to doubt that Europe's economy will regain real traction anytime soon.

By David Fairlamb, with Jack Ewing, in Frankfurt

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