Europe's Banks Can't Do Draghi's Bidding
At the core of the European Central Bank's latest round of stimulus is a simple bet: that Europe's stress-tested banks can be nudged into increased lending. But what if the banks aren't nearly as healthy as ECB chief Mario Draghi insists? And what if companies don't want to borrow or depositors prove more fickle?
Europe clearly has both strong and weak banks, but the traditional role of the banking system in attracting short-term deposits and transforming them into lending has been slowly unraveling across the euro area. This not only makes it unlikely that the banks will act in the transmission role on which ECB measures depend, but it also increases the risk that capital is being misallocated. It's not hard to imagine how any of a number of worst-case scenarios could overcome today's relatively weak bank defenses.
One sign of a changed banking environment is that bank deposits remain at their 2008 levels while banks notes in circulation have nearly doubled. The decline of banks as a repository for short-term cash has gone hand-in-hand with decreased lending to the real economy.
This bank-avoidance has profound consequences. Quantitative easing was designed to make cash more available for lending, while negative rates were introduced to punish idle money. But lending has been reduced by more than 10 percent since its peak in 2009, a sign of lack of demand.
This reaction is similar to that of Japanese banks in the 1990s, when the introduction of new capital requirements triggered a banking crisis and wider economic fall-out. In a 1997 study I co-authored on that period, we found that lending that generated short-term retained earnings and boosted bank capital was attractive given the new regulatory environment. There was a high correlation between high-risk lending and the introduction of new capital requirements in 1992 by the Bank of International Settlements.
There were other contributing factors to the Japanese crisis, but as the IMF noted in a report on that period, "the Japanese banking crisis serves as a warning that such a crisis can befall a seemingly robust and relatively sophisticated financial system."
Europe's banks may still be healthier than the majority of Japanese banks in that period, but that doesn't mean they are invulnerable. According to a 2015 European Central Bank report, European non-performing loans have tripled since 2008. Simultaneously, pushed by declining interest rates, profitability in European retail banks has also declined, with return on assets dropping to zero in 2013 from 0.6 percent in 2007. Negative interest rates since have not helped; they encourage banks to pursue higher reward (and higher risk) opportunities.
If lending has been anemic, the non-performing loan picture suggests a steady rise in risk-taking from banks, possibly to compensate for the lower profit margins and the higher levels of capitalization required following the financial crisis.
The weaker banks are of course concentrated in the most challenged euro zone economies. NPLs are estimated at 4 percent in France, 7 percent in Spain and as high as 17 percent in Italy. This compares to NPL levels of 2 percent in Germany, and just over 1 percent in the U.S.
The increased stress on Europe's banking system is reflected in a decline in two other measures: the price of banking shares and the market for credit default swaps. Bank share indices are back to their immediate post-crisis levels, a decline of 70 percent from the 2007 high. With such low capitalization levels, banks have found profit margins squeezed and even fewer funds available for lending.
Credit default swaps -- effectively insurance contracts against the non-payment of a security -- may no longer be the indicator they once were but they still tell a story. They tell us that the likelihood of bank default has markedly increased. Subordinated European bank debt, according to CDS prices, is now more than twice as risky as it was in September 2014.
The lack of a euro zone deposit guarantee system, which has been sought by Italy but resisted by Germany, means bank deposits are backed by segregated state credit, rather than monetary authority. While Italy averted contagion from the troubles faced by its third largest bank, Banca Monte dei Paschi, earlier this year, it is not clear that, given its large sovereign debt, it would be able to convincingly do so again should more banks be affected. And a problem in Italy could easily spread. All it would take is an external shock. Indeed, 20 of Europe's largest banks have energy loans totaling $200 billion, or a quarter of their common equity. Oil prices have edged up lately, but it doesn't take a lot of imagination to see how a reversal could prove catastrophic. And that is only one of a number of potential shocks.
Draghi has refuted claims that the ECB has run out of fuel to stimulate demand in the euro zone; instead, he hit the gas pedal. The double-or-nothing approach ignores the way Europe's banks -- the transmitters of the hoped-for stimulus -- are not in a position to play the role he has given them.
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Jean-Michel Paul at JPaul@acheroncapital.com
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Therese Raphael at email@example.com