Oxstones Investment Club™“PROBABLY the most successful monetary-policy measure undertaken in recent times.” That is Mario Draghi’s self-effacing judgment on the outright monetary transactions (OMT) programme, the promise made by the European Central Bank (ECB) last summer to buy the bonds of struggling euro-area governments. The ECB’s president deserves credit for bringing calm to bond markets. But in reality the situation is still awful, and Europe’s banks are at the heart of the problem.
The euro-zone economy has contracted for six consecutive quarters. The IMF this week revised its 2013 forecast down again: it expects the euro zone to shrink by 0.6% this year. (Just to rub things in, the fund adjusted its forecasts for Britain upwards.) The outlook in the core euro-zone economies has worsened, thanks in part to a slowdown in Chinaeuro-area governments: in May German exports suffered their sharpest fall for two years. But the brunt of the pain is being borne by the peripheral economies.
Greece is in its sixth straight year of recession; Spain’s unemployment rate stands at almost 27%; Italy’s credit rating was downgraded this week. Benoît Coeuré, an ECB board member, got it right on July 10th when he said that the euro zone “is still engulfed in a severe crisis”. The OMT programme may keep the financial speculators at bay, but pressure can build on the streets as well as in bond yields. Years of joblessness, economic hardship and edicts from creditor countries are straining the political fabric in Portugal and Greece.
Credit corpses
Banks are central to Europe’s prospects. The fear, especially in peripheral economies, is a repeat of Japan’s experience in the 1990s, when “zombie” banks staggered along for years, neither healthy enough to lend to firms nor weak enough to collapse. There are the same unvital signs in Europe. The average price-to-book ratio for European banks remains below one, suggesting that investors think lenders are worth more dead than alive. In America, where banks were recapitalised quickly, the ratio exceeds one. Italy’s two big lenders, UniCredit and Intesa Sanpaolo, have ratios of 0.34 and 0.42 respectively.
The suspicion of European lenders is well-founded. The amount of shaky loans keeps climbing: worryingly, there are more non-performing loans in the Italian banking system than there is core “Tier-1” capital. Lots of peripheral banks have been loading up on their own governments’ bonds: Portugal’s three biggest banks increased their holdings of Portuguese sovereign debt by 16% in the first quarter of the year. Mortgages account for even more bank assets’ and house prices keep falling—at the fastest pace on record in Spain in the first quarter.
Weren’t the Europeans supposed to be cleaning up their balance-sheets? Private-equity firms that have raised billions to buy up distressed assets from European banks are kicking their heels while they wait for deals to arrive. Regulators worry that banks, rather than writing off or selling bad loans, have been fiddling with the models that dictate how much capital they need to hold. Danske Bank, a big Danish lender, was abruptly ordered by its supervisor to change its calculations last month, lowering its capital ratio. Denmark is outside the euro, but even German politicians joke about the nasty surprises in their banks’ balance-sheets.
None of this presages a full-scale collapse: European banks have more capital than they did before the start of the crisis. But lending is being throttled. As far as the periphery is concerned, the ECB’s attempts to kickstart growth with ultra-low interest rates is one of the least successful central-bank policies of recent times. Loans to non-financial firms contracted in May by 4.1% in Italy, 5.0% in Portugal and 9.7% in Spain. Some of that is caused by the impact of recession. But it also reflects financial fragmentation. Banks in strong countries are lending less across borders. Lenders in weak countries pay more to borrow than banks in strong ones. This divergence ripples through to customers: the difference in the cost of borrowing between German and Spanish firms rose from a mere six basis points in summer 2011 to 149 basis points earlier this year.
Channel-hopping
As long as Europe’s banks are not strong enough to lend, its economy will struggle to grow. Mr Draghi and his fellow policymakers should concentrate on three cures.
The first is to unclog the lending channels. There are mechanisms for the ECB to try to lower bank-lending rates in the periphery. But it could also usefully weaken the dependence of small and medium-sized enterprises (SMEs) on banks by helping prise open the capital markets—by, for instance, buying up securities backed by SME loans. That would mean helping some countries more than others, something that makes the ECB uneasy. But this horse has bolted: the central bank’s policies are already having an uneven effect across the euro zone. The European Investment Bank could also ease credit by taking a “first-loss” position in SME-backed securities. There has been a lot of talk about this sort of thing, but too little action.
The second cure involves lifting the cloud of suspicion over European banks. The ECB will undertake an “asset-quality review” before it takes up the role of euro-zone banking supervisor next year. Previous stress tests by national supervisors were not tough enough—and convinced nobody. The asset-quality review is the ECB’s first and best chance to establish its credibility. Banks that fall short must be recapitalised—by raising fresh equity from private investors, by bailing in creditors and, in some cases, by bringing in public money.
That raises the familiar spectre of the Spanish and Italian governments worsening their own finances by borrowing to prop up domestic lenders. That is a reminder of the importance of the third cure: a proper banking union, supervised by the ECB, with a common resolution fund (proposed this week by the European Commission) and a joint deposit-guarantee scheme. The euro zone will not work without a banking union. Here Germany is the block: it hints that it might consider taking on such mutual obligations in the future, but not now. The problem is that now is when the banks are half-dead. Waiting for zombies to come back to life is a fool’s game.
Tags: Britain, Danske Bank, euro-area governments, Euro-zone, european banks, European Central Bank, European lenders, Germany, Greece, IMF, italy, monetary policy, OMT programme, Portugal, Portuguese sovereign debt, slowdown in China, SME loans, SME-backed securities, SMEs, spain