Opinion

Euro area banks remain vulnerable

Strengthening the banking system is important to achieve a sustainable recovery, because it will revitalise credit to the healthier segments of the economy. However without restructuring, euro area banks are still vulnerable.

By: , and Date: August 21, 2015 Topic: Banking and capital markets

This article was also published in Expansion, Il Sole 24 Ore, Kathemerini, Handelsblatt, and will be published in Diario Economico.                                       Expansion logoIl Sole logoKathemerinihandelsblatt logodiario economico logo

The euro area’s biggest banks have reported record profits. The stress tests published by the European Central Bank late last year showed that the largest banks—those with assets of more than €500 billion—have been able to cut their non-performing exposures and increase their provisions. But the euro area banking system is not out of the woods. The vulnerabilities lie in the small and medium-sized banks, those with assets below €500 billion. Together these banks own 50% of the euro area banking system assets.

In our research, based on 130 euro area banks directly supervised by the ECB, we find that banks are often superficially well capitalized—their regulatory capital ratios and even their equity capital looks reasonable. Only one in ten small banks has equity less than 3% of its assets; one in six medium-sized banks has an equity/asset ratio below 3%. But banks are vulnerable either because they have a high share of non-performing loans or they have insufficient resources to cover for possible losses on the non-performing loans. This is a widespread problem but one that is especially acute in the countries that have faced high stress since the start of the crisis.

To identify the troubled banks, we asked a crude but simple question. If 65% of non-performing loans have to be written down, how many banks would still have equity that is at least 3% of the bank’s assets? The answer, we find, is that about a third of small banks, with almost 40% of small-bank assets, would fall below the 3% equity threshold. Medium-sized banks would face similarly extensive stress. By comparison, only one of the euro-area’s 13 “large” banks would be considered stressed under our enhanced stress test.

Corroboration for our findings comes from bank share prices. While the stock prices of all banks are still well below their pre-crisis peaks, the small and medium-sized banks that we identify to be stressed have had particularly weak performance. Even this understates the problem since many of the most stressed banks are unlisted. If our scenario were to unfold, the stressed assets of the small and medium banks would add up to about €3.6 trillion, about 38% of small and medium bank assets—and 16% of entire euro-area banking system assets.

 

Evolution of banks’ stock market prices
20150821 banking vulnerability

Source: Bruegel using data from Thomson Reuters Datastream. Note: Number of listed banks: 45 (23 Small, 12 Medium, 10 Large).

 

The troubled banks tend to serve a narrow range of geographically concentrated customers. As the local economy suffers, so do the banks, which, in turn, further hurts local economic prospects. This vicious cycle keeps non-performing loans high—and growing. But despite such localization, their stock price movements were highly synchronized in the early phase of the crisis, as if there were contributing to the broader systemic tensions. In other words, at moments of panic, they add to the panic well beyond the communities they serve.

For dealing with banking vulnerabilities, European policymakers seem wedded to a single response: to pump more capital into the banks. Even after the ECB’s latest asset quality review and stress tests, the entire focus was on how much more capital the banking system needed. Indeed, critics focused mainly on whether the official estimates for recapitalization were too low.

We also believe in well-capitalized banks—with the focus on equity rather than on fuzzy regulatory capital. But the real problem in Europe is that the banks in trouble have had long-standing governance problems. Often they are either government-owned or have links to the government. They have long been the source of patronage and unhealthy lending practices. Even if the new supervisory system helps clean up some of these past pathologies, the question still must be asked: what economic purpose do these banks serve? The continuing problems in Europe’s smaller banks are sending a message: Europe has a problem of overbanking.

The bottom line is that the euro-area’s banking sector needs pruning. In the United States, hundreds of banks have been closed or merged since the start of the crisis—the bulk of such action was taken quickly so that the problems would not fester. In the euro area, after much effort, the authority to resolve banks has now been standardized across the member states. Yet, there has been little action. Despite rules to impose losses on banks’ owners and creditors, there remains a reluctance to do so.

It is well past time to aggressively restructure, consolidate and close the weakest euro area banks. Failure to do so will act as a drag on economic recovery, much as it did in Japan.

 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint.

Due to copyright agreements we ask that you kindly email request to republish opinions that have appeared in print to [email protected].

Read article More on this topic More by this author
 

Podcast

Podcast

Taming inflation?

What are the implications of prolonged inflation?

By: The Sound of Economics Topic: Macroeconomic policy Date: May 25, 2022
Read article More on this topic More by this author
 

Opinion

Buy now, pay later: the age of digital credit

A relatively new fintech market, BNPL is currently not regulated in the EU, meaning that consumers do not have the same protection level as they do for other credit products.

By: Maria Demertzis Topic: Digital economy and innovation Date: May 17, 2022
Read about event More on this topic
 

Past Event

Past Event

What is in store for Euro area economies?

ECB Executive Board Member Philip Lane discusses the outlook for Euro area economies.

Speakers: Maria Demertzis and Philip Lane Topic: European governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 5, 2022
Read article More on this topic
 

External Publication

What drives implementation of the European Union’s policy recommendations to its member countries?

Article published in the Journal of Economic Policy Reform.

By: Konstantinos Efstathiou and Guntram B. Wolff Topic: Macroeconomic policy Date: April 13, 2022
Read article More on this topic
 

External Publication

Close cooperation for bank supervision: The cases of Bulgaria and Croatia

In-depth analysis on the banking supervision cooperation in Bulgaria and Croatia prepared for the European Parliament's Committee on Economic and Monetary Affairs (ECON).

By: Zsolt Darvas and Catarina Martins Topic: Banking and capital markets Date: March 30, 2022
Read about event More on this topic
 

Past Event

Past Event

Tackling future risks to banks

How to address vulnerabilities in banks in the coming years?

Speakers: Maria Demertzis and Elizabeth McCaul Topic: Banking and capital markets Date: March 29, 2022
Read article More on this topic More by this author
 

Opinion

The week inflation became entrenched

The events that have unfolded since 24 February have solved one dispute: inflation is no longer temporary.

By: Maria Demertzis Topic: Macroeconomic policy Date: March 8, 2022
Read article Download PDF More on this topic More by this author
 

External Publication

Book notes: Monetary policy in times of crisis

Review of 'Monetary policy in times of crisis: a tale of two decades of the European Central Bank' published in the Central Banking.

By: Francesco Papadia Topic: Macroeconomic policy Date: February 17, 2022
Read about event More on this topic
 

Past Event

Past Event

A debate on fiscal rules and the new monetary strategy

Presentation of the Yearbook of the Euro 2022.

Speakers: Maria Demertzis, Fernando Fernández, Gonzalo García Andrés, José Carlos García de Quevedo, Pablo Hernández de Cos and Jorge Yzaguirre Topic: European governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: February 17, 2022
Read article
 

Blog Post

European governanceInclusive growth

12 Charts for 21

A selection of charts from Bruegel’s weekly newsletter, analysis of the year and what it meant for the economy in Europe and the world.

By: Hèctor Badenes, Henry Naylor, Giuseppe Porcaro and Yuyun Zhan Topic: Banking and capital markets, Digital economy and innovation, European governance, Global economy and trade, Green economy, Inclusive growth, Macroeconomic policy Date: December 21, 2021
Read article
 

External Publication

European governance

EU borrowing—time to think of the generation after next

Financing post-pandemic recovery via EU borrowing has proved remarkably straightforward. So why keep it temporary?

By: Grégory Claeys, Rebecca Christie and Pauline Weil Topic: European governance, Macroeconomic policy Date: December 9, 2021
Read about event More on this topic
 

Past Event

Past Event

How to deal with small banks: consolidation, tailoring and the fintech challenge

Small banks face multiple challenges. What structural changes are needed to tackle these pressures?

Speakers: Alexander Lehmann, Nicolas Véron, Xavier Vives, Anne Fröhling and Philip Evans Topic: Banking and capital markets Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: December 9, 2021
Load more posts