Against the tide: Eurozone still under the cosh
The financial sector remains central to the eurozone’s economic woes. Promises of ECB support only prolong the problem.
The ECB revealed its analysis of eurozone banks in its comprehensive assessment at the end of October with an asset quality review. And the results were broadly benign, as expected. Europe’s banks have been raising capital and increasing bad-loan provisioning. They have also been shrinking balance sheets to reduce the level of risk-weighted assets.
But I remain unconvinced that the problem of Europe’s debt-ridden banks is over. The new stress test looks flimsy. Although the ‘adverse macro scenarios’ have been toughened up, they are still not as tough as those used in the US. They also fail to factor in the macro pressures the eurozone faces, specifically the deflation scenario and the implications this has for debt sustainability.
So the financial sector remains at the core of the eurozone’s economic woes. Weak corporates and overleveraged households continue to weigh on bank balance sheets and lenders across the region remain vulnerable to write-downs.
This is most noticeable in Italy, which slipped back into recession in the first half of this year, compounding the pressures on the struggling corporate sector where non-performing loans are concentrated. Italian bad debts are running close to €170 billion and growing at over €2 billion a month. While bank provisioning has risen to €123 billion in an effort to cover these expected losses, this is still an insufficient buffer. In an adverse scenario based on a 40% NPL ratio – compared to the current 15% – and a 50% recovery rate for corporate debt, as well as 10% default rate for household loans and 50% recovery on these defaults, my forecast for total Italian banking sector losses would be closer to €200 billion. That would slice through both existing provisioning and then half of tier-1 capital. Spanish banks could suffer losses of €170 billion on the same basis, while total losses in Portugal, Greece and Ireland could add another €80 billion to the total.
The issue of the nexus between bank and sovereign debt also continues. There was a brief attempt by banks to cut exposure at the end of last year. But since then, holdings have resumed their climb. So if there is a renewed sovereign debt crisis as a result of another recession in Europe in 2015 making debt servicing unsustainable, the banks remain vulnerable
Sure, the ECB is standing by to do ‘what it takes’ and, as I explained in last month’s column, Draghi is aiming to get the ECB’s balance sheet back to early 2012 levels, or closer to €3 trillion from €2 trillion now. This will be positive for bank profitability in the short run, but it also sustains the umbilical connection between sovereign and bank debt, which was at the root of the eurozone’s debt crisis in the first place.
Although Draghi would deny it, the ECB’s asset purchase programme is backdoor bank recapitalization. The ECB is targeting purchases of around €300 billion in the first instance, which compares to the €60 billion of new capital the EBA expects banks will raise themselves this year. So money will be freed up. However, making the leap to extending credit is likely to require confidence in the recovery story, which is distinctly lacking.
The stress tests not only look less rigorous than their US equivalents in their macro and market assumptions, they overlook the fact that given low potential growth and low inflation, debt sustainability in the unreformed eurozone economies is at serious risk.
There is the continuing problem of fiscal slippage. This is partly a function of weaker than expected growth. But equally there has been poor policy execution, or just inaction in the case of Italy and France. In Spain, public-debt-to-GDP rose by 6.8 percentage points in Q1 this year and threatens to pass the magic 100% of GDP mark.
Debt problems across the region will get worse as the effects of prolonged lowflation or outright deflation begin to be felt. Although interest rates have declined, this has barely exceeded the drop in inflation, keeping real interest rates elevated. The impact of low inflation on nominal GDP growth is as toxic for debt profiles as fiscal policy failure.
So the AQR and stress tests still do not address the underlying problems of bad credit that slow growth and lowflation are compounding. Nor do they solve the issue of the sovereign/bank nexus. The euro banking crisis remains.