Against the tide: Europe’s banks still in trouble

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By:
David Roche
Published on:

Another European banking crunch is on the horizon thanks to legacy problems that have not been fixed.


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There are wider implications for Europe in the problems facing Deutsche Bank, Germany’s largest bank. Deutsche’s dilemmas are just an oversized example of the structural frailties of the entire European banking sector. Europe’s bank reforms enacted to date have been blunted by political compromises while regulations intended to make banks safer are pressuring profitability and elevating the capital shortfalls that under capitalized banks are already struggling with.

The implications are threefold. It undermines the ECB’s monetary policy transmission, it undermines growth and it exposes the frailties of the single currency project. That is euro negative longer-term, but it creates scope for big repatriation flows in the coming few months as banks scramble for liquidity by selling dollar assets.

Deutsche’s problems suggest another European banking crunch is in the offing. All this stems from legacy problems that were inadequately dealt with previously. These have, until recently, been most visible in the Italian banking system. But the problem is far broader than that. Bad debts in the eurozone as a whole exceed €1 trillion, which equates to 3% of total banking sector assets and 9.2% of the loan book. 

On top of this, the sector is blighted with overcapacity, which the pre-crisis boom had masked. Regulation to prevent a repeat of the financial crisis is counter-productive in the shorter-term too, placing higher capital requirements on already under capitalized banks. Meanwhile, Basel III regulations hamper those areas of business that are still profitable. Then add on the effects of Nirp (negative interest-rate policy) and very flat yield curves that undermine the core bank business model of borrowing short and lending long.

Deutsche itself only just passed the ECB’s bank stress tests in July and failed those of the US Federal Reserve. Indeed, the IMF in a June report on the German banking system said: “Deutsche Bank appears to the most important net contributor to systemic risks in the global banking system.”


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Resolving such a web of problems is made more complex by the competing national identities of the eurozone and post-crisis political fragmentation. Quite simply, even if governments had the flexibility to bail out their banks, it would only further inflame the anger.

While zombified banks will be drip fed liquidity to help them muddle through, this can only weaken eurozone confidence and economic recovery. It directly undermines the ECB’s efforts to improve credit transmission, restricting banks’ ability to lend. This is critical for the eurozone’s non-financial corporate sector – the engine of growth and employment – where bank lending accounts for 70% of credit, compared to just 20% in the US.

Resolution

What can be done to resolve this? Well, banking union must be finally executed in full. But that requires German acquiescence on mutualization (deposit insurance, for example). And the political calendar – German federal elections are not until September 2017 – means that it is a non-starter. The banks also need to raise a lot more capital – the ECB estimates €20 billion – but in reality it is probably closer to 10 times that. That is a tall order in such an environment. You would have to be nuts to invest with so little visibility. So asset disposals will have to be accelerated and liquid assets liquidated to keep the wheels turning.

The ‘no bailout’ rules – the EU’s Single Supervisory Mechanism and Bank Recovery and Resolution Directive – prohibit, or make more difficult, resolving the problem through government intervention. What is likely is that there will be increasing pressure to consolidate at a national level, as we’ve seen to an extent in Italy; filling capital holes with profits from those institutions whose business models have kept them in the black.

More immediately, these problems will undermine monetary policy transmission, putting the ECB on the hook to do more. But it’s doubtful whether ‘more’ will do much at all. In fact, ‘more’ might simply heap more misery – particularly if it means more Nirp – on the banks’ struggling business models.

It could also have big currency implications. Eurozone banks have been big buyers of US Treasuries since the ECB introduced negative deposit rates. There is now a strong risk of repatriation as Europe’s banks liquidate to free up funds. That may buoy the euro for a while. But the longer-term story is negative for the single currency project.