Another banking crisis will knock out the core

Europe’s banks are broken. We have always suspected that, but recent evidence suggests that nearly six years after the crisis first began to manifest itself seriously they are still grossly impaired.

Recall what it is that banks do — despite the mystique and the bluster, its actually pretty simple.

Some people have money and others need it. Banks act as a middleman to facilitate those that want it to get it from those that have it, in return for them taking a cut of the interest charged. Lending money out is risky. That is why banks charge an interest rate on loans that is greater than that which they pay on deposits — apart from needing to make a profit and cover costs, they need to put some money aside for the inevitable defaults and bad loans. These retained profits, plus some other ‘safe’ assets, are the banks reserves, or its capital

Banks need, under prudential regulation, to hold a certain amount of capital, a proportion of the assets they have (loans made). If banks have more capital they are in a position to expand. The problem for European banks is that they are stymied by the fact they have written down bad loans to an extent sufficient to impair their capital base but by no means enough to clean their balance sheet of bad loans. Caught in a double bind, they are unable to efficiently do their job as intermediaries and as credit creators.

As part of the ongoing efforts to get to the root of the problem the ECB has initiated an asset quality review. This is in effect yet another stress test. Previous tests have been greeted with derision as they claimed all was well when it was manifestly not. Thus this stress test, to be credible, needs to fail some banks — any banks.

Recent research has looked at what holes might be lurking in the capital. Looking at the 109 largest banks with €22 trillion in assets, a hole of between €5bn and €66bn is found, even assuming no further deterioration of any assets — an unstressed situation. The biggest holes are in the core — French and German banks — and the smallest in the periphery. Ireland, if things don’t get any worse, does not need any more capital in its banks.

But what if things do go south? Writing off bad loans of capital-weak banks is the only way to kill zombie banks who crowd out and hinder the banking system. In this stress situation the banks are woeful. Assuming reasonable levels of reserves to be held, European banks may need between €500bn and €750bn. Again the worst holes are in the core banks especially French German and Belgian banks.

So what to do? Senior bondholders are sacrosanct and while depositors of unimportant nations such as Cyprus might be bailed in that won’t happen to real depositors, those of the core. So banks will limp along. But there is a potential solution — promissory notes. The notes were created to shore up the capital base of Anglo Irish Bank, and allowed it to access liquidity from the Central Bank of Ireland. The problem with the notes was not their existence — it was that they were required to be extinguished over a fairly swift timetable, placing unbearable strain on an already strained exchequer. But were these to be created by the national authorities of the core, we could well imagine much longer periods for extinguishing being put in play. While the numbers seem large, in the context of the (shrinking) ECB balance sheet of €2.2bn even the largest amount required is not unbearable. Doing this would ‘cure’ the banks, in so far as it would allow a full write-down of impaired loans and thus position them for re-growth. It would allow a clean start to be made.

But the inflation fears of the ECB, never more imaginary than now with deflation staring the eurozone in the face, will not allow this. The consequence is that we flirt with a further crisis not merely knocking out the periphery but the core.


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