Restructuring European banking systems

Marco Onado

02 September 2011

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IMF chief Christine Lagarde was correct; politicians are now focused mainly on European sovereign debt, but banks are the real problem. In her Jackson Hole speech (Lagarde 2011), she said developed-country growth is throttled by the overhang of excessive debt. This means that large swaths of European banks’ assets are worthless. Lagarde is also correct in her finger-pointing. Politicians and national regulators are to blame. They have been dragging their feet and avoiding the radical responses needed to put an end to the crisis. But is she right in calling for more injections of capital into European banks?

Enough capital? For a default in the periphery, yes. But for one in the core, no

In my previous Vox column (Onado 2011), I argued that European banks’ capital is adequate to stand a significant reduction of the value of their claims on the 3 peripheral countries. Moreover, most banks have already marked-to-market their positions on these assets. In other words, the present level of bank capital is adequate to absorb losses limited to the 3 periphery countries.

After all, in the past months, European banks have increased their capital substantially, as the stress tests published in July have shown. According to a recent study (Citi 2011), the group of European banks covered by Citi has added over €270 billion of core capital since the end of 2008. Is it possible to go further than that? Is the amount of capital adequate to let the banking system face the storm?

The simple answer is: it depends. The higher the uncertainty, the higher the capital required – there is no limit to how much is enough if the uncertainty rises high enough. If bank capital is 5% of total assets, a 10% decrease in the value of banks’ assets is enough to expose creditors to losses. If bank capital is 10% of total assets, a 20% decrease in asset values puts the position underwater. Of course if the banks go under, the economy plummets, taking the banks’ asset values down with it. This is a paradox similar to the liquidity trap. Beyond a certain point, it is like crossing the “event horizon” of a black hole; uncertainty cannot be dissolved however strong the public intervention.

Decrease uncertainty rather than raise capital

However, if the crisis moves beyond Greece, Ireland, and Portugal, no capital injection can reassure markets about possible losses on a few big Eurozone countries. As Wyplosz (2011) pointed out, “When we add up the public debts of Greece, Ireland, Portugal, Spain and Italy, we reach something like €3,350 billion; that is 35% of the Eurozone GDP; 130% of German GDP.”

This simple arithmetic suggests that it would be better to reduce the uncertainty surrounding European banks’ assets. If the uncertainty is not resolved, no amount of capital will be enough. European leaders have not yet tried this road. Instead, they made a timid attempt to involve the private sector in the Greek bailout worked in July, but that proved to be ineffective. The markets judged it “dead on arrival”, according to the Financial Times (2011).

The basic problem with European banks

The following figures help clarify the difficulty of the present European situation and in particular the extent of the current debt hangover. Both refer to the 5 major European countries and the 3 peripheral countries that needed the joint intervention of the EU and the IMF. The figures are based on the data on EU banking structures published by the ECB (2010). Figure 1 compares the annual rate of growth of GDP at market prices, total loans to the nonfinancial sector, and total assets. Figure 2 shows the ratio of the same loans to total assets in 1997 and 2009.

Figure 1. European banking systems: Growth of GDP, loans, and assets, 1997-2009

Figure 2. European banking: Loans-to-deposits ratio 1997 and 2009

The figures show that:

  • In all European countries bank loans and bank assets grew at annual rates at least 2 or 3 times that of nominal GDP.
  • Total assets (which include loans to other banks and securities) followed more or less the same pattern.
  • Loans also grew much faster than deposits. Therefore the loans-to-deposits ratio increased significantly over the period. While in 1997 only Ireland, the UK, and Germany were above the 100% line, in 2009 all countries except Greece were in this region of Figure 2.

Is this sustainable?

When a nation’s whole banking system sees its outstanding loans rise at a pace that is multiples of that of income, one grows suspicious. Can they sustain the present level of debt, be they private or public sector borrowers? This, of course, is the basic problem of the financial crisis that has been ricocheting around North Atlantic financial markets since August 2007. But the figures also show that European banks have a huge funding problem. It explains why European banks are in their current difficulties; no wonder the market is pricing a higher risk for European banks.

  • Credit Default Swaps, or CDSs (a form of default insurance), are trading close to their all-time highs and well above 2011 lows.
  • Most US banks’ CDSs are trading nearer the 2011 lows and well below 2008-09 highs.

Another indicator of the funding problem is the 10-year euro swap spread, which measures the difference in cost between a 10-year fixed/floating rate swap between banks and the 10-year Bund rate. The average for European banks is currently 3 times the US average – levels comparable to those seen during the Lehman crisis.

This tension is not showing up in short-term spreads, but this is only because the ECB is undertaking an extraordinary effort. This cannot last forever.

  • The net effect is a permanent increase of funding costs for European banks and a significant squeeze on their operating profits.
  • A scenario where banks can raise a substantial amount of new capital is a sort of “mission impossible” – their stocks are already trading well below book value.

Restructuring European banking systems

The only sensible alternative is a significant restructuring of the banking systems. There are two recommendations here.

  • First, banks’ balance sheets must be put on a diet.

This means getting rid of the non-strategic assets that normally hang around after a long merger-wave. This is a responsibility of individual banks and their senior management, but moral persuasion from regulators and governments is also needed. Managers and directors can have a vested interest in preserving the present size, which can make it easier to extract private benefits and pursue rent-seeking behaviour.

It is worth remembering that size is the main form of restructuring for banks now. According to ECB data, neither bank branches nor staff-headcounts increased substantially in the 1997-2009 period. Some even decreased. Thus, the announced plans to slash staff by thousands of workers have proved difficult to implement.

  • Second, private and government debt levels must fall to sustainable ratios in order to eliminate doubts on banks solvency.

The sustainability of private debt varies from country to country and therefore it is not suitable for international agreement. But according to many, even for the US, this is the only way to avoid a long recession (Rajan 2011, Posner and Zingales 2011).

In Europe, sovereign debt is the issue where an international agreement that brings about effective sustainability is overdue.

  • The rescue plans for Greece, Portugal, and Ireland (albeit in different degrees) pretended the problem was liquidity – that the nations just needed a few billion to tide them over to the next pay cheque, so to speak.

This thinking was based on systematically overoptimistic hypotheses.

In doing this, European leaders hoped to buy time. But the result has been growing pessimism and a spread of contagion. It has now reached countries with limited levels of budget deficits (Italy), or outstanding debt (Spain). These countries have debt that can be brought under control even under a scenario that envisions reasonable interest rates and moderate GDP growth. But in a world of contagion, such calculations can be blown away by fear.

For 30 years capital-adequacy regulations have been based on the assumption that government securities issued by major countries are risk-free.

  • Current bank regulations do not require a single cent of capital to cover government bonds held by banks.
  • We cannot move overnight to a world where this assumption no longer applies without massive disruptions.

Plainly then, the solution must be to reduce uncertainly on the assets rather than increase the capital.

Conclusion

We must learn the lesson of the failure of the July rescue plan. We must work out a credible restructuring of the debt of peripheral countries to ring-fence the damage. As Tabellini (2011) said, “Eurozone leaders must draw a line between solvent and insolvent Eurozone nations before the markets do it for them.”

Eurozone leaders have so far treated the sovereign debt issue as a liquidity problem. We now see that it is a solvency problem. It is time to call a spade a spade. As Gros and Mayer (2010b) wrote after the first bailout package in May 2010, “a liquidity problem postponed is a problem solved, but a solvency problem postponed is a problem made intractable.”

Ring-fencing the 3 peripheral countries will help dissolve doubts on the debt of the major countries. At that point, even a lower level of capital could prove adequate and recapitalisation could take place more gradually and in more favourable market conditions.

References

Citi (2011) “Venus & Mars. Banks Stocks and Spreads in Europe and US”, 26 August 2.

European Central Bank (2010) “EU Banking Structures”, September and previous issues.

Financial Times (2011) “Greece and collateral: dead on arrival“, 25 August.

Gros, Daniel and Thomas Mayer (2010b), “Financial Stability beyond Greece: Making the most out of the European Stabilisation Mechanism”, VoxEU.org, 11 May.

Lagarde, Christine (2011) “Global Risks Are Rising, But There Is a Path to Recovery”, Remarks at Jackson Hole, 27 August.

Onado, Marco (2011) “European stress tests: Good or bad news?”, VoxEU.org, 16 August.

Posner, Eric and Luigi Zingales (2011), “A Loan Modification Approach to the Housing Crisis”, University of Chicago.

Rajan, Raghuram (2011) “Why we cannot inflate our way out of debt”, Financial Times, 15 August.

Tabellini, Guido (2011) ”The Eurozone crisis: What needs to be done”, VoxEU.org, 15 July.

Wyplosz, Charles (2011) “They still don’t get it”, VoxEU.org, 22 August. 

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Topics:  EU policies

Tags:  Eurozone crisis, debt restructuring

Professor at Bocconi University, Milan and former Commissioner of the Italian public authority responsible for regulating the Italian securities market (CONSOB).

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