Economics and politics - comment and analysis
9. March 2016 I Dirk Ehnts - Heiner Flassbeck I General

2016 will prove a critical year for the European banks. Part 1

2016 will prove a critical year for the European banks. Part 1.

By Heiner Flassbeck and Dirk Ehnts

European banks clearly appear to experience major problems. One of the many indications is falling share prices. The Euro Stoxx Banks Index (which refers to banks from within the euro zone) has fallen from 77 in August 2015 to 43 February 2016 – a loss of 44 % in half a year (see here). Only in 2009 and 2013, in the wake of the recession, did the index reach a lower value. What is the cause of banks doing so poorly? Should we again expect a recession in the euro zone because of a dysfunctional financial sector?

There is no question that the poor economic performance in Europe is gnawing at the profits of the banks. Europe is in its fifth year of stagnation. This stagnation followed a deep recession, itself a result of the global banking crisis. Since the end of World War II there has never been such a long period of economic stagnation or recession as in the case of Italy for example. Because of the poor economic outlook, progressively more loans end up turning into bad loans. The great majority of these loans will probably not be recuperated.  All of this is the direct result of austerity prescribed by Germany. Austerity makes it impossible for the proper dynamics of a market economy to function. There will always be bad loans, but, normally, when the economy grows, new and better loans constantly more than compensate for losses. Now even the ECB warns against the extreme one-sided orientation of the policy a whole. A few days ago, ECB President Mario Draghi told the European Parliament that ‘It is becoming clearer and clearer that fiscal policies should support the economic recovery through public investment and lower taxation’ (see here).

But what about the banks? The regulatory changes that are being proposed may complicate the position of the already weakened banks even further. On January 1st of this year, the EU’s Bank Recovery and Resolution Directive came into effect. It originally is an integral part of the so-called Banking union (see here). These are very important matters. In the background of these reforms, which seem technical at first, lay fierce disputes about the direction that economic policies in Europe should take.

The mainstream policy makers, led by economists belonging to the neo-liberal camp, mostly from Germany, who dominate the euro zone, push for policy changes which would have the effect that banks as well as governments could become insolvent. They insist that such changes would not imply that the taxpayer would have to bail-out insolvent banks or lose money in any other way, but, tellingly, they also do not know what to do in case of a long crisis with a loss of assets by investors who hold bank capital or government bonds.

The sole idea of these politicians is that bail-outs must be prevented in the future. During the global financial crisis, many governments rescued banks because they feared systemic problems. There is no discussion that banks which mismanaged their funds and took unjustifiable risks should disappear from the market. Unfortunately, this is easier said than done. The problem is that bad banks contaminate good banks. If bad banks disappear their loans will never be paid back, so good banks incur heavy losses. With the bankruptcy of Lehman Brothers, the looming danger of a domino effect resurfaced that could potentially have bankrupted many major banks and severely damaged the global financial sector as a whole. The bail-out kept banks that were in fact insolvent afloat because the government bought shares of banks that were considered ‘systemically relevant.’ This means, of course, that the government became a stockholder. In many cases, the government even became a majority stockholder. But this is, in effect, nationalisation and this is exactly what the (German) mainstream policy makers tried to prevent.

The alternative to a bail-out seems to be bail-in. In a bail-in, the shareholders absorb the losses of the bank. A bail-in will only work if the equity of the bank is not too low. Equity is expensive for banks and currently the capital ratios of many banks are still too low. This is the reason why banks have to pay a risk premium on own their bonds and therefore their share prices sink. The problem with this is that it makes raising new equity capital more expensive. Europe, under significant German pressure, has nonetheless decided to go down this road. Will it work? The Financial Times is not sure:

‘Will more regulation help? The push for ever higher capital requirements in theory makes banks safer but in practice makes them uninvestable. Creditors increasingly understand that if a bank cannot earn back its cost of equity, then the cost of bail-in debt should be higher. This, in turn, erodes the return on equity and pushes up the cost of equity further — the opposite of what is desired. The risks of such a negative feedback loop are particularly acute for banks with legacy non-performing loans. The stock of NPLs on European banks’ balance sheets is still about €900bn’ (see here).

Proposals can look good in theory, but that does not mean that they would work in reality. The policies could even be counterproductive. There is more. Ever-louder voices argue in favour of implementing insolvency procedures for governments. This means that even government bonds would officially become potentially risky investments and must therefore be backed up by equity.  The discussions about these proposals are based on a special report of the Advisory Council of July 2015 on the further development of the architecture of the euro area (see SG 2015 paragraphs 65 ff.). The idea is to establish a ‘government insolvency mechanism’ and to strengthen claims for forced privatisations of state assets when insolvency occurs. This, proponents say, would re-enforce the principle of unity of responsibility and control as well as the non-assistance (no bail-out) clause.

The problem with such proposals is exactly the same as with the bail-in option for bank shareholders. Government insolvency leads to higher interests rates, which drives up the interest burden of the government in question and thus further increases the risk of insolvency or ongoing insolvency. We have seen this mechanism at work in the crisis countries of Southern Europe.

The implementation of state insolvencies and bank bail-ins makes negative feedbacks – also called doom loops – in the financial system as good as inevitable. Higher interest rates will lead to falling credit ratings on government bonds, thereby forcing banks to raise more capital. However, once governments run the risk of becoming insolvent, the risks for losses on government bonds in the portfolios of banks also increase. As a result, interest rates on additional required equity (to compensate for risk) rise. This triggers the negative feedback cycle that we explained above. The danger is that, if this negative feedback mechanism kicks in, at the end of the process both governments and banks will be insolvent and that the euro will be dead and gone. The Telegraph recently quoted Peter Bofinger who said that the minority voters in the German Council of (Economic) Experts fear that precisely such negative cycles may lead to a collapse of the euro zone (see here).

The problems facing the banks today are considerable and potentially dangerous and they complicate everything enormously. The policies that are being implemented by the European Central Bank to stimulate economic growth can have the opposite effect in some countries. On top of all of this come the direct effects of deflation. We will explain this in part 2.