Europe weighs its options to deal with troubled banks

by Enrico Colombatto

European banks are in bad shape, and shareholders and bondholders are feeling the heat. With governments and regulators still groping for a solution, various options have bubbled to the surface.

Summary
Three main responses have been proposed to Europe’s banking crisis: 1) more stringent regulation and a cap on government debt purchases; 2) setting up bad banks to be financed by taxpayers or monetary expansion; 3) bail-ins requiring shareholders and bondholders to assume heavy losses. With the policy debate now focused on the need for a political solution, it appears that the third response is the least likely and that taxpayers will ultimately be asked to pick up much of the tab.

Many European banks are still in trouble. Some ventured into risky financial investments (including toxic derivatives) and got burned. Others lent to businesses and consumers that had become unable to repay their loans after the economic slowdown hit. Almost all major European banks bought large quantities of Treasury paper from governments whose finances suddenly proved fragile, leaving them vulnerable to possible “haircuts” or forced rescheduling.

To make matters worse, the entire banking industry is suffering through a period of low margins and modest business volumes. Near-zero inflation is squeezing the markup on loans, good borrowers are scarce amid low growth and high uncertainty, and retail customers are less and less willing to pay high asset management fees.

Low performance

In short, banking has become less profitable; often it is not profitable at all. While commercial banks’ balance sheets look cleaner than in the past, potential losses loom just around the corner, and many observers believe that their capital and reserves are still too thin. Italian banks alone are burdened with 200 billion euros of non-performing loans. This figure could be twice as large if one includes “performing” loans rolled over because borrowers could not repay the principal.

There is some good news for those who fret about the possible collapse of the banking system. The European Central Bank has effectively promised to print all the euros it takes to avoid any liquidity shortage resulting from a run on the banks. But for the moment, liquidity is not a burning issue, as shown by the number of European banks considering buybacks of their own shares and bonds. In fact, a bank run is unlikely to occur, unless it is provoked by the national governments or by the authorities in Brussels or Frankfurt. This does not mean that everything is under control. Nonetheless, individual bank failures would not necessarily mean contagion.

In order to deal with the banking problem, the European Union has put forward various proposals. They differ according to their real target, some are clearly misdirected, and each would entail different consequences. For the sake of simplicity, we will focus on three broad options.

More discipline

One option would be to tighten regulatory standards. Advocates of this approach want reserve and capital requirements to be increased and the range of permitted banking operations to be restricted, so as to limit irresponsible risk-taking. The new curbs would apply to commercial operations, the abuse of derivatives and purchases of government bonds, as Bundesbank President Jens Weidmann has been urging for the past two years.

Such changes would probably fail to stop risk-taking, since no regulator will ever be able to assess the quality of each borrower. The idea that such activity could be eliminated rests on shaky theoretical foundations, since a central authority cannot be expected to determine the ideal degree of risk to be assumed by every bank, depositor and shareholder. Nonetheless, if approved and effectively enforced, Mr. Weidmann’s proposals would make it more difficult for EU member countries to finance their budget deficits, and thus encourage them to cut expenditure and restore fiscal discipline.

Moreover, by capping the purchase of government bonds, one would probably weaken the vicious link between banking and the world of politics, a symbiotic relationship in which bankers finance public debts and in return get state guarantees, government subsidies and lax monitoring from financial supervisors. We have become familiar with the results of this toxic codependency over the past decade.

Bad banks

Another scenario would involve some sort of assisted cleanup program aimed at removing bad loans from the commercial banks’ balance sheets. These dubious assets would be shifted to state-controlled “bad banks,” giving the incumbent bankers a fresh start.

In theory, this scenario presents a number of attractive features. It makes depositors, bondholders and shareholders happy, since banks without their non-performing loans are much less likely to go broke. Moreover, the threat of painful bail-in programs would recede and market tensions would subside.
However, it should be kept in mind that lawmakers and regulators prefer to deal with – and monitor – a small number of big players rather than myriad small lenders. Consequently, they are not shy about cracking down on counterparts with weak bargaining power. This suggests that any cleanup or bad-bank program would accelerate the process of concentration in the European banking industry. Weaker small and medium-sized banks that cannot find partners or buyers would find themselves in deep trouble.

One can speculate about whether lawmakers should have any influence over the size of banks. There is no doubt that a wave of banking mergers would blur rather than clarify the picture, creating opportunities for special privileges under the guise of “special regulatory provisions” and “temporary measures” to restore efficiency to the industry.

Honest cleanup

The third scenario assumes that the EU’s original bail-in philosophy prevails, allowing the market to do the heavy lifting. In contrast to what many people fear, this would not be a catastrophe. It is true that many banks are in bad shape, and a cleanup enforced by honest auditing would lead to significant losses for shareholders and bondholders.

Yet, depositors would be safe. History shows that panics occur not when balance sheets are truthful, but when governments intervene and order that banks be temporarily shuttered, cash withdrawals restricted and capital movements regulated or prohibited. Certainly, some banks would probably shut down. But the risk of contagion should not be exaggerated, especially if lawmakers refrain from spreading terror and then riding like white knights to the rescue.

Political calculus

In order to determine which scenario is most likely for Europe’s banking industry, one should focus on the political costs of each option.

If Mr. Weidmann’s proposals were adopted, funds now being channeled to public debt would be freed up for loans to companies and consumers. An effective cap on banks’ bond purchases would lower the price of long-term government bonds and cause debt-servicing costs to soar. Governments would come under heavy pressure to cut expenditure and/or increase taxation. With regard to costs, individuals and institutions that helped finance public debt would suffer, taxpayers would be required to pick up at least part of the tab, and welfare states would have to be downsized.

The outlook would be different if the authorities allow banks to move their questionable assets into newly created bad banks. In this second scenario, the key issue is who would pay for these undesirable assets, and how much. There are two possibilities. If governments step in, the funds will come from additional debt. Current and future taxpayers will foot the bill, in effect subsidizing the weak banks that sell off their non-performing assets to the bad banks.

A second possibility would involve the European Central Bank. In this case, the ECB would print the euros required to fund the bad banks, possibly in return for more regulatory and monitoring powers. This is actually tempting, since the political benefits would be immediate, while the costs would be much harder for politicians and voters to perceive. Sooner or later, they would emerge as inflation and a distorted credit market – but that would take time.

Costly compromise

The third scenario is essentially a free-market solution. Non-performing loans would be sold to healthy banks or possibly written off as losses. Shareholders and bondholders of weak banks would pay a heavy price, but those not involved with these poorly managed companies would not have to pay for others’ mistakes.

Clearly, this scenario meets the tests of common sense and fairness. It is also the least likely to happen. Since the EU banking crisis now hinges on political leadership and expediency, one can expect solutions consistent with politicians’ interests and their propensity to seek arrangements via long negotiations with diverse interest groups.

Europe’s banking problem will probably not be solved in the next two years. Political compromises, however, will be found, and guiltless taxpayers will eventually pay the price – possibly in the form of a new wealth tax.

Related GIS Articles:

• Global trends: Europe’s weak spots ready to become new crises
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• Proposed fiscal board may widen political rifts in EU
• The day after the night before – where do Greece and Europe stand after the referendum?

Source: Geopolitical Information Service