Introduction: How much impact will the European banking crisis have?
Since July 2016, there have been continuous reports of bankruptcies such as Deutsche Bank and Sienna Bank in Italy. Whether the problems in the European banking industry can be properly resolved directly affects the stability of the European economy and even the global economy. This article reviews the situation of the European banking industry and analyzes its future development direction.
After the Brexit referendum, European stock markets experienced a sharp decline, led by banking stocks (STOXX, Bank Index). As the risk aversion subsides, European stock markets are gradually recovering, but bank stocks continue to fall deeply. Since July 2016, there have been continuous reports of bankruptcies such as Deutsche Bank and Sienna Bank in Italy. The US Department of Justice is like adding insult to injury to European banks, and the Italian government can only temporarily postpone the urgent rescue of the domestic banking industry. The European banking industry is facing a very serious crisis, which is also one of the biggest risk points for future global economic growth.
What’s wrong with the European banking industry?
After the Brexit referendum at the end of June 2016, European bank stocks fell first. In the following six months, the overall European stock market slightly rose, and the market concerns caused by the Brexit referendum also eased. Among them, bank stocks quickly recovered and rose significantly. Amidst numerous internal issues and negative news, the rebound of bank stocks seems somewhat unexpected. However, if we extend the time, we can see that after the subprime crisis, European bank stocks have been in a long-term slump. Although stock prices rebounded slightly in the second half of 2016, they are still at historical lows.
The biggest problem in the European banking industry is undoubtedly Italian banks. The top three large banks in terms of asset size – Italy’s Yuxin Bank, Italy’s Intesa Sanpaolo Bank, and Italy’s Sienna Bank – all have significant bankruptcy risks. The non-performing loan ratio and provision coverage of the three banks are significantly higher than other European banks, as well as Deutsche Bank, which is also deeply mired in the quagmire. Among them, Bank of Sienna has the most serious problem, with a non-performing loan ratio rising to 35% and a provision coverage ratio as high as 130%. Compared to the non-performing loan ratio, the provision coverage ratio can better reflect the bank’s own risk prediction.
At the end of July 2016, the European Banking Authority (EBA) released its latest bank stress test report. Among the 51 banks participating in the test, 37 European Central Bank regulated banks have strong Tier 1 capital adequacy ratios for common stocks, averaging 13.2%, which is better than the previous two test results. The test results also show that under unfavorable conditions, the core capital adequacy ratio of banks will decrease from 12.9% to 9.2%. This result is also better than the last test, indicating that the overall risk resistance of the European banking industry has been enhanced.
But the performance of various banks varies greatly. Especially the Italian bank Sienna, not only ranked last in the test results, but also had a capital adequacy ratio of only -2.44% under the impact. This means that if there is an impact in the next three years, Sienna Bank will go bankrupt. Even worse, at the end of December 2016, the European Central Bank stated that the funding gap of Bank of Sienna was larger than the previously announced 5 billion euros, at 8.8 billion euros. This result was recalculated by the European Central Bank based on stress test results. Although the Italian government recently approved a 20 billion euro bank bailout plan, rescuing the Sienna Bank alone would consume a lot of ammunition. In the stress test, the other four Italian banks performed slightly better than Sienna Bank, but also below the average level. Recently, Deutsche Bank, which was caught in the eye of market turbulence, only had a slightly higher market attention level of 7%.
Where are the problems in the European banking industry?
High non-performing loan ratio
The size of the Italian banking industry ranks fourth in the eurozone, with non-performing assets of approximately 360 billion euros (about 400 billion US dollars), accounting for about one-third of the total non-performing assets of the eurozone banking industry and one-fifth of all consumer loans in Italy. The overall non-performing loan ratio of the Italian banking industry is as high as 18%, far higher than other European countries during the same period; The non-performing loan ratio of the Spanish banking industry is also relatively high, at 11%, while the non-performing loan ratios of France and Germany remain within 4%. According to the international warning line of 10% for non-performing loan ratio, the non-performing loan ratio of the Italian banking industry has already exceeded the standard. The non-performing loans of Italian banks have mainly increased since the 2008 financial crisis, during which the Italian economy almost stagnated, resulting in a synchronous increase in the proportion of non-performing loans to gross domestic product (GDP). According to a survey by the Bank of Italy, the recovery rate of all non-performing loans between 2011 and 2014 was 41%. At this ratio, the total non-performing loans of 360 billion euros can only be recovered by 147.6 billion euros, resulting in a loss of 212.4 billion euros, which is about 13% of Italy’s GDP.
Profit is difficult to improve
After the subprime crisis, the Italian economy has been weak and sluggish, with GDP growth only better than Greece. At present, the year-on-year growth rate of Italy’s GDP is only about 1%, after two consecutive years of negative economic growth following the outbreak of the European debt crisis in 2012. Although the Italian government has the intention to boost the economy, the space for the fiscal sector to exert its power is too narrow. The proportion of government debt to GDP has reached 130%, only better than Greece’s 170%, and far exceeding the overall government debt burden of the eurozone (about 90%). This economic environment clearly does not support the improvement of corporate profits, which in turn is not conducive to the improvement of the non-performing loan ratio of banks.
The environment of long-term low or even negative interest rates has also caused significant damage to the profitability of the European banking industry. At present, only the European Central Bank imposes negative interest rates on commercial banks, but commercial banks dare not transmit negative interest rates to the retail end, and the burden of negative interest rates cannot be transferred. In addition, negative interest rates have limited stimulation on credit, resulting in a significant compression of profits for the European banking industry.
Excessive exposure to derivative risks
Due to the continuous compression of profits, European banks must rely on high-risk derivative trading. Deutsche Bank’s 2015 annual report showed that its exposure to derivatives reached 215 billion euros, slightly narrowing from 318 billion euros in 2014. This level is not as alarming as the market rumor of 42 trillion euros, but there is indeed a huge risk involved. Deutsche Bank’s current net fair value of derivatives is 18.3 billion euros, with a Tier 1 capital of 58.2 billion euros. Its derivative exposure is close to 12 times the net value of derivatives and nearly 4 times that of Tier 1 capital, indicating a high leverage ratio. Once a crisis arises, such high leverage will amplify risks and banks may suffer heavy losses. In terms of derivative risk exposure, the Italian banking industry is far behind Deutsche Bank.
Outdated ability to handle bad debts
The European banking industry is also facing another serious problem, which is its low ability to handle bad debts. At a time when profits have significantly decreased, the European banking industry has reduced its loan loss provisions and reduced its ability to resist risks. At the same time, the proportion of bad debt write offs in the European banking industry is very low, which can lead to sustained debt pressure on companies and difficulty in recovering profits. This in turn affects the lending ability of banks and reduces their willingness to lend.
Government debt drag down
Banks in countries with better internal economies and higher savings rates in Europe will issue loans to other countries. For example, Germany’s private savings are used to lend to governments and businesses in countries such as France, Italy, Spain, Portugal, and Greece. As of July 2016, the government liabilities held by eurozone banks (including loans provided to governments and government bonds held) amounted to 4.2 trillion euros, nearly 40% of the eurozone GDP. The proportion of government debt to the total assets of the European banking industry is 15.6%, and the proportion of the Italian banking industry is as high as 18.5%, resulting in higher implied sovereign risk in the European banking industry. After the subprime mortgage crisis and the European debt crisis, many governments and companies in Europe were unable to repay their loans, and banks were unable to continue extending these debts, resulting in a sharp increase in default rates.
What are the impacts of issues in the European banking industry?
Firstly, from the perspective of scale, the risk outbreak has a wide range and deep impact. Italy, currently facing the most severe banking situation, has a GDP of 1.6 trillion euros, second only to Germany’s 3 trillion euros and France’s 2.2 trillion euros. The total asset size of the Italian banking industry is also very high. According to the European Banking Authority’s statistics, the asset size of the Italian banking industry ranks fourth in the eurozone (first quarter of 2016), accounting for about 10% of the overall banking industry size in the eurozone. The huge scale of the Italian banking industry determines that once risks erupt, they will inevitably have a wide-ranging and significant impact. If there is a systemic risk, it could lead to a crisis in Italy or even globally.
Secondly, from a political perspective, it may pose a risk of the disintegration of the European Union. At the end of 2016, the Italian constitutional referendum ended in failure without any unexpected incidents, and Prime Minister Renzi resigned as promised. Although the capital market recovered from the volatility in a few hours, after all, Renzi left a political window, and Italy has now entered a temporary government custody state. If Italy were to hold early elections as a result (from 2018 to 2017), the currently popular populist party, the Five Star Movement, may benefit. The Five Star Movement has a strong Eurosceptic ideology and is also a strong advocate for Brexit. After coming to power, they are likely to actively promote Italy’s withdrawal from the EU. Brexit has already caused global panic, and if Italy withdraws from the EU again, the stability of the EU will be further impacted.
The withdrawal of larger economies from the EU will set a “bad example” for other countries, especially with the relatively stable economic situation in the UK, which will exacerbate the idea that “Brexit is harmless”. The French people are known for their anti European sentiment, and in 2005, they rejected the EU Constitutional Treaty in a national referendum. According to a recent survey by the Pew Research Center, 61% of French citizens have a negative view of the European Union. If Italy withdraws from the EU, it is not impossible for France to also withdraw. With the departure of the largest economies one after another, the European Union has effectively disintegrated.
How to solve the problems in the European banking industry?
Due to the serious and potentially far-reaching problems in the European banking industry, there are also difficulties in finding solutions.
Bank self rescue
The Bank Recovery and Liquidation Directive (BRRD), which has been implemented since 2015, clearly stipulates that the government cannot use taxpayer funds to rescue banks until their shareholders and creditors bear the losses, so banks may need to start self rescue first. But the bank is already in a state of decline, and self rescue is not easy. The financing sources of Italian banks are mostly individual investors. If the banks rescue themselves, many retail investors will suffer losses. At present, the Italian government has found a transitional solution to address this issue by establishing a fund called Atlante to help respond to the banking crisis. Its funds mainly come from banks, insurance, pension funds, and other institutional investors. The Italian government has also injected 3 billion to 5 billion euros into the fund to help purchase non-performing assets of troubled banks such as Sienna. The scale of this fund is not large, which is a drop in the bucket for the non-performing assets worth hundreds of billions. However, it can slightly alleviate the urgent situation, and as the fund size gradually expands, it may also develop into an important force for rescue.
Domestic government assistance
The Italian government has always hoped to rescue its banking industry through government funding. But the Bank Recovery and Liquidation Directive (BRRD), which began to be implemented in 2015, was the policy formulated by the European Union after summarizing the experience and lessons learned from the subprime crisis. Both the EU and German governments insisted on not relaxing, and there was great resistance to direct assistance from the Italian government. However, once the situation becomes serious, the Italian government may reach a compromise with the EU to classify the outbreak of banking risks as’ force majeure ‘. This will activate special provisions in the BRRD regulations, temporarily requiring the government to provide assistance to protect the interests of retail investors in Italian banks. At the end of 2016, the Italian government, with the tacit approval of the European Union, approved a € 20 billion bailout fund to rescue the country’s banking industry. Just hours before the Italian government made this decision, Sienna Bank announced that its plan to raise 5 billion euros for the project had failed. If the Italian government does not provide assistance, it is equivalent to sitting idly by as the Bank of Sienna goes bankrupt. Ultimately, Sienna Bank will apply for assistance from the Italian government and provide preventive capital restructuring feedback in accordance with Article 32 of the BRRD Act.
However, government assistance does not mean there is no cost. You can refer to the case of Greece: the Greek banking industry experienced a crisis in 2015. The Greek government reached an agreement with the European Union to implement three rounds of bailout for the banking industry, avoiding the spread of a systemic crisis. But according to EU requirements, the Greek government implemented a series of austerity and reform measures, restructured the banking industry, and investors still suffered some losses.
Unification of Finance and Currency
Given that the default of “too big to fail” banks such as Deutsche Bank or Sienna Bank could lead to the collapse of the EU financial system, Germany and the European Central Bank would never dare to risk putting these banks into bankruptcy protection. The European Union has now approved the Italian government’s bailout of the banking industry. Since it has already begun, it will definitely not be just a one-time rescue. Just like the EU’s aid to Greece back then, in order to prevent Greece from collapsing and leaving the EU, EU policies were hijacked and the scale of aid was expanding. The bailout of Italian banks may be like a bottomless pit, plunging the EU into another debt quagmire.
So is the banking industry problem already unsolvable? I don’t think so. The ultimate solution is the unification of fiscal and monetary policies that has been discussed for many years. Due to the unique nature of the EU system, the implementation of its fiscal policy is extremely difficult. If fiscal policy and monetary policy can be coordinated, it is possible to maximize the effectiveness of the government. For example, the “helicopter money” advocated by former Federal Reserve Chairman Ben Bernanke may come in handy. By using “helicopter money” (i.e. “deficit monetization”, where the funds for government fiscal expenditures are directly provided by the central bank without repayment), the government can directly rescue critical banks without worrying about debt burden. Although the burden was ultimately shared equally among all residents, at least in terms of policy ammunition, the government will no longer be stretched thin.