Risk of new banking crisis as 'kick and hope' strategy runs out of road
Brexit has hit Europe's recovery and the biggest casualty will be banking
Published 10/07/2016 | 02:30
The acute phase of the eurozone sovereign debt crisis in 2012 was triggered in Italy, not in Greece or one of the other small peripheral economies. The European Central Bank eventually took action - an Italian collapse would have threatened the survival of the common currency - and crisis was deferred. But the eurozone banking system has not been fixed, and the extend-and-pretend tactic is facing another challenge. UK Prime Minister David Cameron's referendum gamble has not merely come unstuck, it has gone wrong at the wrong time.
Europe's fragile recovery is threatened by the Brexit decision. Sterling has fallen sharply and surveys of business confidence have turned suddenly negative in Britain and elsewhere in Europe. There is a risk that corporate investment, weak before the vote, will dip further and consumer confidence has also taken a knock. There is greatly increased volatility in asset markets, and forecasts of economic performance across Europe have been trimmed back. The uncertainty stemming from the Brexit decision will persist until the new relationship between Britain and the EU is clarified, which could take several years.
The biggest casualty in Britain and the eurozone has been confidence in the banking sector. Bank share prices have weakened as investors fret about further loan losses and inadequate loan-loss provisions. Shares in Deutsche Bank, the eurozone's largest, trade at 30pc of book value. The most acute problem is in Italy, where the banking system has yet to deal decisively with non-performing loans. Since the extent of the banking crisis began to emerge in 2008, eurozone policy has insisted on a 'too little, too late' approach to fixing bank solvency. Stress tests on bank balance sheets have been too lenient and too little fresh capital has been raised.
Banks will lose the confidence of depositors and other lenders unless their assets are believed to exceed their liabilities by a comfortable margin. The stock market should value bank shares roughly in line with their net worth, the excess of assets over liabilities shown in the books. If share prices fall well below the book value this means that the market does not believe that the assets (mainly loans) are worth as much as the bank maintains. They are factoring in concealed loan losses which the banks, and their supervisors, have failed to acknowledge.
Once declining share prices raise the red flag, the next phase is deposit flight. Banks own mainly illiquid assets (loans) but have demandable deposits and can quickly find themselves unable to meet outflows.
Central banks can step in and provide temporary liquidity but this is a stop-gap. Ultimately, loan losses have to be confronted and dealt with through re-capitalising the stronger banks and closing the lost causes. One way to re-capitalise is to write down bondholders in failing banks but this is politically toxic in Italy, where the banks have been permitted to sell bond-like instruments to retail investors, many of whom think they are holding guaranteed deposits.
The textbook recommendation on banking crises is to recognise losses and re-capitalise quickly. This advice has been ignored consistently in the eurozone's dangerous tactic of extend-and-pretend and the endgame is looming in Italy. Over the year to date, some Italian bank shares have halved and the weakest banks are priced in the market at under one-fifth their book value. This should mean curtains, unless fresh equity capital, adequate to absorb the concealed losses, is mobilised quickly.
The Italian state is heavily indebted and is still running a sizeable budget deficit. It can, however, borrow at low interest thanks to the ECB's support for eurozone bond markets. The Italian sovereign could borrow more and subscribe for extra shares to recapitalise the weakest banks, supplementing the inadequate rescue fund cobbled together pre-Brexit. But there are problems with eurozone rules on bank recovery and resolution, and the new rules, agreed with much fanfare as the key step in creating a proper banking union, appear unsuited to dealing with the first serious challenge to follow their adoption. The EU's Bank Recovery and Resolution Directive has equipped policymakers with the tools needed to handle various contingencies, except the one which has actually arisen.
If the eurozone functioned as a proper monetary union the central authorities would take the lead in dealing with the Italian crisis. The ECB is spending €80bn each month supporting the eurozone market in sovereign and corporate bonds, the so-called quantitative easing, or QE programme. It has been estimated that just one month's spending on QE would be more than enough to fix the Italian banks if the money was devoted to direct re-capitalisation, with the ECB acquiring share stakes in the weakest lenders. This is not allowed under existing rules. Setting up a Nama-style operation to buy the dud loans at a discount is not enough either. It would crystallise the concealed losses, as it did in Ireland, and make transparent the capital shortfall. Expect lengthy late-night sessions some Friday in Brussels when another ingenious fudge will be sought.
The list of indebted countries in the eurozone facing early elections or struggling along with minority governments is lengthening.
The Irish and Portuguese governments lack a durable parliamentary majority, there has been no government in Spain for seven months despite a second election, while the Italian government trails a populist opposition party in the polls and could lose a critical constitutional referendum in October.
The party now leading the Italian opinion polls, the Five Star movement, favours departure from the eurozone.
National elections are also due in France, Germany and the Netherlands next year, with the National Front, keen to exit the euro and the EU itself, gaining ground in France.
The Brexit shock will feed into these important elections, with incumbent politicians reluctant to be seen making concessions to the deserting British in the exit negotiations. One possibility is that no progress will be made until these elections are out of the way, pushing the exit timetable back, prolonging the period of uncertainty and exacerbating the risk of a prolonged economic slowdown.
More generally, the Brexit vote has encouraged Eurosceptic parties around Europe, including parties opposed to the common currency, to EU membership, or both.
A sharp recession in Britain would cool their ardour, a high price to pay from an Irish perspective.
A period of steady economic recovery, especially in the more indebted eurozone countries, was always the vital component in a policy based on hoping the banks would repair themselves without surgery.
The combination of weaker recovery prospects and political instability flowing from Brexit has made the kick-and-hope strategy for the banks look increasingly inadequate. The result could be a re-run of the 2012 eurozone crisis.
There is a limit to what the Irish Government can usefully be doing until Britain clarifies its negotiating position, and the focus for now should be on securing the improvement in the condition of the banking system and in the public finances.
Irish bank shares have weakened substantially, the concerns about non-performing loans have not gone away and plans to offload the Government's shares into the market are off the agenda. The temptation to loosen Irish budget policy will have to be resisted - it just got riskier.