Making bank

Long-term reforms that European Central Bank implemented recently focus on building lender confidence—at a cost.

By David Grossman

As bad as the financial crisis was in the United States, it is Europe that has felt the fallout of the global recession most strongly. Much of this has to do with the relative sizes of the two countries’ central banking systems. When Wall Street collapsed, the Federal Reserve quickly suspended the free fall by taking $1.2 trillion of mortgage-backed securities and other potentially worthless assets onto its own balance sheet. The masses might make a run on a bank, but no one would dare question the full faith and credit of the U.S. government. The parallel could not happen with the European Central Bank (ECB), which is in charge of all 17 countries in the Eurozone. The ECB simply couldn’t assume the debts of entire bankrupt European countries and have that be the end of it; there’s just not enough money for that. Nevertheless, the ECB is still responsible for using regulations and policies to maintain the purchasing power of the euro, and subsequently the financial stability of all of Europe. In this process, it has to walk a fine line. Many banks have capital shortfalls that take a long time to replenish; at the same time, the regulation intended to stabilize the system restores consumer confidence at the cost of lowered profit margins. Too many restrictions and the banks can operate freely in the present even though they will still eventually collapse under the pressure of past loans. Bottom line, the European banks are a mess. They’ve been putting off recognizing losses for so long that no one knows how much they’re really worth and no one feels comfortable depositing money. After decades of seeing the can kicked down the road, the ECB has finally decided to pick it up and recycle the whole thing. A new era of structural long-term reform is just beginning.

First, the ECB is combing through the balance sheets of 128 major European banks to determine the number of non-performing loans (NPLs), which is the accounting term for debts that the bank has officially given up on collecting. Banks in Spain, Portugal, Italy, and Ireland claim to have bad loans totaling seven to 16 percent of their assets (compared to just two percent for banks in Germany). Concern has been heightened by fears that these numbers have been artificially manipulated by “forbearance,” the practice of easing the terms of borrowing for creditors in default of “bad loans” so that their debts may be reclassified as “good loans.”

In addition to creating standardized rules to deal with NPLs, the ECB is planning to raise the core-capital ratio, a risk-weighted comparison of risk-free assets to risky assets, to eight percent. Analysts predict that banks will need to raise an additional $69 billion in capital to meet these new requirements, which will have to come first from internally generated profits and bond holders or—if that fails—from Europe’s bailout fund, the European Stability Mechanism (ESM). Although financially stable governments like Germany’s complain about others tapping the ESM when it is more “fair” for Italy, Spain, etc., to bail out their own banks, the independent move by Mario Draghi, president of the ECB, to provide an FDIC insurance-type mechanism has gone a long way towards stabilizing Europe. Deposits in a shaky bank tend to stay there a lot longer if a €500 billion fund is standing behind it saying “don’t you worry ’bout a thing, I’ll cover your losses in a pinch.”

Although media attention has been directed toward national debt, private debt owed to the banks has ramifications for economic growth far beyond that of public debt owed by troubled countries. When a country goes into debt, politicians aren’t generally smart enough to cut back spending, but when a household or corporation goes into debt, much of future income is spent servicing the interest on that debt rather than flowing into the economy in the form of consumer spending. The same International Monetary Fund that determined that private debt has a stronger burden on economic growth than public debt has found that in Portugal, Spain, and Italy, 50, 40, and 30 percent of debt is “owned by firms which cannot cover their interest payments out of pretax earnings.” When corporations in Japan took on too much debt and became “zombie companies” that could no longer grow, GDP was effectively frozen during what became known as Japan’s “lost decade” of economic growth in the 1990s. The same threat of long-term stagnancy is now threatening much of Europe.

Another major concern in Europe is household debt, which in countries like the Netherlands and Ireland has grown past 100 percent of GDP. In the United States, someone with a loan can simply “walk away” by handing back the keys and giving up both the house and what remains of mortgage payments. But in Europe this is not the case, and the choices for those with underwater homes are limited.

In addition to the ECB’s new banking regulations, European governments need to fast-track bankruptcy and tax reforms to cut losses now and encourage long-term economic growth. For example, Portugal has pioneered out-of-court bankruptcy settlements that have reduced legislative uncertainty and allowed companies to quickly restructure and resume operations. When slashing government borrowing and spending was insufficient, Europe’s acute public solvency crisis was solved by international bailouts. The chronic issue of private debt now needs to be cured gradually by restoring consumer confidence and proceeding from there. For all the earlier conflicts of interest between European countries, they’re finally heading in the right direction, together.

David Grossman is a first-year in the College.