Europe’s banks are too feeble to spur growth

Tests are not a complete fix for banking sector, still less for economy’s wider problems

Following the stress tests, the European Central Bank concluded that 25 institutions, nine of them Italian, would need to add a total of €25 billion in capital. Photograph: Ralph Orlowski/Reuters

Following the stress tests, the European Central Bank concluded that 25 institutions, nine of them Italian, would need to add a total of €25 billion in capital. Photograph: Ralph Orlowski/Reuters

 

Will the asset quality review and stress tests conducted by the European Central Bank and the European Banking Authority mark a turning point in the euro zone’s crisis? Up to a point. They are an improvement on what has gone before. But they are not a complete fix for the banking sector, still less for the economy’s wider problems.

The optimistic assessment is that the ECB has at least done enough to mend the banking system. There are two things to be said for this judgment: first, the ECB has taken a close look at the quality of assets in the system; and, second, the “stresses” imposed in the tests are tough. They seem comparable to those imposed by the Federal Reserve on US banks. The ECB concluded that 25 institutions, nine of them Italian, would need to add a total of €25 billion in capital. This number has already fallen to €13 billion because of capital-raising undertaken this year.

Perhaps the most important possibility omitted by this assessment is that of sovereign default. This bears on a fundamental concern: risk-weighted capital requirements, on which the analysis is based, involve making judgments about the safety of different types of assets. This is especially problematic in the euro zone, where the lack of a unified fiscal backstop for banks means that national governments are responsible for rescuing troubled institutions. Moreover, the solvency of the euro zone’s highly indebted members is more doubtful than that of countries with their own currencies. Since a banking crisis would be even harder to deal with in the euro zone than elsewhere, it would be wise for its banks to have bigger capital buffers that stand a better chance of preventing one. This is particularly important when actual leverage is so much higher than the risk-weighted capital ratios suggest.

Questionable

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High leverage also impairs the ability of banks to finance growth. A responsibly managed yet highly leveraged institution would seek to make heavily collateralised loans, against property, for example; or to hold highly rated assets. This is likely to militate against the productive investment the euro zone needs.

For these reasons, one must doubt whether the capital in euro zone banks is enough to drive the economy forward. But this is just one part of a still bigger problem: the dramatic weakness of aggregate demand and the slow slide into ultra-low inflation and, quite possibly, deflation. Sounder banks do not necessarily generate faster growth in demand. Indeed, causality goes far more in the opposite direction.

Two former ECB officials have expressed sharply different views about how policymakers should respond. Otmar Issing, the bank’s former chief economist, argues that monetary policy is already too loose from a German point of view and that it would be a mistake for Berlin to loosen fiscal policy, too. Lorenzo Bini Smaghi, a former member of the executive board, argues that stronger demand is needed in Germany to prevent the European economy from falling into deflation. The vital point is that the euro zone has a single monetary authority, which should take a view of the entire euro zone economy.

Nominal GDP

Core inflation

The question, however, is how to achieve higher demand growth in the euro zone and creditor countries. Experience in the US and UK suggests that unconventional monetary policy might work. But the ECB is hampered by the constraints (perceived and actual) on purchases of government debt. If Germany is opposed to such purchases, then its opposition to active fiscal policy as well, even when it is able to borrow at close to zero real interest rates over 30 years, ensures continued euro zone stagnation. That just cannot make sense.

It is essential not to make too much of the stress tests and asset quality review. Yes, they are real improvements. But they do not mean that euro zone banks will now drive growth. They still have too little capital for that. More important, the euro zone lacks a credible strategy for reigniting demand. If much of the German policy elite continues to deny this is even a problem, the crisis of the euro zone must remain unresolved. That is a disaster. – (Copyright The Financial Times Limited 2014)

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