By Thomas Cooley, Charlie Nusbaum, and Peter Rupert
In the aftermath of the European debt crisis much has been done to try to improve the safety and stability of the financial system. It was clear that one key to financial stability was to complete the process of a banking union within the Eurozone (the EA19). To that end they have adopted a Single Supervisory Mechanism centered at the European Central Bank. In 2017 they implemented a Single Resolution Mechanism for addressing insolvent or illiquid banks. Question: Is a Euro in an Italian Bank, as viewed by the market, the same as a Euro in a German Bank? Until the answer to that question is yes, the banking system remains fragile. A key ingredient to an affirmative answer is a Single Deposit Insurance system. So far the Germans have been steadfast in their opposition to unified deposit insurance for obvious reasons. The balance sheets of banks in the third and fourth largest economies in the Eurozone carry a lot of legacy risks in the form of non-performing loans and a heavy exposure to the debt of the sovereigns. We have documented these issues in earlier posts. The only way out of this bind is for banks to improve the health of their balance sheets. We consider this next.
Stronger Banks in Europe?
One of the major concerns in the European financial sector during 2017Q1 was the mix of outstanding loans. During the first quarter of 2017, the ratio of non-performing loans to all outstanding loans in Greece, Cyprus, Ireland, Portugal, and several Eastern European countries signaled potential trouble ahead. At the end of 2017, these same regions remain the trouble spots in this regard. Indeed, 44.9% and 38.9% of loans from Greek and Cypriot banks are over 90 days past due. The remaining trouble spots have a non-performing loan ratio of 6.5%-15.2%. All of these countries, however, have improved their loan portfolios throughout 2017.
From 2017Q1 to 2017Q4, the ratio of non-performing loans to all loans in Cyprus and Greece has decreased by 4.9 and 1.3 percentage points, respectively. Throughout the EU28, the same decreased by 0.76 percentage points. The only two countries who saw their position worsen in this respect are Estonia and Sweden, though both remain below 2%.
The EU28 financial sector continued to improve its ability to cope with distress. As a whole, the EU increased its liquidity coverage ratio by just under 4%. While several countries saw a substantial decline in this measure, it does not give us pause.
Indeed, despite Sweden, Estonia, and Hungary’s large decrease in their liquidity coverage ratios, they all remain above the 148% coverage ratio in the EU as a whole. The only country not in compliance with the Basel III minimum liquidity requirement rule of 90% for 2018 is Greece, which held only 11% of its 30 day expected net cash outflows in high quality liquid assets. Excluding Greece, every EU member nation is already compliant with Basel III’s final liquidity requirement of 100%, which is set to go into effect next year.
Profitability remains an area of concern, however. As measured by return on equity, the profitability of European banks decreased by 0.78 percentage points. Despite this overall downward movement, over half of the EU28 beat out U.S. banks, which had a return on equity of 8.4% in 2017Q4.
The operating efficiency of European banks as measured by the cost to income ratio showed little change since 2017Q1 overall, decreasing by just 0.33 percentage points. As in 2017Q1, central European countries have some work to do to bring down costs. German and French banks remain the least efficient with cost to income ratios of 80% and 71%, respectively.
On the other hand, over half of European banking systems maintained cost to income ratios around 50%. For comparison, major U.S. banks range from 58% (Morgan Stanley) to 76.2% (Wells Fargo). While measures of efficiency differ depending on the ratio considered, virtually all fall within this range for U.S. banks.
Inching Toward Stability
Despite the positive signs in many countries, caution remains to drawing an optimistic conclusion regarding the stability of European banks, particularly in the EA19. Two key points to stress are that participation and size matter. What do we mean by participation? Many of the countries that boast a healthy financial system have little relevance with respect to the a healthy monetary union. In fact, 3 of the 5 countries with the lowest NPL ratio are not members of the monetary union while 4 of the 5 countries with the highest NPL are members of the EA19. In addition, 4 of the 5 financial sectors suffering from low efficiency as measured by the cost-to-income ratio are Euro adopters. As a result, the positive trends emerging in Europe are deceiving.
Moreover, the performance of Eurozone banks must be weighted according to their respective sizes. While Italian banks are moving in the right direction, they maintain a cost to income ratio above 60%, a non-performing loan ratio of 11%, and a tier 1 capital ratio of just 13%. As one of the largest economies in the EU, this low performance carries much greater weight than the strong Luxembourg banks. Even more striking is the polarization between Germany, the largest economy among both the EA19 and EU28, and Italy, the 3rd largest EA19 and 4th largest EU28 economy, with respect to their TARGET2 balances.
The TARGET2 system was set up in 1999 as a payment settlement system between European banks. TARGET2 balances can be interpreted in two ways: as a reflection of current accounting financing or as a measure of the capital account. Prior to the financial crisis, TARGET2 balances remained roughly even throughout the the EU. Following 2007, however, German banks began taking on the role of primary creditor in the EU, whereas Italian banks assumed the role of primary debtors. Broadly speaking, these trends can be seen as a reflection of net capital inflow for Germany and net capital outflow for Italy. This picture presents a very clear message: a Euro held in Italian banks is not yet valued equally to one held in German banks. The same story emerges for Spain, the 4th largest economy in the EA19. Until an Italian or Spanish Euro is seen by the market as equal to a German Euro, we hesitate to claim that the European financial sector or EA19 are stabilizing.
While long term systemic shocks are always a concern, improved loan portfolios and high liquidity coverage ratios signal that European banks are improving their ability to cope with short term financial distress. In light of mixed profitability measures, sustained difficulty in Greece, and a persistent divergence of TARGET2 balances among the largest European economies, however, the ECB is right to maintain its holding pattern thus far in 2018 (here, here, and here) until the largest European economies signal stronger, more uniform improvement. Moreover, we see several challenges that must be tackled to resolve the fragility of the European Monetary Union. First, legacy debt and the size of non-performing loans in the larger economies have prevented a willingness on the part of well-performing countries to fully integrate their banking sectors with countries such as Italy and Spain. Reconciling these differences is of first order importance to promoting a sound and robust financial system. Second, a unified deposit insurance scheme must be implemented in the EMU. Until such a policy is implemented, it is difficult for us to see how or when market participants will value a Euro equally across all Eurozone banks.
Finally, recent political events in Italy have caused even greater concern over the state of the Monetary Union. Despite reassurances by Italy’s Economy Minister that it has no plans to leave the Euro, political parties espousing anti-Euro policies have gained a fair bit of traction in Italy with roughly 30% of the voters favoring such an exit (here). Should these policies continue to gain in popularity, it is not unimaginable that the EU could face an Italian BREXIT (exIT). Whereas Britain has always remained on the periphery of the Union, an Italian exit would strike at the heart of the Euro Area. Such a move on the heels of a BREXIT would make it difficult to see how the Eurozone, or EU for that matter, could survive in its current form. Indeed, Italian politics has the potential to make BREXIT look like a tea party.
Click here for an in-depth evaluation of the European banking system and the EMU from the 2018 “State of the Union Conference” held in Florence this past May. Skip to 1:53:30 to see remarks by Thomas Cooley.