World Review | Europe again likely to duck the problem of troubled banks

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Europe again likely to duck the problem of troubled banks

Europe again likely to duck the problem of troubled banks
For the last two years, Bundesbank President Jens Weidmann has been calling for tighter EU banking industry regulatory standards (source: dpa)

MANY European banks are in bad shape, and shareholders and bondholders are feeling the heat. With governments and regulators still groping for a solution, various options have bubbled to the surface. Taxpayers should watch their wallets, writes World Review Expert Professor Enrico Colombatto.

Some banks ventured into risky financial investments (including toxic derivatives) and got burned. Others lent to businesses and consumers that had become unable to repay their loans after the economic slowdown hit. Almost all major European banks bought large quantities of Treasury paper from governments whose finances suddenly proved fragile, leaving them vulnerable to possible “haircuts” or forced rescheduling.

To make matters worse, the entire banking industry is suffering through a period of low margins and modest business volumes. Banking has become less profitable; often it is not profitable at all. While commercial banks’ balance sheets look cleaner than in the past, potential losses loom just around the corner, and many observers believe that their capital and reserves are still too thin. Italian banks alone are burdened with 200 billion euros of non-performing loans. This figure could be twice as large if one includes “performing” loans rolled over because borrowers could not repay the principal.

The European Central Bank has effectively promised to print all the euros it takes to avoid any liquidity shortage resulting from a run on the banks. But for the moment, liquidity is not a burning issue; in fact, a bank run is unlikely to occur and individual bank failures would not necessarily mean contagion.

In order to deal with the banking problem, the European Union has put forward various proposals. One would be to tighten regulatory standards. Advocates of this approach want reserve and capital requirements to be increased and the range of permitted banking operations to be restricted, so as to limit irresponsible risk-taking. The new curbs would apply to commercial operations, the abuse of derivatives and purchases of government bonds, as Bundesbank President Jens Weidmann has been urging for the past two years.

Such changes would probably fail to stop risk-taking, since no regulator will ever be able to assess the quality of each borrower. Nonetheless, if approved and effectively enforced, Mr. Weidmann’s proposals would make it more difficult for EU member countries to finance their budget deficits, and thus encourage them to cut expenditure and restore fiscal discipline.

Moreover, by capping the purchase of government bonds, one would probably weaken the vicious link between banking and the world of politics, a symbiotic relationship in which bankers finance public debts and in return get state guarantees, government subsidies and lax monitoring from financial supervisors. We have become familiar with the results of this toxic codependency over the past decade.

Another scenario would involve some sort of assisted cleanup program aimed at removing bad loans from the commercial banks’ balance sheets. These dubious assets would be shifted to state-controlled “bad banks,” giving the incumbent bankers a fresh start.

However, any cleanup or bad-bank program would accelerate the process of concentration in the European banking industry. Weaker small and medium-sized banks that cannot find partners or buyers would find themselves in deep trouble.

The third scenario assumes that the market is allowed to do the cleanup. In contrast to what many people fear, this would not be a catastrophe. Depositors would be safe. This would, though, lead to significant losses for shareholders and bondholders. Clearly, this scenario meets the tests of common sense and fairness. It is also the least likely to happen.

Since the EU banking crisis now hinges on political leadership and expediency, one can expect solutions consistent with politicians’ interests and their propensity to seek arrangements via long negotiations with diverse interest groups. Hapless European taxpayers are likely to end up footing a huge part of the bill for the whole mess.

For a more in-depth look at this subject with scenarios looking to future outcomes, go to our sister site: Geopolitical Information Service. Sign in for 3 Free Reports or Subscribe.

Professor Enrico Colombatto

ENRICO Colombatto is a professor of economics at the University of Turin, Italy. Professor Colombatto is also Director of Research, Institut de Recherches Economiques et Fiscales (IREF) in ...

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