Big bang, not big bucks, the key for euro zone bank lending

By Reuters

Oct 23, 2014 11:41 PM EDT

If the European Central Bank really wants to kick-start the euro zone economy, it should ensure the bloc's banks are up to the task of lending.

The International Monetary Fund has estimated that nearly three-quarters of euro zone banks need to significantly change their business models before they will be able to meet the demand for credit when the economy recovers.

This week's stress test of Europe's largest banks gives the ECB an opportunity to overhaul the sector, closing struggling banks and ensuring the ones left standing can sell loans profitably.

But expectations for a "big bang"-style restructuring of the banking sector are low, given the political sensitivities at play, and instead the market is factoring in just a handful of failures out of the 130 banks set to be tested, with a few mid-sized banks in southern European countries such as Italy and Greece seen to be most at risk.

"In testing banks, the ECB is like a cat approaching a bird very slowly and not wanting to scare him off," said Jan Pieter Krahnen of Frankfurt's Goethe University.

Instead of triggering an overhaul of the sector to get the euro zone economy moving, the ECB is throwing money at the problem, cutting interest rates to record lows and offering banks cheap loans if they lend more to businesses.

So far, the results have not been encouraging. Last month, banks took up just 82.6 billion euros last month of the 400 billion the ECB has put on offer, and a Reuters consensus forecast is that they will take up another 175 billion at the next tender in December, which still leave them about 140 billion short of the maximum.

Lenders say the demand just isn't there from corporate borrowers, but that is only one part of the story.

The banks have also been avoiding lending, particularly in southern Europe, where arrears are still climbing from the credit binge that precipitated Europe's financial crisis, clogging up the system and curbing banks' ability to offer fresh credit.

The fact that bad debts are still rising in countries such as Italy and Spain, six years after the collapse of Lehman Brothers sent the global financial system into a tailspin, reflects a reluctance to tackle the problem.

In Spain, for instance, the tally of bank loans tumbled from almost 1.9 trillion euros in 2008 to less than 1.4 trillion now. Meanwhile the amount of credit deemed at risk -- where nothing has been repaid for three months -- has trebled to 184 billion euros, almost one fifth of Spain's annual economic output.

Banks and governments in Europe have often preferred to sweep such problems under the carpet, hoping that a resumption of economic growth will resolve them, or inflation will make the debts less onerous. But the economic outlook has worsened, and prices are barely rising at all.

"Non-performing loans will be there for a long, long time," said Bridget Gandy of Fitch ratings agency. "We are talking about huge amounts of money. In a period of slow economic growth, that's going to drag and drag."


Even without the legacy of bad debt, new international regulations also make it more expensive to lend money, and banks have been reluctant to take on more risk while the ECB audits and stress tests their balance sheets this year.

Although the ECB funding is cheap, making fresh loans still requires banks to find additional capital, which they may not be willing to do.

In Greece, for instance, some small companies are being offered borrowing rates at up to four times the average cost of borrowing in the euro zone.

"We have been facing borrowing rates of 8 to 11 percent, which is tough for a small business to swallow," said Vassilis Korkidis of Greece's Confederation of Hellenic Commerce. "As a result, some are simply avoiding bank borrowing."

"About eight out of 10 loan applications are being turned down. Banks ask for guarantees, collateral that far exceeds the amount of money they are willing to lend."

In the meantime, around 130,000 small and medium-sized firms have closed in Greece since the onset of the financial crisis.

Part of the problem for banks in Greece, Spain and Italy is that they still face a higher cost of funding to peers in northern Europe whose economies and governments are seen as more creditworthy.

Italian banks have to pay on average 1.1 percentage points more to attract funds than German banks do, which they have to pass on to borrowers via higher lending rates.

Europe's stress tests are meant to help lower banks' cost of funding by ensuring that lenders that are not adequately protected against future losses are either be reinforced, restructured or shut down, thus reassuring investors.

But the reluctance to lend may persist even after the tests, and Britain provides a hint of what to expect.

It was the first country in Europe to shake out its financial system in 2008, pumping tens of billions of euros into two of its largest lenders, Royal Bank of Scotland (RBS.L) and Lloyds (LLOY.L), and instructing peers to reinforce capital defenses.

Yet this did nothing to stop the overall tumble in lending. Having grown in the run-up to the crash at the fastest pace since the 1980s, when British comedian Harry Enfield's released his hit 'Loadsamoney', lending has been falling since mid-2010.

"The fact that banks have built up capital doesn't mean that the risks are lower," said Marcel Fratzscher, president of the German Institute for Economic Research.

"We may get the lost decade, as happened in Japan, with the banks relying on the ECB for finance but not lending. This period of stagnation may last longer than the great recession."


It is not all the fault of banks. With even large economies such as Germany and France spluttering, many businesses in the euro zone are simply reluctant to borrow.

In Italy, struggling to climb out of its third recession in six years, the chief executive of Unicredit (CRDI.MI) said this month that he had taken to personally calling customers to encourage them to apply for loans.

Federico Ghizzoni said businesses in Italy had requested or expressed interest in taking loans amounting to just over half of the 7.75 billion euros that his bank borrowed via the ECB's four-year loan program in September.

With consumer spending stagnant and the first signs of deflation lurking, companies are putting off investments. "Machinery that once had an average life span of eight or nine years may now be kept and not replaced for 15-20 years," he said.

But even in Ireland, the euro zone's fastest growing economy, lending to companies fell at an annual rate of 11.8 percent in August, the fastest decline in three years.

Banks such as Bank of Ireland BLIR.I and Allied Irish Banks (ALBK.I) have ramped up loans to small and medium-sized businesses, but they are starting from a low base and not everyone is feeling confident about the recovery.

"We will probably look back in three years, as business practitioners, and say that was a 10-year recession," said Larry Murrin, president of the Irish business and employers' confederation and CEO of major food exporter Dawn Farm Foods.

"We're now at a phase where we're seeing tangible positive news, very encouraging -- but business needs to see five, six quarters of sustained growth before confidence returns."

Yet others are frustrated at their lack of traction with the banks.

"I won an absolutely incredible contract, an opportunity to strengthen the business beyond description, but I couldn't fund it because nobody would give me the money," said the head of a Dublin-based environmental services company, who was refused a loan from five lenders this year. "That flattened me."

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