Tuesday, 22 May 2018 10:20

7 Reasons Why European Banks Are In Trouble

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Authored by Philipp Bagus via The Mises Institute,

While the euro crisis seems far away as all Eurozone countries ran government deficits below 3 percent of GDP, there is one problem for the euro that quietly keeps growing: the unresolved banking crisis. And this is not a small problem.

The Eurosystems´and euro banks´ balance sheets totaled €30 trillion in January 2018, that is about 291 percent of GDP.

European banks are in trouble for several reasons.

First, banking regulation has become tighter after the financial crisis. As a consequence regulatory and compliance costs have rise substantially. Today banks have to fulfill demands by national authorities, the European Banking Authority, the Single Supervisory Mechanism, the European Securities and Markets Authority and the national central banks. Being at a staggering 4% of total revenue currently, compliance costs are expected to rise to 10% of total revenue until 2022.

Second, there are risks hidden in banks´ balance sheets. That there is something fishy in European banks´assets can quickly be detected when comparing banks market capitalization with their book value. Most European banks have price-to-book ratios below 1. German Commerzbank´s price-to-book ratio stands at 0.49, Deutsche Bank´s is at 0.36, Italian UniCredit´s at 0.23, Greek Piraeus Bank at 0.14, and Greek Alpha Bank at 0.34.

With a price-to-book ratio below 1, buying a bank at the current prices and liquidating its assets at book value, an investor could make profits. Why are investors not doing that? Simply, because they do not believe in the book value of the banks´assets. Assets are too optimistically valued in the eyes of market participants. Considering that the equity ratio (equity divided by balance sheet total) of the Euro banking sector is at only 8.3%, a down valuation of assets could quickly evaporate equity.

Third, low interest rates have contributed to increasing asset prices. Stocks and bond prices have increased due to the monetary policy of the ECB, thereby leading to accounting profits for banks. Monetary policy has, thereby, artificially propped up banking profits during the last years.

Fourth, according to the ECB non-performing loans (NPLs), i.e. loans where borrowers have fallen behind in their payments, amount to €759 bn., that is 30% of the banks´ equity.

Fifth, more trouble for banks lies ahead. Due to artificially low interest rates, insolvency rates have fallen. In Germany in 2003, 39,470 companies (1.36% of existing companies) became insolvent. By 2017 insolvencies had fallen to 20,200 companies (0.62%).

Insolvency Rate in Germany 2003-2017, by %

Source: Creditreform.de

Companies that otherwise would have had to close, can survive due to interest rates close to zero. Their survival is not without cost as they suck up resources that could be used in other projects. Every year of the ECB´s zero interest rate policy 10,000s of bankruptcies are postponed adding to a growing stock of zombie companies. The zombie companies contribute to the anemic growth...

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