SLOUCHING TOWARDS A BANKING UNION / THE ECONOMIST ( A MUST READ )

Europe’s banks

Slouching towards a banking union

The prospects of big bank bail-outs are intensifying calls for a central fund

Jun 9th 2012

BLINK and you might miss it. Amid the headlines over Spain’s deepening banking crisis, two smaller members of the euro area quietly moved along with plans to recapitalise their own banking systems. Portugal, which is already on life support, said it will inject €6.6 billion ($8.2 billion) into three of its largest banks. To its east, the Cypriot government said it too may need European help to raise €1.8 billion to recapitalise its second-largest bank.

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The growing number of capital calls across banks on Europe’s periphery is leading to a freeze in funding markets, as investors fret that banks may be hiding big losses and as banks lose trust in one another. “The interbank market is totally closed,” says the boss of one large European bank, adding that he is keeping excess cash at the European Central Bank (ECB) rather than lending it to other banks.



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It is also causing jitters in government-bond markets as risk-averse institutional investors such as pension funds and insurers worry that governments in the periphery may be swamped by mounting losses in their banking systems. Money is flooding into the safest option, Germany, where the government borrowed five-year money at just 0.41% on June 6th. Despite these signs of panic, the ECB left rates on hold at its June meeting.

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The crisis is intensifying calls for the establishment of some sort of banking union, with centralised powers and funding to regulate and supervise banks as well as to recapitalise ailing ones and to insure retail deposits. On June 6th the European Commission took the first steps towards this with a proposed framework for dealing with failing banks that includes plans for sharing some of the costs of recapitalising cross-border banks.



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The crisis is most acute in Spain, mainly because the sums of money involved are largest. On June 5th Cristóbal Montoro, the budget minister, said the country needed help from European institutions to recapitalise its banks because the “door to markets” was closed to the Spanish government. This was preventing it from issuing €19 billion of bonds to recapitalise Bankia, a troubled agglomeration of local savings banks that incurred huge losses on property loans. Two days later the Spanish government sold €611m of ten-year bonds at 6.04%, compared with 5.74% in April.



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Were the capital hole in Spain limited to €19 billion the country would probably have little trouble raising the money, although an idea to bypass markets and hand bonds directly to the bailed-out bank fizzled out. Yet many people now think this sum is just the tip of the iceberg. Analysts at Credit Suisse reckon that Spanish banks may have to set aside another €150 billion against losses, mainly on loans to property developers. To remain solvent after such losses the Spanish banking system may have to raise €50 billion-70 billion, or 4.5-6.5% of Spanish GDP, analysts reckon.



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That figure looks relatively manageable when set against Ireland’s recapitalisation of its banks, which has so far amounted to almost half of its GDP. Yet the call for government cash in Spain comes at a time when the country is already struggling to retain the confidence of bond investors amid growing capital flight. Almost €100 billion, about one-tenth of GDP, was pulled out of the country’s banks and bond markets in the first quarter.




.Losses are also mounting elsewhere in Europe’s banking system. Portugal, which won praise on June 4th from the European Union and the International Monetary Fund for its austerity programme, is injecting capital into its banks to fill a shortfall identified in stress tests conducted last year by the European Banking Authority. Cyprus too needs to inject money into its banks before July..
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.Yet as quickly as banks are filling their existing capital holes, new ones seem to be appearing. Analysts at Nomura note that non-performing loans are rising in several European countries, including Italy and Germany. They reckon that a severe recession in Europe could cost the region’s 90 biggest banks €420 billion in losses and consume about a third of their capital, with big shortfalls in Britain, France and Germany in addition to those already emerging in Spain (see chart).



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A deep recession is not inevitable, and banks would probably be able to generate some of that capital from profits or asset sales. The real worry is that local regulators will allow banks to hide losses rather than force them to set aside provisions and perhaps ask for capital from their governments. That would further undermine investors’ confidence and could accelerate capital flight from weak banks and weak economies.


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Signs that this is happening are already apparent. Confidence in the Bank of Spain has been badly dented by the revelation of large losses at Bankia just weeks after senior bank supervisors trotted around financial capitals to assure investors that Spanish banks were well capitalised. This loss of confidence is also infecting healthy banks and has prompted the bosses of several Spanish banks to call for capital injections into the country’s weaker ones.



.It also reinforces calls for strengthening bank oversight. The commission’s proposals for dealing with failing banks are a small step in this direction. Under its scheme, big cross-border banks would have to draw up resolution plans and issue debt that could be “bailed in” or converted into shares to recapitalise them if they fail. It also proposes the creation of national funds worth at least 1% of bank deposits that could help to deal with failing banks. In a step towards greater integration of banking oversight, it said these funds might be used to help banks in other European countries.


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These proposals are unlikely to go down well with investors in bank bonds, who are at greater risk of loss, nor with governments with well-regulated banks, which would be in danger of paying for the losses of poorly regulated ones. Yet strengthened oversight and the ability to recapitalise banks quickly with combined euro-zone resources are essential to break the vicious spiral linking failing banks and overindebted governments.