The Original Sin of European Finance

The origins of banking lie in mortal sin. Making money on someone else's time was prohibited by the Catholic Church since the 5th century, strictly forbidden by Islam and criticized by the Torah. "Doing God's work" would have landed you straight in Dante's seventh circle of Hell.

For these reasons Europeans have always had a complex relationship with banking. To avoid the social stigma, bankers have long tried to make banks "better" and more acceptable. The first of Europe's modern banks can be traced to Italy's Renaissance period, when Franciscan monks created the Mounts of Piety. These were charity institutions that lent at moderate rates: The banks' primary objectives then were social and political, not economic.

Paradoxically, by trying to redeem themselves and make lending more mutual, some of Europe's banks also have a tendency to become weaker, and remain vulnerable to another crisis. Current economic theory says that banks do not only take deposits and lend, but do so by allocating resources in an optimal way throughout the economy. But what is optimal? Over the past half-century, European banks grew to be the largest in the world, with €31 trillion in total assets, according to data from the European Central Bank (ECB). Many evolved into large, public institutions—some too big to fail.

The majority, however, are still run very differently. Italy's 37 Banche Popolari and 387 cooperatives; Spain's 15 Cajas de Ahorros and 74 Cajas Rurales; France's Fédérations Régionales and Caisses Locales, Germany's seven Landesbanken and 422 Sparkassen; and even Britain's 45 Building Societies, still operate mostly for social purposes. Their largest shareholders are their governments and local authorities and most are not listed, meaning control is hardly exchangeable.

This is a two-tier system, with two different models of banking. Deciding which one is right opens up economic and ethical questions: Should banking be primarily for-profit, or rather a social and political function? If pursuing profits at all costs can generate too-big-to-fail banks, history shows that government-subsidized social institutions are not sustainable either.

When growth is stable, mutual credit institutions get cheap credit to small borrowers, sometimes below market rates. But on rainy days, these banks often earn too little to stand on their own feet. The German Landesbanken returned an average -0.8% on equity in the decade before 2009, according to calculations by the International Monetary Fund (IMF), versus 4%-6% for other German banks. Similarly, the Italian Popolari and Spanish Cajas averaged among the lowest returns on assets in Europe between 2004-2012, according to the European Association of Co-operative Banks. This is also due to a large banking network with hefty costs: There are more bank branches in Italy than there are hotels or schools.

In some cases, the nexus between governments and banks can generate distortions and misallocation of capital for political purposes that do not make economic sense. The recent default of Hypo Alpe Adria in Austria is a case in point. The bank had started out as a small local lender and by 2008 had grown to an international bank with €40 billion in total assets, while the region of Carinthia guaranteed its debt under far-right governor Jörg Haider. Its restructuring now will cost Austrian taxpayers more than €8 billion and may push the sovereign to lose its triple-A status. Similarly, the Spanish Cajas were heavily exposed to real-estate loans, and connected to local authorities who used to draw most of their tax revenues from stamp duty on property sales.

So far, large banks have been the focus of European regulators. It is the right strategy: Many of them are undercapitalized and some are too big to fail—larger than their respective economies. But mid-tier and small banks are important too. The International Monetary Fund estimates that all together, mid-tier and small banks account for more than half of bank assets in Germany, and more than 40% in Italy and France.

Many of these weaker banks have been able to continue their business without redressing their structural problems. Those banks with less than €30 billion in assets will not be included in the European Central Bank's upcoming stress tests, which leaves out Italy's cooperatives and Germany's Sparkassen. In addition, German banks recently won lighter scrutiny on their residential-mortgage portfolios. And so far, many mid-tier banks have been making up for their meager profits by buying sovereign bonds—in Italy and Spain they hold roughly 10% of their balance sheet in government paper, which requires no capital under Basel III rules.

To restart lending, regulators will need more than asset purchases: Even the ECB's mooted €1 trillion purchase program would only be temporary relief, if banks remain structurally weak. Eventually, I believe Europe will have to open up the lid covering its social-banking institutions and move towards consolidation, as recommended by the IMF and other policy makers. Regulators must focus on too-big-to-fail banks, but also on others that are too small to survive. Spain has already moved swiftly, aggregating its 45 large Cajas into 15 at the end of last year. Germany and Italy are still trailing behind.

The end-game of consolidation is a self-sustainable banking system, with more capital and fewer, stronger banks. The consequences of inaction are potentially dangerous: The U.S. lost 32% of its banks during the savings-and-loan crisis. European banks need to operate for both social and economic objectives. To serve their economies and to grow with them, and to make a profit without the stigma of sin.

This article was originally published by The Wall Street Journal on April 8, 2014.

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