Europe Needs Less Banks and More Lending

The European Central Bank on Sunday will publish the results of its stress test on 124 European banks. Most are likely to pass, and the net capital shortfall reported by the test will likely be small, around €10 billion ($12.65 billion). But underneath the broadly positive results, the test will almost certainly highlight deeper structural weaknesses in Europe’s banking system.

Like an energy grid relying mostly on one type of power plant, Europe’s credit pipeline remains vulnerable. There are 6,790 banks in the eurozone, providing 80% of credit. Together they form the largest banking system in the world, with €30 trillion in assets on their balance sheets, more than three times the eurozone’s GDP. Capital is low, set at a minimum of 3% of assets, while losses at troubled banks have added up to 15% during the 2008 crisis. Banks remain closely intertwined. More than a third of their debt is in the hands of other banks, according to central-bank data.

Lack of diversification and high interconnectedness mean a crisis can still spread from one bank to another. Bail-in mechanisms shift the cost of bank losses to equity and subordinated debt investors in a crisis, but do not improve efficiency, capital or the availability of credit.

Since 2008, banks have cut €594 billion of lending in the eurozone and £189 billion ($303.04 billion) in Britain. Policy makers hope lending activity will restart after the tests. The good news is that banks have raised €130 billion in equity and €40 billion in subordinated debt since 2013. But this may still not be enough to be able to increase lending. Plugging the gap will take time.

Even if few banks fail, around a third of the 124 in the test remain close to the pain threshold. Midtier lenders look particularly weak, especially in Italy and Germany. Having resisted consolidation over the past decades, they are exposed to high costs and low profitability. Many would be unprofitable without carry trades on sovereign bonds, against which banks do not need to hold capital. Cost inefficiencies also are widespread. There are more bank branches per person in Italy than pharmacies or restaurants.

The stress test will uncover these weaknesses. The exercise will simulate a recession, with losses on the banks’ loan book and securities holdings, testing their ability to recover over a three-year period. Banks with little earnings capacity will fail.

The endgame is more lending from nonbanks as well as a leaner and more efficient banking system. For that, Europe needs reform that “accelerates rather than retards the creative destruction process,” as ECB member Benoît Cœuré said last week. Europe’s banks have seen little of that over the past decades, with some notable exceptions, such as Spain. Other countries, especially Italy and Germany, have been reluctant to consolidate their banks.

The first answer to reduce reliance on bank credit is to promote borrowing through bond markets. The value of high-yield bonds outstanding has tripled in Europe over the past five years, to €300 billion, with many first-time issuers. But only large firms have the critical mass to afford borrowing through bonds, which generally start at €100 million per issue. The problem remains improving access to credit for small firms, which are responsible for roughly 80% of job creation in Europe. Rates on small-business loan rates are two percentage points higher in the periphery than in core Europe, and nearly 20% of small- and medium-size firms in Italy and Spain say access to credit is their biggest problem.

A second answer is the ECB’s latest plan to promote a market for asset-backed securities (ABS), which aims at bridging the gap between small firms and bond markets. ABS are loans that banks originate and bundle together, and that can be sold to investors. This allows banks to lend essentially without growing risk on their balance sheets. Banks need to sell the full ABS structure (senior, mezzanine and equity) minus a retention requirement, to gain capital relief on the loans they issued. The ECB can buy only senior tranches of ABS, the least risky part, and mezzanine tranches only with a guarantee. But Germany, the Netherlands and France have nixed government guarantees, despite the low historical default rate (2-3%) on mezzanine securitizations.

There are other national-level efforts to promote nonbank credit. The Netherlands, Italy and Finland have been promoting the market for minibonds, high-yield bonds of around €50 million issued by midcap firms. Yet the market remains small and inaccessible to smaller firms, which generally require much smaller loans. Italy has opened up lending activity to insurers and credit mutual funds. The U.K. is promoting crowdfunding platforms, which together have originated almost £2 billion. Still,this is a drop in the ocean compared to the £189 billion of loan deleveraging in the U.K.

Europe needs fewer and more efficient banks, and November will mark the start of a new era. With the ECB becoming Europe’s bank regulator, stress tests and increased disclosure may become a regular exercise. EU governments should support the central bank’s plan to develop an ABS market, as well as promoting nonbank lending. But eventually the choice will come down to embracing change and creative destruction, versus protecting old business models that are no longer viable.

This article was published on The Wall Street Journal on October 23, 2014.