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A chance to restructure Europe's financial architecture

Europe is back in black. France’s new president, Emmanuel Macron, and Germany’s Chancellor Angela Merkel are now working in tandem. The European Commission on Wednesday published a new roadmap to European integration. After eight long years, the political crisis that engulfed Europe seems to have moved elsewhere.European leaders have a lot of work to do. The first step should be restructuring Europe’s financial architecture. European firms and banks are in better shape, yet far from healthy.

If the U.S. recovered quickly from the crisis, it is also thanks to its financial system, which allowed firms and banks to deleverage quickly by openly recognizing losses in capital markets. Europe, instead, is still stuck with €1 trillion ($1.12 trillion) in nonperforming loans, around 10% of eurozone gross domestic product.Part of the problem is structural: Europe’s financial infrastructure lacks flexibility. Firms rely largely on bank loans to borrow, and bankruptcy procedures are slow and expensive. This makes the exit from a balance-sheet recession longer and more difficult.The risk is that Europe will go down the same path as Japan, where banks extended credit to zombie firms for decades, engulfing the economy in a slow stagnation. Europe’s policy makers need to shake up its financial system and build a stronger banking and capital-markets union.

The first place to start is with fewer and stronger banks. Eurozone banks have deleveraged down to €31 trillion in assets from €35 trillion in 2008 and raised more than €250 billion in capital over the past nine years, yet still they are nearly three times the size of the eurozone economy.The banks’ business model need to be fixed. In some countries, banks have become a petrified forest of institutions: Italy’s central-bank governor, Ignazio Visco, noted on Wednesday that his country’s banks lack profitability and need to cut costs — about time for a country where banks still run more branches per capita than restaurants, according to OECD data.

Second, Europe needs a quicker and simpler framework for bankruptcy and debt restructuring. Bankruptcy in Europe can be two to three times more costly than in New York State, according to World Bank data. Holders of nonperforming debt in Italy need up to several years to recover what they are owed, even after an agreement with debtors. If the cost of handling failure is steep, banks will apply an extra charge when giving out loans. This means credit will cost more even for performing firms, and entrepreneurs will think twice before taking risks.

Third, Europe needs more alternatives to banks, including bonds and securitizations. Capital markets make up only 10% of corporate funding in Europe’s periphery and up to a third in the core countries, compared to 75% in the U.S.Thus few European firms benefit directly when a central-bank stimulus lowers bond yields. It also means that in a crisis, Europeans keep most of the losses for themselves. U.S. high-yield borrowers restructured more than half of corporate-debt losses in bond markets, to a value of more than $500 billion.

By comparison, 95% of losses in European corporate debt remain in the loan market, a large part of which still sits on the banks’ books.The other part of the problem is social and political: Europeans leaders need to accept economic failure. Keeping zombie firms or banks alive reduces growth and productivity, as recent ECB research has shown. Yet it remains a popular policy: Italy recently approved a €400 million rescue plan for loss-making Alitalia, the third one in 30 years.

A government that keeps inefficient sectors alive may preserve short-term political stability, yet will inevitably take away resources from productive industries and stifle long-term growth. After many gyrations, European leaders have a window of opportunity to strengthen public institutions as well as private financial markets. It is time to take down the petrified forest and plant the seeds for a diversified and stronger financial system.

This article was published on The Wall Street Journal on June 1, 2017.

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