Bad Banks Really Do Hurt Your Economy

(Bloomberg Opinion) -- Since taking over as the main supervisor of the euro zone’s largest lenders, the European Central Bank has waged a war against sickly lenders.

The regulator has forced banks to be more open about the value of the exposures sitting on their books, and urged them to write down bad loans faster. All this should not only bolster financial stability, it should also help growth: providing less forbearance to “zombie” borrowers ought to free up credit for more promising startups.

These demands have been met with scepticism by some investors and regulators, particularly in Southern Europe. They argue that the ECB’s actions have resulted in an unnecessary destruction of shareholder value as banks scrambled to raise new capital. This has caused unnecessary turmoil, damaging both vulnerable and healthy banks. Finally, the ECB stands accused of having little evidence to prove that its strategy was actually helping to revive the region’s economy.

A recent working paper from the ECB fills this last gap. Until recently, most research on the link between weak banks and zombie firms relied on the Japanese experience of the 1990s. Dan Andrews and Filippos Petroulakis instead looked at data from 11 European countries between 2001 and 2014, a period covering the euro zone crisis.

Their findings are striking. For a start, weak banks are much more likely to be connected to zombie companies: troubled lenders are between 13 and 19 percent more so, suggesting that forbearance is a significant factor.

The report also found evidence that zombie firms do indeed crowd out credit to healthier companies. By keeping companies alive artificially, lenders lower the average profitability of a particular industry. That makes banks more reluctant to lend to rivals in the same sector even if they are in better shape.

The results clash with other work from Guido Tabellini and Fabiano Schivardi, two Italian academics, who had found that a large stock of non-performing loans didn’t crowd out new credit to better companies. However, their particular paper only looked at new lending to zombie firms and didn’t look at the other ways of providing forbearance, such as maturity extensions. They also ignored the consequences on the wider markets of a bank’s lending behavior, which prevents them from isolating the effect the two ECB researchers describe.

Still, it would be wrong to conclude that pushing banks to offload their non-performing loans is sufficient to restore economic growth. The ECB paper finds that in sectors that are more exposed to weaker banks it is harder to reallocate capital towards more efficient firms. Without a well-functioning bankruptcy regime that allows companies to be restructured speedily, however, lenders have little incentive to pull the trigger on an ailing borrower. This is an essential requirement for turning a vicious circle of forbearance into a virtuous circle of healthy lending.

Of course, it would be easy to dismiss the ECB’s new evidence as self-serving. But it chimes with plenty of other work from reputable analysts.

Two OECD researchers looked into a group of rich countries and found that a high share of industrial capital tied up in zombie firms has negative effects on investment, employment and productivity growth, particularly in countries such as Italy and Spain. Gita Gopinath, now chief economist at the International Monetary Fund, and colleagues have found that increasing capital mis-allocation is an important explanation for the productivity slowdown of Southern Europe.

All of this points to a paradox: The countries that are resisting the ECB’s crackdown on bad loans the hardest are those who stand to benefit most from a fresh start. Rather than blaming the supervisors, they would be wise to concentrate on the truth of its message.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ferdinando Giugliano writes columns and editorials on European economics for Bloomberg Opinion. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.

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