Euro-Zone Banks Needs Better Risk-Sharing Mechanisms

(Bloomberg View) -- Last week, the European Commission and the European Central Bank announced new rules on how banks should treat dud loans. The good news is that the changes will help make European banks more resilient in the future. The bad news is that the euro zone banking system remains insufficiently equipped to deal with a new crisis.

European banks are still struggling with the aftermath of the financial crisis and the ensuing recession. Unlike their U.S. rivals, many European lenders chose not to sufficiently write down their non-performing loans, since this would have required raising significant amounts of new capital. The U.S. banks took a different route: They tackled the problem head on, helped by the Troubled Asset Relief Program (TARP) whereby the government spent more than $400 billion to stabilize the financial system.  

The consequences of the European delay are still visible: Even now that the euro zone economy is recovering, this pile stands at around 760 billion euros ($935 billion) for the bloc's significant banks, with Cyprus, Greece, Italy and Portugal most affected.

Non-performing loans are a problem for both banks and the economy. They keep managers from seeking new and profitable lines of business andtake up bank capital, which limits the ability of lenders to extend new credit to other firms. This has a negative effect on the European economy: Research by the Organization for Economic Cooperation and Development has found that the misallocation of credit is one of the main culprits for slow productivity growth in some euro zone countries such as Italy.

The Commission's new rules require lenders to set money aside over time in order to cover up to 100 percent of the value of a bad loan. Under this principle, called "calendar provisioning," banks will have eight years to cover fully a secured loan, and two years for unsecured loans. The timing is generous: In most cases, this is enough to understand whether a creditor is good for what he owes. The rules will apply to all banks and only to new loans, allowing for a more than adequate phase-in period.

The Commission's plans, which now need to be discussed with the European Parliament and the Council (the body representing member governments), will take some time before they come into effect. Meanwhile, the ECB will be able to apply its new guidance (also announced last week), which in many ways is more stringent than the Commission rules: It applies to any loans that are classified as non-performing as of April 1 and gives banks seven years to provision for secured credit, instead of eight. However, these are expectations, not binding rules. The ECB still has plenty of discretion and will mainly use the new tools in the case of banks that are of particular concern.

The euro zone's decision to leave the existing stock of bad loans untouched is, to some extent, understandable: Demanding banks fully provision for their existing bad loans immediately could trigger a cascade of capital increases. Investors would find it difficult to satisfy all these demands for new equity, forcing several lenders into unwarranted liquidation.

Even so, the ECB shouldn't be content with the status quo. The supervisors should demand that the banks are much more honest about the value of their loan books. These demands may lead the weakest banks to fail; but provided these failures are handled in an orderly manner, there's no reason for this to be a problem. As Sabine Lauteschlaeger, a member of the ECB's executive board, noted in a speech at the Florence School of Banking and Finance last week, the job of supervisors is not to keep individual banks alive. "The result would be weak banks that stagger on, zombie-like, barely able to survive in good times."

No rule, however tough, will ever prevent crises from happening. When they do, euro zone member states must have mechanisms in place for cost-sharing, or banking troubles will quickly escalate into a full-blown sovereign debt crisis. The euro zone's "banking union" aims to break the link between the financial health of banks and the country in which they are located, but it remains incomplete.  

The EU's Single Resolution Fund (SRF), which authorities can use when they are winding down a large and interconnected bank to purchase assets from it or soften the blow to investors, is currently capped at 55 billion euros. It should be expanded, for example by obtaining a credit line from the euro-zone rescue fund, (the European Stability Mechanism). This would ensure it can intervene in a major crisis. The ESM should also be allowed to intervene more easily in a troubled bank. In theory, the ESM has the power to do so, but any intervention still requires a contribution from the domestic governments, which would add to the deficit and potentially raise investors’ concerns over debt.

The euro zone also needs what it can't quite bring itself to create right now: a joint guarantee on deposits. Depositors should know that their current accounts (up to 100,000 euros - the amount currently protected in all EU countries) enjoy a European safeguard, regardless of the severity of the banking crisis which is happening in their country.

Germany currently leads the opposition to deposit insurance because of fears that taxpayers could be on the hook for less careful Italian or Spanish lending decisions. This is the wrong way to look at it: German banks too have been severely affected by the crisis, because of a string of poor lending and investment decisions. They could just as easily get into trouble again.

The Commission and the ECB are right to demand banks be more prudent with their lending. But to fully prepare for future crises, the new measures will not be enough.

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 View. 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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