Europe Cannot Afford To Be Complacent About European Banks

Authored by Krishna Guha, op-ed via The FT,

The EU has so far escaped the crisis seen in the US but weaknesses mean risks remain…

Europe — with the exception of Switzerland — has had a good banking crisis so far, with no domestic stress. This is not an accident: the EU has done a better job of regulating and supervising its banks than the US. But it would nonetheless be wildly imprudent to assume that some variant of what happened in the US could not happen in Europe.

This means that the European Central Bank — whose rate-setters meet on Thursday — must proceed carefully with its remaining rate rises and it should be a wake-up call to complete banking union.

European banks, like US ones, face large unrealised losses on assets acquired during the period of ultra-low interest rates that fell in value when interest rates shot up. As in America, some losses are on government bonds, but eurozone banks also hold a lot of fixed-rate mortgages.

A bank that made a 20-year fixed-rate loan at a rate of 1.5 per cent will face losses year after year if it has to pay more than half the current ECB deposit rate of 3 per cent for its own funding — even if the loan does not need to be sold and the loss crystallised up front.

Europe is better prepared for this because — unlike their US counterparts who exempted midsized regional banks from certain regulations in 2019 — the EU authorities applied the full set of liquidity and capital regulation across their banking system.

EU supervisors also zeroed in on interest rate risk with stress tests that involve a big rate shock applied broadly to European banks. This helps explain why the bloc has not experienced US-style stress to date.

However, the likelihood that some bank somewhere in the EU ended up badly mismanaging interest rate risk in ways that were missed by its national supervisor must still be quite high.

Moreover, while European supervisors stress tested banks for an interest rate shock (on the asset side of their balance sheets) they did not test for the other half of the stress that hit US regional banks — a simultaneous shock to the stickiness of bank deposits (on the liabilities side).

This shock to stickiness led to deposits fleeing Silicon Valley Bank at a pace eight times the fastest run in the 2008 financial crisis, fatally wounded First Republic and, for a period, destabilised the entire US regional banking system. It was the combination of this shock to stickiness of deposits with the interest rate shock that was novel and dangerous.

We do not really understand the shock to stickiness in the US, nor know how persistent it will be. But the underlying technology shock from mobile internet banking that allows customers to move deposits at the flick of a finger is present in Europe, too.

Moreover, Europe is worse placed to deal with such a twin shock were it to arise. Deposit insurance at €100,000 is too low, and there is no systemic risk exemption of the kind the US authorities invoked to protect all depositors and quell runs, while Europe’s single resolution mechanism for failing banks is too rigid.

And after years of gridlock and failure to complete banking union, there is still no common European deposit insurance fund, raising the risk that a bank crisis could reignite a bank-sovereign “doom loop” with bank losses threatening the solvency of weak governments and deposits fleeing weaker countries to stronger ones.

The ECB is standing behind periphery debt with its new transmission protection instrument, or TPI, bond-buying tool, but this is as yet untested. The failure of European bank stocks to rebound fully is telling us that risks remain. Even without domestic stress, banks will be less profitable with higher funding costs and — as the new ECB bank lending survey shows — they will tighten credit further.

With core inflation elevated, the ECB does still need to edge rates a bit higher, or risk a loss of inflation credibility and a spike in long-term interest rates that could ignite a bank crisis.

But the central bank will need to proceed very carefully to avoid shocking the system. With additional credit tightening already emerging, this means no return to jumbo-sized half-point rate rises. The ECB should also consider letting banks roll over some of the funding it provides that will soon expire, and avoid reducing its quantitative-easing holdings of sovereign debt too quickly.

EU governments, meanwhile, should view the US stress as cause to get serious about finishing the banking union before — not after — they too face a bank crisis.

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The author is vice-chair of Evercore ISI and a former member of the management committee of the New York Fed