Europe's Banks Still Need Restructuring

October 26, 2009 10:00 AM

Most discussions about financial stability tend to focus on steps to ensure that last year's meltdown does not happen again, including tighter regulation of capital and compensation policies, prevention of moral hazard through new resolution mechanisms, overhaul of supervisory structures, and reform of governance and disclosures.

But Europe's policymakers should remind themselves that the current crisis has not been solved yet. True, the market is no longer in panic mode, and macroeconomic contagion has been successfully prevented so far in the European Union's more volatile central and eastern countries. But while some banks have started repaying state aid, the banking system remains largely under state guarantee. The latest numbers from the International Monetary Fund [pdf] suggest that huge bank losses remain undisclosed, especially in the euro area. And government finances are being stretched to an unprecedented limit.

Meanwhile, weak banks keep financing weak companies to delay the day of reckoning, even in cases where that day is overdue. Simultaneously, the companies that would get the most value from credit, especially those with a potential for high growth, will not have access to it. Experience tells us that the resulting "zombification" of the banking system, which is not only about credit crunch but misallocation of capital on a vast scale, has a powerful negative impact on growth.

We also know that the financial system will remain crippled as long as there has not been a system-wide "triage" in which government authorities check the health of all large banks under a single methodology to value assets more reliably than in the published financial statements, share the result with all market participants, and take action—including dissolving some banks if some institutions are insolvent or too weak to be brought back to health. The US savings and loan crisis in the 1980s, the Sweden crisis in 1992–93, and the experience in Japan in the 1990s all illustrate that such triage is the key to exiting systemic banking crises. In the United States, the "stress tests" of this spring have enhanced trust and enabled considerable levels of capital-raising. Whether they were sufficient remains a matter for debate, but their effect has been positive so far.

A triage process is always politically difficult to initiate, because it identifies winners and losers and can trigger the use of public money, though it did not in the US case (the stress tests came more than six months after the Troubled Asset Relief Program [TARP] and led to no direct fiscal expenditure). In Europe this difficulty is compounded by the mismatch between a basically integrated EU banking market, where competitive forces largely (if imperfectly) straddle borders, and supervisory institutions that until now have remained essentially national.

European integration has become too advanced for nations to act alone: with economic nationalism running high, policymakers in each country prefer a dysfunctional status quo to revealing weaknesses in some of "their" banks that would expose them to the risk of being taken over by "foreigners." At the supranational level, no player is strong enough to force action. There does exist a Committee of European Banking Supervisors (CEBS), but it has almost no power of its own. A European Banking Authority is planned to replace it and will probably develop some teeth eventually, but not for many years. The European Commission's competition services are doing a remarkable job of forcing restructuring in return for state aid, but they have no systemic stability mandate and are at risk of overextension. The result is, to a large degree, policy paralysis.

Just contrast the three-page results of the "stress tests" carried out by CEBS, released earlier this month, with the US communication back in May. CEBS assures us that things are all right, but it gives no bank-by-bank numbers, so the market cannot identify which institutions need more capital and how much. In spite of carrying the same name, the US stress tests in effect delivered triage, while the EU ones do not. The latter seem not to have moved the market an inch.

Given the institutional mismatch, only political leadership can break this stalemate. Germany is the pivotal country here, being both the EU's largest player and one where a number of major financial firms, starting with most Landesbanken, are believed to be financially feeble. But not coincidentally, Germany's banking and political communities are uniquely intertwined. This incestuous relationship has impeded bold action under the Grand Coalition. Whether it can change following last month's German election is a major question for Europe's future.

If such change happens, then Germany would have enough heft to foster EU-level action. This could take the form of a temporary multi-country fiduciary entity to carry out the triage, broker any intergovernmental negotiations if joint interventions are needed, and manage those assets that would fall under public ownership as a result.

Contrary to some maximalist views, the crisis has taught us that the burden of intervention can be shared among countries on an ad hoc, bank-by-bank basis. In other words, unity of action is required for successful handling of banking situations, but fiscal federalism is not. Just as the single currency has proved fairly resilient even in the absence of an EU federal budget, a credible supranational crisis management framework can be created without asking member states to abandon their fiscal discretion.

With this in mind, Germany's options look fairly simple. Either it leads a triage process jointly with its neighbors, a difficult task that calls for unprecedented solutions but a necessary condition to restoring sound credit conditions. Or it continues defending sticking-plaster fixes that amount to inaction, with the price being sluggish growth for an unlimited period of time, as in Japan during the "lost decade." Your choice now, Ms. Merkel.

Nicolas Véron, a visiting fellow at the Peterson Institute for International Economics, is a research fellow at Bruegel and the coauthor, with Adam S. Posen, of Policy Brief 09-13: A Solution for Europe's Banking Problem.