13 August 2015

VoxEU: Still vulnerable - The eurozone’s small and medium-sized banks

The ECB’s publication of the results of a comprehensive assessment of 130 banks under its oversight (ECB 2014) identified problems in terms of non-performing assets and capital shortfalls. Nevertheless, the outcome brought a sense of relief to financial markets. Unlike stress tests conducted in July and December 2011 by the European Banking Authority, the ECB’s assessment was considered broadly credible.

The assessment showed that the largest banks appear to be out of the woods. However, our recent research shows that small and medium-sized banks – and among them the unlisted banks – remain under considerable stress (Mody and Wolff 2015).

[...]

 ‘small’ banks have about 14% and ‘medium’ banks have 29% of total bank assets in the Eurozone.

Small and medium-sized banks thus control a sizeable share of the Eurozone’s bank assets. They have also received substantial bailouts. During recent periods of market pressure, small to medium-sized banks have become closely interconnected in the market’s perception, thereby posing a broader systemic risk. Though there is no cause to believe that the vulnerabilities of small to medium-sized banks will lead to widespread banking distress, their weakness could delay the recovery.

To measure the vulnerability of individual banks, we conducted a simple ‘stress test’ which asks the following question – if 65% of a bank’s non-performing loans have to be written off, after accounting for provisions, what would the bank’s equity/assets ratio be? Contrary to the ECB, we look at non risk-weighted equity. If the ratio falls below 3%, we consider the bank to be ‘under stress’. This, we acknowledge, is very crude. It is intended only to assess where the current trouble spots are without claiming to detect all problems.

[...]

Altogether, the evidence suggests that the most serious vulnerabilities lie in the medium-sized banks. They have experienced a decline in deposits while large banks have reduced their debt and derivatives, and small banks have reduced their debt. On the asset side, the stressed medium-sized banks reduced their net loans much more significantly than other banks, suggesting they have had to adapt their businesses substantially to deal with the pressures they face. This is not to suggest that large banks cannot pose risks. But crisis management has allowed them to emerge from the deep shock the Eurozone experienced in a healthier way.

Resolution without delay

In the European policy context, these findings are important for three reasons:

• First, the small to medium-sized banks serve domestic markets and their continued stress impedes the flow of credit and limits the potential for economic recovery – the weakness of these banks is one reason why bank lending in Europe remains weak;
• Second, to the extent that these banks are unable to lend because of lack of demand, they might be subject to a deflationary (or low inflation environment) risk – lenders might struggle to repay their loans. In combination, banks and the corporate sector could (continue) to drag each other down;
• Third, the geographical distribution of the banking stress is worrying – countries that have experienced increased unemployment also have many stressed small and medium-sized banks. While their large banks are healthier and can to some extent compensate for that weakness, the slow resolution of bank problems in the small and medium-sized sector can delay the recovery further.

Tackling these issues

To tackle these issues, the focus should be on how and when to restructure and resolve banks. The ECB’s comprehensive assessment and stress tests focussed on capital shortfalls but so far, under the Eurozone’s Single Supervisory Mechanism, no bank has been forced into recovery and resolution. We believe it is a pressing requirement to aggressively restructure, consolidate and close the weakest banks. Our analysis suggests that 38% of the assets of small to medium-sixed banks (16% of the assets of the entire banking system) very likely deserve to be subjected to this. The aim would be to remove non-performing exposures from balance sheets as much as possible. In some cases, it would involve closing the banks. In other cases, bad assets might have to be separated and then be transferred to a bad bank or traded in markets for distressed assets. In still other cases, asset separation might have to be followed by consolidation and mergers with stronger banks. EU mechanisms to facilitate bank restructuring and resolution, such as the Bank Recovery and Resolution Directive, should be put to use without delay.

Full article on VoxEU (with charts)

© VoxEU.org