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Are European Bailouts Risking A Huge Financial Crisis?

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EDITOR NOTE:  Imagine yourself running a bank. Now, imagine your government pushing your bank to offer loans at an extremely low rate to businesses and households facing extreme financial hardships. Typically, you’d charge a higher interest rate for the risk. In some cases, you wouldn’t even offer the loan. But now, your government is pressuring you to go against what’s reasonable for the good of the economy. Are you getting a sense that this is going to blow up in your face eventually? Well, that’s what’s happening in the Eurozone. It’s a high wire act that comes as a consequence for failing to prepare for tail risks (pandemics in general) and not having the courage to undergo austerity.

The measures implemented by governments in the eurozone have one common denominator: a massive increase in debt from governments and the private sector.

Loans lead the stimulus packages from Germany to Spain. The objective is to give firms and families some leverage to pass the bad months of COVID lockdowns and allow the economy to recover strongly in the third and fourth quarters. This bet on a speedy recovery may put the troubled European banking sector in a difficult situation.

Banks in Europe are in much better shape than they were in 2008, but that does not mean they are strong and ready to take billions of higher-risk loans. European banks have reduced their nonperforming loans, but the figure is still large at 3.3 percent of total assets according to the European Central Bank. Financial entities also face the next two years with poor net income margins due to negative rates and a very weak return on equity.

The two most important measures that governments have used in this crisis are large loans to businesses partially guaranteed by the member states and significant jobless subsidy schemes to reduce the burden of unemployment.

Almost 40 million workers in the large European nations are under a subsidized jobless scheme according to Eurostat and Bankia Research. Loans that add up to 6 percent of the eurozone's GDP have been granted to allow businesses to navigate the crisis. So, what happens if the recovery is weak and uneven and the third and fourth quarter growth figures disappoint, as I believe will happen? First, the rise in nonperforming loans may elevate the total figure to 6 percent of total assets in the banking sector, or €1.2 trillion. Second, up to 20 percent of the subsidized unemployed workers will probably join full unemployment, which may increase the risk in mortgage and personal loans significantly.

Banks may face a tsunami of problems as three factors collide:

  1. a rise in nonperforming loans
  2. deflationary pressures from a prolonged crisis
  3. the central bank keeping negative rates that destroy banking profitability.

We estimate a rise in net debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) of the largest corporations of the Stoxx 600 soaring to 3x from the current 1.8x. This means that banks may face a wall of delinquencies and weakening solvency and liquidity in the vast majority of their assets (loans) just as deflationary pressures hit the economy, growth weakens ,and the central bank implements even more aggressive but futile liquidity measures and damaging rate cuts.

This combination of these three problems at the same time may generate a risk of a financial crisis created by using banks' balance sheets massively to bail out every possible sector. It may undo the entire improvement in the balance sheet of the financial entities, achieved slowly and painfully in the past decade and destroyed in a few months.

Weakening banks' balance sheets and hiding larger risk at lower rates in them may be an extremely dangerous policy in the long run. Governments have pushed banks to give loans to businesses and families with very challenging financial conditions and this may come back like a boomerang and hit the European economy, where 80 percent of the real economy is financed by the banking sector according to the ECB.

Governments should have taken more prudent measures and addressed the COVID-19 crisis with tax cuts and grants and not so much through massive loans, even if those are partially guaranteed by the states. If the sovereign debt crisis starts to creep up again, there will be a fourth risk that may damage banks and the financing of the real economy.

The response of banks in this crisis has been positive but may be too much too soon. And clearly they are taking on too much risk at too low rates. So far, financial entities are being prudent and have made large provisions to strengthen their balance sheets. However, these provisions may need to be doubled in the next quarters. Taking measures to avoid creating a financial crisis from these extreme policies will be critical to avoiding a larger problem in 2021–22.

Originally posted on Mises Institute

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