A V Rajwade: A banking crisis in the euro zone?

Commercial banks in several countries in the euro zone are facing major problems arising from bad loans and falling profits - return on equity is below five per cent as compared to around 20 per cent before 2008, at least partly because of much lower interest income. The largest bank in the zone, namely Deutsche Bank (DB), has been hit by a threatened penalty of $14 billion by US authorities for its malpractices in selling mortgage-backed securities, back in 2007-08; separately, some of its executives are facing charges of helping falsify the accounts of an Italian bank a few years ago.

Arguably, the weakest banking system is in Greece as the economy has been shrinking for the last six to seven years since the sovereign debt crisis. Portugal had its own crisis back in 2011 and thanks to the conditionality imposed as part of the rescue, even now growth is meagre, investment in the real economy has been falling, and most banks are undercapitalised in terms of Basel III norms. One case that made headlines a few months ago was that of Novo Banco created by carving out a "good bank" out of Banco Espirito Santo. The good bank itself now seems to be having problems and some of its bonds have been transferred back to the bad bank, somewhat arbitrarily, and the bond holders are obviously angry. And, the Polish government would like to force banks, which had given housing loans to individual borrowers denominated in the Swiss franc, at a time when Swiss interest rates were much lower than in the euro zone, to convert such loans in the domestic currency but at the exchange rate prevailing when the loan was given! If it succeeds in doing so at least some banks would obviously suffer large losses.

The banking system of Italy, the third-largest member country in the zone, is also in deep trouble. The aggregate non-performing assets are of the order of €360 billion gross, and the fund created to help out bank rescues has been exhausted in recapitalising just one. Fiscal austerity rules, implemented by the high priest of fiscal discipline, namely Germany, do not allow the Italian government to help out the banking system, no matter how it may want to. Meanwhile, the European Banking Authority, the European Union bank regulator, published last month the results of stress tests ("an analysis conducted under unfavourable economic scenarios designed to determine whether a bank has enough capital to withstand the impact of adverse developments"). The tests revealed that, while banks are better capitalised than they were five years back, they could face a shortage of capital, and many have failed the stress tests standard. A panel of independent academics has estimated that the capital shortfall is of the order of €900 billion! To put that number in perspective, in five years, European banks have added just €260 billion to their capital. The bigger question is whether capital based on mathematical models can ensure that no recourse to public funding would be necessary.

In some ways, DB may well prove to be a test case. It has "core capital" (that is, net of secondary capital like compulsorily convertible bonds, etc) well above the Basel III norms. Yet, its share has dropped 50 per cent this year itself, and it is trading at a three-decade low: the proximate cause is the $14-billion demand from the US authorities, which the bank is trying to negotiate down. It remains to be seen what the final bill will come to. The premium on credit default swaps on its senior bonds has shot up since they are subordinated to deposit and other liabilities; it also has huge, ill-liquid, difficult to value (Level 3) assets. Commerzbank, Germany's second-largest bank, is terminating the services of 10,000 employees, and ING is shedding 7,000 jobs to cut costs.

The DB case illustrates one peculiarity of the banking business compared to most others: In banking, profits come first, and it takes time for losses to surface; in most businesses in the real economy the sequence is exactly the opposite. DB's malpractices in 2007-08 are costing it heavily in 2016. A related issue is contagion: Will confidence in the Italian banking system be shaken further by DB's problems? Another issue: Are capital ratios enough to maintain confidence in financial intermediaries? As it is, earlier this year, the International Monetary Fund described DB as the riskiest globally significant bank.

The author is chairman, A V Rajwade & Co Pvt Ltd;
avrajwade@gmail.com