The European Banking Authority (EBA) recently released its first analysis of the health of the bloc’s banks amidst the coronavirus pandemic, and the results were mostly encouraging.
The work that European financial institutions did since the last financial crisis to shore up their capital buffers is paying off. After scrutinising 117 EU banks, the EBA noted that the bloc’s financial sector is in a much better state than going into the eurozone crisis—and that most banks have built up sufficient buffers to weather the deep recession which Europe is facing.
The fact that the EU’s banking system is, on the whole, able to withstand the oncoming financial storm should allow European policymakers to focus their efforts on addressing weak spots and lingering problems which are putting strain on the union’s banks. Indeed, the picture isn’t equally rosy everywhere. Despite the overall optimism of its analysis, the EBA warned that some banks—particularly those which were already dealing with particular challenges or are heavily exposed to sectors which the crisis has hit particularly hard—may not survive the steep fall in profitability.
If some mismanaged banks contributed to the last financial crisis, it’s a different story this time around. The banking sector is bolstering the overall economy’s stability, to the extent that Reuters recently opined that “regulators will owe banks a favour post-pandemic”. Such a favour could be ensuring that banks aren’t subject to populist policies sapping their reserves, and helping lenders clean up bad debt that’s still weighing them down.
Pleasing the people at the banks’ expense
One of the core metrics which the EBA assessed was banks’ capital positions. Maintaining a healthy amount of capital, however, is challenging for banks in countries like Croatia, where a troubling series of laws and judicial rulings have left the financial sector on the hook for billions.
The trouble started in 2015, when Croatia’s Social Democrats were facing a tight re-election battle. They turned to what a later Croatian minister described as an insufficiently thought-out and populist move. Around the turn of the millennium, Croatians had favoured loans denominated in Swiss francs due to the low interest rates these loans offered. With the Swiss franc rising against the kuna in 2015, however, repaying these loans had become more expensive—and so the Croatian government suddenly converted them all to loans in euros with retroactive effect, using the exchange rate from when the loans were taken out. The forced conversion undoubtedly pleased borrowers whose debt shrunk as if by magic, but it placed a heavy burden on the banks which were expected to swallow the losses.
The European Commission and the European Central Bank both called on Zagreb to rethink the loans conversion, arguing that it disproportionately harmed the financial sector and that its retroactive effect might run contrary to EU law. Rather than reversing the controversial conversion, Croatia seems to be doubling down on it. The country’s supreme court is now pondering whether borrowers who took out Swiss franc loans can have the entire contract nullified and be paid out compensation, something which would wipe another $2.9 billion off of the banks’ capitalisation right as they most need the funds.
Bad debt an albatross around banks’ necks
The damage such populist decisions are doing to banks’ ability to build up capital buffers is one important area which European policymakers should address in order to make sure that the bloc’s financial sector stays strong through this economic downturn. Another area of concern is bad debt that some lenders, particularly in Italy and Greece, are still carrying on their books.
Italian and Greek banks have made major efforts to clean up their balance sheets and have chipped away at the mountain of bad debt which they inherited from the last financial crisis—mostly loans taken out by small companies, which went out of business and had not provided the banks with sufficient guarantees to cover their borrowing.
Over the past decade, lenders have tried everything to manage their exposure to these problematic loans—selling billions of euros of them to large investment firms, bundling them together with more palatable assets to entice investors, and selling fresh shares to raise capital. The coronavirus-induced downturn, however, is making it painfully clear that Europe needs to move still faster on whittling away this lingering remnant of the eurozone crisis.
On average, 2.7% of loans in the eurozone are nonperforming, but 7% of Italy’s loans are still bad from the last recession—and a shocking 35% of Greece’s. What’s worse, lenders are likely to be saddled with a fresh crop of defaults as businesses go belly-up in the current crisis. The ECB’s March decision to relax its rules on when loans are considered non-performing has so far staved off a huge increase in banks’ bad debt.
Covering the losses on these loans, however, is still eating up capital that the banks can’t afford to spare at the moment, just as the forced loan conversion has drained the capital available to Croatian lenders—90% of which are subsidiaries of firms from other EU member states. European policymakers should rejoice at the EBA’s assessment that the European financial system is overall in good shape to withstand the ongoing economic contraction—but they should not lose sight of these weak spots which are fragilizing European banks’ ability to sail through this storm.