LOOMING BANKING CRISIS: IS EUROPE READY?
by Ben Winnemore
2008 was the wake-up call for Europe on the regulation of European banks and financial institutions and emphasized the need for further economic integration. If greater economic integration is to occur, our financial sector must be protected, with greater scrutiny placed on collateral, liquidity, and the ability to meet margin calls. A fragmented banking system will never end well, due to asymmetric regulation and supervision, with the difference in insolvency practices creating uncertainty and inefficiencies. This also leads to/results in limits on cross-boarder consolidation which then stifle growth in markets and reduce the beneficial impact of economies of scale. This disproportionately affects the European South, with nations such as Greece , Italy, and Spain bearing the brunt of the economic damage. It is not fortuitous that the aforementioned countries were caught off guard in 2008 with the financial instability ultimately devolving into the sovereign debt crisis.
This happened primarily due to the accumulation of non-performing loans (NPLs) in the South, with Greece having a 40% NPL ratio that crippled corporate and consumer loans, and with fragmentation being the catalyst as the sovereign bank nexus worsened, and the nation became reliant on external bailouts, bringing the EU down with it. For a frame of reference, financially mature nations such as the UK and Germany typically have a NPL ratio below 2%. Beyond this, there is also the underlying issue of sovereign debt with an increase in European bank holdings of their government’s debt, leading to a dangerous sovereign-bank nexus that is a disease in public finances.
In comparison to their US counterparts, European banks are significantly underperforming in terms of profitability due to a mix of low interest rates, high operating costs, and intense competition. There is also a lack of enterprise, and innovation, leading to limited digitalization and, consequently, a slower integration of the fintech industry – a development that European markets should fully embrace. Such inertia is largely a consequence of history. London has long been at the forefront of financial innovation hence the City is home to 4 times as many Fintech unicorns than any other European state.
Throughout the continent there are also uneven levels of capital adequacy and liquidity among European banks that increase systemic vulnerabilities. This implies that smaller commercial banks face higher risks when confronted with crises such as the pandemic induced crash, when there were increased credit risk, credit quality decline, liquidity and funding pressures, and capital adequacy issues, all of which combined to favour the leading European banks, further stifling innovation and concentrating power into those that have repeatedly mismanaged collateral and credit risk. Prime example: Credit Suisse. The mere fact that the Swiss banking sector, often seen as a beacon of stability across the globe, lost that amount of confidence, at such a rapid rate, created an underlying doubt about the sustainability of European banking. It displayed to the world the lack of practices and mechanisms to mitigate contagion risks that were amplified by uncoordinated responses. While Swiss authorities acted swiftly, the European Union’s response mechanisms, such as those of the European Banking Union, were not directly involved, leading to greater uncertainty.
Credit Suisse struggled to modernize and adapt to an increasingly volatile and competitive global environment. The problems also reflected a lack of coordination in European regulatory overlaps. The coexistence of national regulators with EU-level authorities such as the European Central Bank (ECB) and the European Banking Authority (EBA) has created inefficiencies and inconsistencies in oversight, leading to greater exposure to external shocks such as geopolitical tensions – as seen in Ukraine – global economic fluctuations, energy price shocks, and exacerbating financial stability.
Under a unified economic and regulatory framework, there can exist singular supervision under a centralized banking authority, such as an empowered ECB, thereby clearing irregularities in the policy frameworks and regulatory standards, improving the oversight of cross-border operations. The creation of a ‘Pan-European Deposit Scheme’ (EDIS) would be an ideal solution to integrate deposit insurance across Europe that would boost confidence among depositors and reduce the risk that a bank, such as Suisse, will bring down economic confidence. A federal state would also harmonize insolvency and resolution mechanisms as it would standardize how banks are wound down during a crisis, avoiding prolonged uncertainty whilst also limiting contagion effects across borders.
Beyond this there must be a more even distribution of financial innovation, driving growth and economic incentives, that can protect vulnerable nations from rising interest rates, and weaker capital buffers, as happened in Italy, Greece, or Portugal. The primary concern however should be preventing a potential sovereign debt crisis, in the context of a sharp economic downturn. High levels of sovereign debt in southern Europe could – and probably will – reignite concerns about the sovereign bank nexus. Rising government bond yields could also erode the value of bank held sovereign debt, weakening their balance sheets.
These past few years have also demonstrated the consequences of energy dependence and inflation, with the energy price shock from Ukraine disrupting energy supplies, leading to skyrocketing energy prices in Europe. Unlike sovereign debt, this affected financially mature nations as well with Germany being heavily reliant on Russian energy, causing the nation to face inflationary pressures, increasing fiscal burdens as the government intervened with subsidies and price caps, as also seen in the UK. Inherently though, wealthier northern European countries, such as Germany or the Netherlands, are better positioned to absorb economic shocks from the conflict, while heavily indebted southern countries face greater challenges where nations such as Italy possess a 140% debt to GDP ratio. This divergence strains EU solidarity, and weakens European interests both militarily and financially, making coordinated fiscal and monetary responses more difficult - as seen during the Eurozone debt crisis. This creates a flight to safety sentiment in global markets, reducing demand for bonds issued by riskier European countries, increasing their borrowing costs and widening yield spreads, as seen with the Italian German bond spread, a key indicator of debt stress. Emerging European markets, especially those in the east, then face capital flight during geopolitical crises, leading to weaker currencies and greater difficulty servicing external debt.