The danger of eurozone banking fudges

Posted on July 28, 2016

A man walks on January 25, 2013 past the headquarters of the Banca Monte dei Paschi di Siena (MPS), the world's oldest bank to adopt a government aid plan amid revelations of a derivatives scandal. A media report on January 22 that said BMPS would book a 220 million euro ($293 million) loss on a three-year-old derivative contract was a heavy blow for the floundering bank, which is concluding a deal with the government for 3.9 billion euros in state aid. AFP PHOTO / FABIO MUZZI©AFP

Headquarters of Monte dei Paschi

Negative interest rates are taking the world of finance into uncharted waters. The impact will be damaging for most economies, especially the 19 member countries of the eurozone.

The eurozone is facing a mounting crisis that combines indecisive leadership, uncertainty following Britain’s vote to leave the EU, few indications of meaningful economic growth on the horizon after years of low growth and stagnation, and struggling banks whose problems are compounded by the failure to establish a comprehensive banking union.

    This crisis is about to come into stark focus. The European Central Bank will release the results of stress tests for major banks on July 29 and this is bound to underscore the problem of low capital levels at many banks, especially in Italy. At the centre of concerns is Europe’s oldest bank, Monte dei Paschi di Siena.

    Monte dei Paschi plays an important role in the economic health of its region, but placing it on a stable footing looks increasingly as if it will be politically more difficult than has been expected. A new ruling by the European Court of Justice has upheld the principle of making creditors bear the burden for investment in banks with high levels of non-performing loans and capital difficulties.

    This decision gives support to eurozone hardliners, such as the Dutch and German finance ministers, Jeroen Dijsselbloem and Wolfgang Schäuble, and some European Commission officials, who want the EU’s rules on banking resolution to be fully maintained, with creditors and savers bailing-in to shore up ailing banks.

    The Italian government has estimated that as much as $45bn is needed to secure Italy’s banks and, given intense domestic political pressures, Matteo Renzi, the prime minister, is pushing hard for an old-style government bailout. I believe that the German chancellor Angela Merkel and French president François Hollande understand the risks to the EU of a full-scale political crisis in Italy, particularly with a constitutional vote set for October, and in the wake of the Brexit vote and the ongoing refugee and migrant crisis. They would like to see a compromise, but the ECJ’s decision makes this far harder.

    Making matters worse is the failure of eurozone leaders to design and implement a meaningful set of banking union arrangements. This failure will soon come to haunt the eurozone. There are three aspects to banking union: progress on regulation is being made by the ECB and the European Banking Authority; second, bank resolution rules have been determined, although they are not to be fully implemented until 2018; however, the third aspect, involving the introduction of deposit insurance, has yet to be decided.

    Bank deposit insurance is a crucial safety net for savers and depositors in the US and provides them with a sense of confidence in the banks and the financial system. Italy’s immediate crisis would be less difficult to manage politically if deposit insurance existed.

    The weaknesses of a number of European banks, not just Italian ones, are exacerbated by the fraught global financial environment today. The current weakness, and possible further weakening of the euro compared with the US dollar, reflects the relentless search by investors for short-term yield across the world. This is pushing vast amounts of funds into US markets, in particular, propelling the Dow Jones Industrial Average to record levels.

    The reality is that a weaker euro will at best produce a marginal increase in economic growth, which will not be sufficient to mitigate problems with the banks, high levels of youth unemployment in many countries and the widespread sense of economic stagnation. The US and Japanese economies are growing well below potential. Except for India, there are no bright spots across emerging markets. China’s authorities will do all they can to secure growth above an annual 6 per cent until the 2017 Communist party congress, but then it must confront serious domestic financial difficulties, including a tremendous build-up of debt. And Brexit Britain, with a weaker pound, will be competing even more forcefully against eurozone economies in the depressed global export arena (world trade growth may be less than 3 per cent this year).

    How do you solve a problem like Italy’s non-performing loans?

    Monte dei Paschi di Siena's headquarters

    Establishing a functioning marketplace for bad loans will prove a real test for Italy

    Under current conditions it would be a surprise if the International Monetary Fund does not again revise its global growth forecasts downwards. On July 21, the IMF cut 0.3 percentage points off its January estimate for global growth in 2016 to 3.1 per cent. In all probability, global growth this year will be below 3 per cent.

    Eurozone leaders must not only move quickly to complete the banking union and find a political compromise in order to secure Italian banks; they must also finally turn their backs on austerity economics. They cannot continue to rely on the ECB to produce growth through monetary policy. They need to allow France, Spain, Portugal and Italy to breach rigid EU fiscal deficit targets. Further, they must recognise that unless debt relief is provided to Greece there will soon be another cliffhanging crisis there too.

    The eurozone faces some major policy decisions. Further efforts to fudge crucial issues will not only fuel populist anti-EU sentiment across Europe, but it could have grave global economic consequences as well.

    The writer is president and chief executive officer of William R Rhodes Global Advisors and author of “Banker to the World: Leadership Lessons from the Front Lines of Global Finance”

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