Current Conversations
The elephant in the room


On September 12th, the Economic Times carried an article with this headline: "Not China or Trump, the biggest threat to markets is chance of an European bank failing" (Click here to read the article). Just two weeks after this headline comes the news that the travails at Deutsche Bank are now spooking global markets and pushing them into a risk-off mode.

Current Conversations delved deeper into this market conversation, to get you up to speed with why noted economists and market experts believe that its not the Fed, its not Brexit, its not China - the elephant in the room which can spoil the market party - and one which few want to recognize as the biggest threat - is the fragile state of European banks. Deutsche Bank, is just one of those fragile banks - its one name that's doing the rounds now - some more may well follow.

Banks' Stress Test

A bank's stress test is exactly what it says. It tests the strength and resilience of banks to financial and economic shocks. Recently 51 European banks accounting for about 70% of the industry were tested. The European Banking Authority tested them on two parameters. According to the BBC, there's a "baseline scenario" that assumes continued - though unspectacular - economic growth, in line with most mainstream forecasts. Then there's an adverse one that involves a recession and would lead to more problem loans, and lower profits or losses. (Andrew Walker, BBC, July 29, 2016).

"If last week's European bank stress tests were designed to bolster confidence in the European banking sector it is becoming quite clear that they have failed abysmally. Far from boosting confidence they appear to have helped undermine it by focussing attention on what wasn't tested, as opposed to what was," says Michael Hewson, chief market analyst at CMC Markets UK. (, Aug 3, 2016)

Banks' Capital

The results focussed on whether the capital of banks would be adequate in both those scenarios. Adequacy of capital is essential to withstand losses from bad loans and shocks from economic downturns. If the capital is not enough, then governments might have to bail out the banks, in the interests of financial stability and in the interests of the depositors and bond holders.

"The ECB perceives the current level of capital in the euro area banks to be satisfactory and intends to keep the supervisory capital demand stable," says Korbinian Ibel, a senior European Central Bank, ECB, official.

"As the banks went into this stress test with a higher average capital ratio than in earlier years and are overall more resilient, the stress test results are not expected to lead to an increase of the overall level of capital demand in the system." (Andrew Walker, BBC, July 29, 2016).

However there have been doubts about the soundness of Portuguese banks and the IMF has cautioned about Deutsche Bank, while Spain's Santander Bank did fail stress conducted by the US Federal Reserve a little while ago.

Basel III Requirements

According to the European Banking Authority, at the end of 2015, the tier-1 common equity capital ratio of Europe's largest banks was 12.4% of risk weighted assets. The global average is 11.8%. This is a key measure to gauge financial soundness of banks. It is the percentage of capital which banks have to set aside for the loans made by them. Typically the risk of assets is weighted or measured as say 100% for corporate loans, 50% for mortgage loans and 0% for cash and funds deposited with central banks. The higher average would entail raising more capital to meet Basel III capital adequacy requirement. In their defence, European banks say that their assets include mortgage loans, and thus their average is higher, since they carry more loans on their balance sheets. This contrasts with American banks who sell their mortgage assets to government owned entities like Freddie Mac, which then packages the loans as asset backed securities and sells them to other investors. On the brighter side the Basel Committee said that most of the 100 biggest banks' capital ratios are better today than in the recent past.

Italy Specific Issues

UniCredit SpA the biggest bank in Italy fared poorly in the stress test. It's portfolio of Euro 80 billion in non-performing loans is the biggest in Europe. Banca Monte del Paschi di Siena is the third largest bank in Italy, the oldest in world and caries Euro 28 billion in bad loans. Italian banks in particular need strong economic growth to be able to rid themselves of their bad loans. It is certainly frightening when one realises that fully 17% of Italian banks loans might never be repaid. This would collapse the banking system. The effect would be felt all over Europe as many Italian loans have been repackaged and sold to investors in other parts of Europe.

The real problem is that of economic stagnation in the European Union, EU, as a whole. Central banks are pushing the envelope in what they can do, but governments may have to chip in with interventions of their own to boost up the economy. Since Italy is part of the EU it does not have the option of simply printing money as a way out of trouble.

Michael Hewson, chief market analyst at CMC Markets UK, said: "Investors are slowly realising that with every spin of the central bank policy chamber the magazine is getting emptier, and in the absence of any will or ability of politicians to step up, central bank policy will continue to move into the realms of the more experimental with every passing day." (, Aug 3, 2016)

New EU rules

In the EU, to deal with distressed banks, the authorities have evolved what is called a policy of 'bail in'. New EU rules which kick in from this year mandate that instead of taxpayers' money being used to bail out banks, funds of creditors who hold more than Euro 100,000 in deposits or bonds would be seized. For example in Cyprus all deposits over Euro 100,000 were seized to cover for the banks' debts. Some of those loans were repaid but many weren't, entailing loss for depositors. In this instance much of the money came from Cypriot retirement funds. Further, this policy looks like a recipe for bank runs.

A huge amount of Euro 200 billion bank bonds in Italy are in the hands of retail investors. If these are seized as per the above principle, it will cause havoc not only in the economy but also in society. Understandably, Italy is loathe to take this route to solve its banks' problems.

The German Angle

The natural solution to this problem would be an EU wide deposit insurance scheme. Since Germany would have to provide a lot if not most of the funds, it is not in favour of this scheme. Equally it does not want to print more and more Euros, another solution to the problem, as that will also affect it adversely. Germany is a major exporter to the rest of the EU and indeed to the world. Any banking crisis would cripple German exports. Economists fear that this could set off a chain reaction leading to a recession if not a depression.

How The World Economy May Be Affected

The world's economic growth has been revised down to 3.3% from 3.5% for 2017 says the National Institute of Economic and Social Research (NIESR). While the EU has grown by 1.5% in the last year, 2017 growth forecast has been lowered by 0.4% according to the NIESR. Dr Angus Armstrong, director of macroeconomics at NIESR, said: "Balkanisation of EU finance comes at a time of financial fragility in the Eurozone banking system. This has added to the financial pressure on some of the largest European banks and the whole banking sector in Italy. As a consequence, growth in the Eurozone is revised down from 1.7 to 1.3 per cent in 2017." (Lana Clements,, Aug 3, 2016)

It is a fact that many European banks have been under a cloud since the 2008 Crisis. Eurozone economic growth has been sluggish, while only in recent months has the Italian economy started to show signs of life, but it may be a case of too little too late. Inflation in Europe is low on the back of low oil prices. As oil's effect on the price levels wanes, prices might start rising. This would present a dilemma for central banks as they might have to increase interest rates, which in turn would cause a slowdown in growth.

Europe's economic problems, social tensions caused by unbridled immigration and the weak financial condition of its banks have the potential to become a deadly cocktail that could derail global economic growth. Let us hope that the world economy weathers these potential headwinds and continues to grow, the only recipe for a brighter future for all of us.

Share your thoughts and perspectives

Do you have any observations or insights or perspectives to share on this issue? Did this help you understand the topic better? Do you disagree with some of the observations? Please post your comments in the box below ..... it's YOUR forum !

Share this article