Chris Johns: Why are Europe’s banks still broken?

Share prices of Europe's banks, including Ireland's main financial institutions, have fallen sharply since the latest results of a "stress test" conducted by the European Banking Authority (EBA).

This was not supposed to happen: the point of a bank stress test is to show that banks will be fine should a new recession hit the economy.

The problem facing the EBA is that this is the latest in a long line of similar tests, many of which have sooner or later been revealed to be based on hopelessly optimistic conclusions. The Irish banks passed many a stress test before their emergency recapitalisations.

Any stress test that concludes that there are serious concerns would have to be accompanied by action to remedy the problem: dodgy banks would have to be recapitalised and/or nationalised; bust banks would have to be closed down.

The EBA does not have much power or authority to do these things so, by definition, its results must always reveal a robust banking system.

The EBA did point a finger at Italy’s Monte de Paschi, which has announced it is raising more capital. The regulator deserves some credit for this, but there is a widely held suspicion that it could have done a lot more. It is what the EBA did not say that is worrying stock markets.

Without accompanying radical remedial action, banks that fail stress tests would in all likelihood face queues outside their branches as depositors clamour to get their money back. The EBA is not there to trigger bank runs.

We did not get much detail about individual banks, nor did we get an insight into the effects of prolonged negative ECB interest rates (bad for bank profits).

A European, but not US, recession was considered. Portuguese and Greek banks were not included. In fact, there were no outright “pass” or “fail” grades, just a discussion of the results.

The reason why the banks are still broken is that they were never fixed in the first place. It is nearly eight years since the night of the infamous bank guarantee; eight years since the failure of Lehman Brothers. And still our banks are not in great shape.

It is not as if there is not a straightforward example of how to mend broken banks: the US did it very successfully. Use public money to force recapitalisation where necessary and shut down the worst banks. Easy really, except Europe (Germany mostly) is implacably opposed to the use of taxpayers' money.

All of this is so important for the simple reason that one of the main headwinds facing the European economy is the impaired banking system.

Transparency

Investors suspect that the EBA tests, in certain cases at least, are just another cover-up. The trouble is that we just do not know: full transparency is notable by its absence.

Again the suspicion is that because they cannot do anything material about problem banks, the EBA cannot tell the whole truth. In such a vacuum lies trouble.

Why are so many European banks thought to be so fragile?

No two banks are the same, but it all comes down to the loans that they have made. When a bank lends its own money – to a customer for a mortgage, for example – that is a matter of supreme indifference to a regulator such as the EBA.

If that customer does not pay the loan back then the only people that suffer are the bank’s shareholders: it is their money at risk.

But when a bank lends out depositors’ money, that’s a different ball game. If those loans are not repaid there is a risk that ordinary mom and pop bank customers will end up out of pocket. That’s the stuff of bank-run nightmares.

Regulators are trying to get banks to lend more of their own money, less of other people’s money. When we see arguments about capital ratios, COCO bonds, fully-loaded tier 1 and the like it is inevitable that our attention will turn to something far more interesting. But those arguments are really very simple: regulators want banks to lend but only with a higher proportion of shareholders’ money and much less of depositors’ money. That’s the name of the regulatory game. Banks reluctantly go along with this but slowly.

Banks can get extra capital – their own money – in one of two ways: retained profits and/or issuing new shares (or other financial instruments).

Bank executives would prefer to pay out profits as dividends rather than retain them for capital purposes: this, they think, will get the share price up and improve the value of their share options. Similarly, banks have to be dragged kicking and screaming to issue new shares as this will drive existing share prices down.

Shock absorbers

Not too long ago a decent pothole would wreck a car’s shock absorbers. Manufacturers responded with better construction techniques and materials. It is rare these days to have to deal with a broken car suspension system.

Banks have not responded like the automakers. Too many bank shock absorbers are fragile, vulnerable to financial potholes.

Some analysts think that until we force banks to lend only their own money the system will be unstable and prone to crisis. That would be a truly radical solution, one that would cause most bankers to give up and try another career. Banks would become what they once were, perhaps what they always should have been: safe, boring utilities. But until we get a proper European Banking Union nothing will really be fixed.

Today’s fragility of Europe’s banks is testament not just to the timidity or stupidity of politicians. Northern European banking problems are deemed to require the seemingly permanent financial torture of the Greek economy and, of course, why our bondholders were never burned.