“Market fragmentation” is one of those euphemistic terms beloved by financiers and ECB- watchers, but which has a very real impact on the economics of the every day.
Take this example. Two small hotels located on either side of the Austrian-Italian border are engaged in the same kind of business activity and bank with the same financial institution. However, the hotel-owner on the Italian side of the border pays almost twice as much as his Austrian counterpart for bank loans.
Welcome to the world of financial fragmentation. Despite the apparent existence of the single market, the huge disparity in borrowing costs for SMEs across the single currency is one of the pressing problems facing the euro zone. Because banks in peripheral countries are forced to pay higher funding costs, they charge higher interest rates to customers. Stories of entrepreneurs in Greece being charged between 10 and 14 per cent for loans are commonplace.
The fact that European SMEs are particularly dependent on bank lending (US companies for example use debt and equity funding to a much larger extent) makes the issue a particularly pressing one for Europe.
As always, the problem will be at the forefront of the minds of the European Central Bank’s governing council at today’s rate-setting meeting in Frankfurt.
While ECB president Mario Draghi frequently raises the issue, the bank is ambiguous about whether moves to tackle fragmented lending rates are really part of its mandate. It has pointed out that the issue is primarily one for national governments, who must do more to reduce debt levels, and deal with the over-reliance of some banks on their own national sovereign bonds.
Nonetheless, the ECB has sought to eliminate the divergences between countries caused by bank funding risks, for example through its long-term refinancing operation – its programme of short-term, fixed-rate liquidity for banks – and interest rate action.
Ultimately, however, it says the key to eliminating fragmentation is banking union, the euro zone’s plan for an integrated banking system.
The first part of that process, the Single Supervisory Mechanism, which will see the ECB assume supervisory control for 85 per cent of the euro zone’s banking system, has an important role to play here, according to the ECB. It believes that the new system of one supervisor for the euro zone will lessen the fragmentation caused by perceived differences in the quality of supervision between euro area countries.
Further, next year’s three- stage stress test process to be undertaken by the bank in preparation for its new role, aims to create a fully comparable set of results. It will also shed greater light on the real state of the euro zone banking sector, thereby removing uncertainty about everything from asset valuation to funding models, which is currently distorting the price of funding.
Which is why the confusion this week surrounding the balance sheet assessments of Irish banks is a worrying sign.
Although the Irish reviews were a separate set of tests required by the troika (Blackrock, for example, will deliver the results of its stress tests of fellow bailout-country Greece tomorrow) the review of AIB, Bank of Ireland and Permanent TSB will feed into next year's European tests.
In this regard, the handling of the announcement of their outcomes this week does not bode well for the euro-wide process.
The three banks issued statements with varying degrees of detail, and leaving significant room for conjecture, with the Irish Central Bank maintaining a notable silence. AIB said that, based on "an initial" assessment of the findings, "the bank believes it continues to be well capitalised." In a succinct but ambiguously worded statement, Permanent TSB said that from the "communicated results", the capital position of the institution was above minimum regulatory requirements. Bank of Ireland's statement was the most forthright. It said it disagreed with the Central Bank's assessment that it should take €1.3 billion in provisions for bad loans.
The public disagreement between a listed bank and the national regulator sets a worrying precedent for next year’s euro-wide stress tests, which will entail heavy involvement by the national regulators of each individual country.
With the three Irish banks and the national regulator failing to put forward a united front and, in the case of Bank of Ireland, in effect agreeing to disagree, is it really feasible to believe that the network of the euro zone’s largest financial behemoths, national regulators and the ECB will find common ground?