Finance: Research, Policy and Anecdotes

I attended a fascinating discussion on European banking organised by the Brevan Howard Centre on Monday, including Ashoka Mody (Princeton, formerly IMF), Ignazio Angeloni (SSM) and Wolfgang Munchau. While set up as a discussion offering differing views on the state and future of European banking, after the different presentations I came away with a rather grim assessment. First, weak banks continue to put a brake on the recovery (especially in Italy) rather than helping it. And as much as recent reforms, including the banking union and other regulatory reforms are going in the right direction, they might simply come too late and much stronger policy action might be needed at this stage.  Ashoka Mody pointed out that the sovereign-bank deadly embrace has turned into a debt-deflation cycle, with the delayed bank restructuring and recapitalization as contributing factor.  As much as the monetary tightening in the U.S, came too late in 2005 to help dampen the housing bubble, actions to address this debt-deflation cycle taken now in the Eurozone might be simply too late, especially if limited to monetary policy.  Much more dramatic debt reduction, including on sovereign debt across several periphery countries might be needed to get out of this vicious cycle, as also demanded by other economists (see for example Charles Wyplosz here).

Second and beyond the current crisis there are severe structural problems, Europe is still overbanked and overbranched, with cost-inefficient business models.   Market-book values that are well below one show limited growth and profit perspectives for banks.  Yes, low or zero, if not negative interest rates do contribute to the banks’ profit depression, but as important are structural cost inefficiencies.  As pointed out by Langfield and Pagano in their Economic Policy paper Europe has been overbanked for quite some time and it seems this still has not been addressed properly. A substantial downsizing of the banking system across the Eurozone might be the only way to not only escape the debt-deflation cycle but also get out of banks’ low profitability cycle. Consolidation, especially among mid-sized banks and hopefully across countries to  create a Eurozone banking system could also serve as contribution to get rid of sovereign-bank doom loop. 

Third, a superficial observer might get the impression that in spite of recent turmoil, there is no immediate threat to banking stability in the Eurozone, as even the Brexit vote has not resulted in any major shock propagation mechanism.  I wonder, however, whether the banking system and financial markets are being propped up by the morphium of QE and easy access to liquidity, with the main risk not coming from economic but rather political shocks.  And as Wolfgang Munchau pointed out, the calendar for the next 12 months is full of potential political shocks waiting to happen. And given the still close connections between banks and government this can be cause for fresh fragility, as in the case of Greece in 2015.

Overview