Customers line up in front of a branch of Bulgaria's First Investment Bank in Sofia on June 27.(NIKOLAY DOYCHINOV/AFP/Getty Images)
Summary
Over the past two years, the European Union has created an environment in which member states facing economic problems can borrow at relatively low interest rates. Because of the European Central Bank's promise of intervention in debt markets, a sovereign debt crisis similar to what Greece experienced in 2010 seems unlikely. High unemployment and weak economic activity, however, continue to undermine the banking sectors of several EU countries, where a growing number of households and companies are struggling to pay back their bank loans.
While it is impossible to predict exactly when and where Europe's next banking crisis will take place, trouble is more likely in states such as Italy or Greece. Outside the eurozone, banks in Hungary, Romania and Bulgaria will also struggle to reduce their portfolio of nonperforming loans. Since a banking crisis is essentially a crisis of confidence, a relatively small event in a secondary country could trigger EU-wide fears of a generalized crisis.
Analysis
In recent weeks, tremors in Portuguese and Bulgarian banks reignited fears of an escalation of the EU financial crisis. First, political problems in Bulgaria culminated in banking panics in late June. Then in early July, news began to surface that the parent company of the Portuguese bank Espirito Santo was in financial trouble. Taken together, these stories reveal the fragility of confidence in the European banking sector.
Several things have changed since Greece, Portugal, Ireland, Spain and Cyprus were forced to request bailouts from the European Union and the International Monetary Fund. First, the European Central Bank's promise to intervene in debt markets has calmed these markets. Even if countries such as Spain and Portugal have difficult times ahead, their governments are currently borrowing at record-low interest rates.
This reduces the possibility of another sovereign debt crisis in the short term but comes with inherent risks. Local investors, mostly banks, hold most of the government debt in Italy, Spain and Portugal. Banks are attracted to this sovereign debt because the interest rates are higher than in Germany or the United Kingdom, and they have confidence that the European Central Bank will back the bonds if it becomes necessary. As a result, banks in the European periphery are increasing their holdings of government debt while limiting credit to households and companies. This process lowers the prospects for a sustainable economic recovery. And as governments find it increasingly easy to sell debt, they will be tempted to postpone economic reforms and over-borrow again.
The European Union has also worked to break the link between fragile banks and central governments. In November, the eurozone will implement the first stage of the banking union in which the European Central Bank will start to oversee the largest banks. The second stage of the union -- the creation of a "single resolution mechanism" to handle banks in trouble -- has also seen progress. The rationale behind the second stage is to free central governments of the burden of saving failing banks and to prevent banking crises from dragging these governments down, as happened in Ireland.
Because Germany has the largest economy in Europe and carries the greatest share of the economic burden in bailing out the eurozone, it is at the forefront of this change of approach to banking crises. The German government approved draft laws July 9 introducing a system in which shareholders and customers will have to take losses when a bank encounters difficulties -- a process commonly known as "bail-in." Berlin hopes to implement the system, which would protect taxpayers from having to fund rescue packages for banks, in 2015, a year before similar EU rules would take effect. Germany's lower house, the Bundestag, must still approve the draft laws by the end of the year. In the coming months, Berlin will push other EU member states to approve similar measures in an effort to bring clarity to the procedure should a banking crisis occur.
Lastly, the European Central Bank has combined the offer of cheap long-term loans for banks with the application of stricter supervision. The bank has promised to be rigorous with its ongoing stress tests in an attempt to send a message to markets that banks are solid and under close oversight from Frankfurt. The central bank will announce these results in October.
Banking Crisis Versus Sovereign Debt Crisis
At the moment, another sovereign debt crisis in Europe seems unlikely. However, although the environment in financial markets has improved substantially since November 2011, when record high levels for Italian bond yields generated widespread fear that a eurozone collapse was imminent, things have actually gotten worse for many households and companies in Europe. The same is true of the banks that lend them money, a reality that could undermine many of the measures that the European Union has recently introduced.
Unemployment remains extremely high in Greece, Spain and Croatia and is also dangerously high in Italy and France. High unemployment means that in many European countries it has become increasingly difficult for families and companies to repay their debt. In some cases, borrowers simply cannot pay their mortgages or consumer loans. Others are "strategic defaulters" who are betting that their national government will offer schemes or moratoriums to relieve their debt.
Outside the eurozone, where the unemployment problem is not as dramatic, banks face other problems. In Hungary and Romania, individuals are having trouble paying their foreign-denominated loans, while in Bulgaria the combination of political instability, social unrest and friction between politicians and bankers has hurt the country's banking sector.
The European Union has successfully mitigated the threat of another debt crisis but has so far failed to address the problem of massive unemployment and its indirect impact on bank loans. Nonperforming loans continue to increase in European banks, and lenders have enjoyed only modest success in getting rid of them. At the peak of the economic crisis in the United States, the rate of nonperforming loans in U.S. banks was 5.6 percent; most European countries are still considerably above that level. The ratio of nonperforming loans is particularly high in Bulgaria, Cyprus, Greece, Croatia, Hungary, Ireland, Italy, Romania and Slovenia.
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The European Union is at a moment of uncertainty. The banking union has yet to begin operations, and markets, banks and customers are not sure how the continental bloc would react to another banking crisis. Perception is as important as reality during times of uncertainty. It may take nothing more than negative data from any of the banks in these countries to generate new fears of another banking crisis.
Risk Factors Across the Map
It is impossible to know where the next banking crisis will be, but data from recent months provides indications of which nations are most at risk.
Italy's large banking sector and weak economy make it a key place to watch. The Italian Banking Association warned July 11 that bad loans in the country had risen to 290 billion euros ($390 billion), up from 87 billion euros at the end of 2008. In the past three years, the top 40 Italian banking groups have posted average negative profits. The Bank of Italy warned July 8 that credit conditions continue to tighten in the country while unemployment continues to rise. Italy's largest banks, including UniCredit and Intesa Sanpaolo, have been selling some of their nonperforming loans, but smaller banks have not been able to do so.
Greece will try to mitigate some of its banking problems in the next couple of months. Athens is putting together a plan to address growing private debt and is expected to present measures by mid-August. Unpaid private debt in Greece is believed to have reached 160 billion euros (88 percent of gross domestic product) and consists primarily of nonperforming loans held by Greek banks in addition to unpaid taxes and social security contributions. Nonperforming loans present the most serious difficulty, and more than a third of all loans in the Greek banking sector are more than 90 days overdue -- the highest ratio in the European Union outside of Cyprus. At the end of March, nonperforming loans stood at 77 billion euros and more than half were corporate loans.
Athens' new measures will reportedly be applied to companies first and households at a later stage. While the details of the plan are unknown, media outlets have reported that Athens is studying an out-of-court mechanism in which creditors would negotiate with debtors on the most appropriate package of debt settlement and payment. Greek officials have said the new measures would not include debt write-downs but would focus on extending installments and lowering interest rates. In the coming weeks, Greece will be dealing with the urgent issue of private debt while also negotiating with its lenders on longer maturities for its massive public debt.
Slovenia narrowly avoided a bailout in late 2013 by pumping some 3.3 billion euros into its banks, most of which are state-owned. The country's political environment remains fragile, and the next government will have to act quickly to ensure further financial stability. The situation is even more difficult in Cyprus, where more than a year after receiving financial aid, the Bank of Cyprus, the island's largest lender, needs additional recapitalization. According to the European Commission, more than half the loans in the bank are nonperforming. With unemployment at 15.3 percent in May (the fourth-highest rate in the European Union) and an expected decline of 4.8 percent in gross domestic product this year, the island will remain in crisis for some time.
Outside the eurozone, several countries are addressing the problem of rising nonperforming loans in different ways. Romania, where more than a fifth of bank loans are nonperforming, is trying to send positive signals to financial markets. On June 25, Bucharest announced plans to join the European Union's "single supervisory mechanism," which gives the European Central Bank power to supervise the stability of banks in participating countries, in 2015. For months, the Romanian central bank has been pushing banks to make large additional provisions for nonperforming loans, and these provisions are cutting into the banks' profitability.
Bulgaria, where the recent banking crises were mostly related to political clashes between bankers and politicians, is doing something similar. In mid-July, Sofia also announced plans to join the single supervisory mechanism. While this mechanism is primarily meant for eurozone banks, Bulgaria wants to signal that it will comply with the European Union's best practices and submit its banking sector to tighter control by the European Central Bank.
Hungary, however, has reacted to its banking problems in a completely different way. Budapest is preparing legislation to convert all foreign-denominated loans back into forints. The Hungarian government has yet to announce whether this conversion will be done at market rates or at special rates, as has been the case in the past. For now, foreign banks operating in the country insist they will stay, but Hungarian authorities have repeatedly said they want a larger part of the country's banking sector to be in Hungarian hands. This new legislation is unlikely to put an end to friction between Budapest and foreign banks.
Europe is at a point where it is seeing some incipient economic growth but without a substantial reduction in unemployment. Banks have reacted to the crisis by severely restricting lending and boosting their capital in an attempt to clean up their balance sheets. While this has temporarily stabilized Europe's banking sector, it has also deprived the economy of credit. This is a key element of economic growth, especially in Europe, where most companies rely on bank loans for funding. At the same time, austerity measures have reduced the purchasing power of families living in nations on the European periphery, hurting domestic consumption and further weakening prospects for solid economic growth. This vicious cycle of governments that do not spend, households that do not consume and banks that do not lend will continue to undermine Europe's real economy and create fertile ground for banking crises.
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