Ten years after the outbreak of the global financial crisis, banks in the euro area have not recovered. The Euro Stoxx Financials is 65% below the pre-crisis peak, whereas the S&P Financials has come close to the pre-crisis level. The different fate of financial institutions is due to different monetary and regulatory crisis therapies of the European Central Bank (ECB) and the Fed.
The Fed lowered its key interest rate faster than the ECB (the Fed’s rate reached zero in 2009) and expanded its balance sheet more quickly via quantitative easing (since 2008). The Fed’s asset purchases included risky securitized mortgage loans (around 50%), which were thus removed from banks’ balance sheets. The US Treasury also purchased banks’ stocks, thus forcibly recapitalizing those banks.
In contrast, the ECB was more hesitant to lower key interest rates. Zero was only reached in 2015. Large-scale, outright purchases of assets only set in March 2015, after the first expansion of the ECB balance sheet had gradually expired. Out of the ECB’s latest 2.600 billion euro asset purchases, about 80% were government bonds. This makes the ECB’s quantitative easing look more like a rescue program for ailing governments rather than for banks, which were left alone with their bad assets.
The quantitative easing programs led the commercial banks to maintain huge reserves at the Fed and the ECB. The Fed has been remunerating these reserves since 2008, with the interest rate climbing to 2.4%. In contrast, since 2014 the ECB has maintained a negative interest rates on commercial bank deposits, currently -0.4%. Thus, the Fed has transferred 95 billion dollars to US banks, while, for instance, German banks have paid 20 billion euros to the ECB.
The Fed has been slowly raising key rates since 2015 and cautiously reducing the volume of its balance sheet since 2016. This has restored the interest rate margins (lending minus deposit rates) of the US banks, which are reporting recovering net interest incomes. In contrast, the ECB has sent no signals of an exit from ultra-loose monetary policy, with interest margins of euro area banks further falling. Net interest earnings of German banks shrank from 66 billion euros in 2008 to 28 billion euros in 2018.
Basel III increased capital requirements in the US and Europe. In the US, the Dodd-Frank Act tightened regulatory requirements and restricted lucrative proprietary trading. Stiff financial supervisors have closed down 541 insolvent financial institutions since 2008. Recently, however, the reporting requirements for almost all (but the largest) US financial institutions were relaxed. Proprietary trading remains indirectly possible for large institutions via market making.
The ECB has been monitoring the 130 largest euro area financial institutions since 2014, which have to build up a bank rescue fund with 60 billion euros until 2023. Tight restrictions on proprietary trading have led to a considerable decline in securities holdings. Frequent stress tests by the ECB are a burden on euro area banks, but they have done little to identify risks, for instance at Dexia, BBVA/Garanti, Carige and Banca Monte dei Paschi.
Fragile euro area banks survive because they are kept afloat with national tax injections or via an opaque network of EU and ECB rescue tools. The ECB’s TARGET2 payment system has turned out to be a quasi-unconditional, zero-interest credit system. Around one trillion euros were handed out via TARGET2 to ailing southern euro area banks, with eased collateral requirements. As a result, bank failures have remained rare, while in particular southern euro area banks report large amounts of bad loans (equivalent to 650 and 1,000 billion euros for the whole euro area).
The unresolved financial and government debt crises, the extended low interest rate policy of the ECB, and EU pressure toward fiscal austerity have all contributed to the huge capital outflows from the euro area (around two trillion euros since 2012), which has further destabilized euro area banks and enterprises. In contrast, the rising interest rates and the successful financial stabilization of the Fed helped attracting large shares of these capital flows to the US, which has strengthened US growth and credit portfolios.
The upshot is that in the southern euro area funding by the ECB is keeping a growing number of zombie banks and enterprises afloat. A substantial part of this burden has spilled over to the northern euro area. As a consequence, many euro area banks are unprepared for the upcoming crisis. It is no wonder that euro area governments are becoming increasingly nervous, planning mergers and capital injections.
Note that a previous version of this post was published at City A.M: Schnabl, Gunther / Stratmann, Thomas: The Misguided ECB Has Been Keeping Zombie Banks Alive. City A.M. 18.2.2019.