The measures implemented by governments in the eurozone have one common denominator: a massive increase in debt from governments and the private sector.
Loans lead the stimulus packages from Germany to Spain. The objective is to give firms and families some leverage to pass through the bad months of the confinement and allow the economy to recover strongly in the third and fourth quarter. This bet on a speedy recovery may put the troubled European banking sector in a difficult situation.
Banks in Europe are in much better shape than they were in 2008, but that doesn’t mean they’re strong and ready to take billions of higher-risk loans. European banks have reduced their nonperforming loans, but the figure is still large, at 3.3 percent of total assets according to the European Central Bank (ECB). Financial entities also face the next two years with poor net income margins due to negative rates and a very weak return on equity.
The two most important measures that governments have used in this crisis are large loans to businesses partially guaranteed by the member states, and significant subsidy schemes to reduce the burden of unemployment. Almost 40 million workers in the large European nations are under a subsidized furlough scheme, according to Eurostat and Bankia Research. Loans that add up to 6 percent of the GDP of the eurozone have been granted to let businesses navigate the crisis.
So, what happens if the recovery is weak and uneven and the third and fourth quarter growth figures disappoint, as I believe will happen? First, the rise in nonperforming loans may elevate the total figure to 6 percent of total assets in the banking sector, or 1.2 trillion euros. Second, up to 20 percent of the subsidized unemployed workers will probably join full unemployment, which may increase the risk in mortgage and personal loans significantly.
Banks may face a tsunami of problems as three factors collide: a rise in nonperforming loans, deflationary pressures from a prolonged crisis, and the central bank keeping negative rates that destroy banking profitability.
We estimate a rise in net debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) of the largest corporations of the Stoxx 600 soaring to 3x from the current 1.8x. This means that banks may face a wall of delinquencies and weakening solvency and liquidity in the vast majority of their assets (loans) just as deflationary pressures hit the economy, growth weakens, and the central bank implements even more aggressive but futile liquidity measures and damaging rate cuts.
This combination of three problems at the same time may generate a risk of a financial crisis created by massively using the balance sheets of banks to address the bailout of every possible sector. It may undo the entire improvement in the balance sheets of the financial entities that was achieved slowly and painfully over the past decade and destroy it in a few months.
Weakening the balance sheets of banks and hiding larger risk at lower rates in their balance sheets may be an extremely dangerous policy in the long run. Governments have pushed banks to give loans to businesses and families with very challenging financial conditions, and this may come back like a boomerang and hit the European economy, where 80 percent of the real economy is financed by the banking sector, according to the ECB.
Governments should have taken more prudent measures and addressed the COVID-19 crisis with tax cuts and grants and not so much through massive loans, even if those are partially guaranteed by the states. If the sovereign debt crisis starts to creep in again, there will be a fourth risk that may damage banks and the financing of the real economy.
The response of banks in this crisis has been positive but may be too much too soon, and, clearly, they are taking too much risk at too low rates. So far, financial entities are being prudent and have made large provisions to strengthen their balance sheets. However, these provisions may need to be doubled in the next quarters. Taking measures to avoid creating a financial crisis from these extreme policies will be critical to avoid a larger problem in 2021–2022.
Daniel Lacalle, Ph.D., is chief economist at hedge fund Tressis and author of “Freedom or Equality,” “Escape from the Central Bank Trap,” and “Life in the Financial Markets.”
Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.