06 May 2013

Benink & Huizinga: Banish the threat from Europe's zombie banks

Europe has postponed the recapitalisation of its banking sector far too long, write Benink and Huizinga for the FT. The danger is that economic stagnation will continue for a long period, putting Europe on a course towards Japanese-style inertia and the proliferation of zombie banks.

It is now urgent to start recognising losses on balance sheets to avoid a proliferation of Japanese-style zombie banks in Europe. To facilitate this, the authors advocate conducting a new and thorough stress test soon, similar to the one administered by US supervisory authorities in 2009. Of course, the financial position of most governments in Europe is much worse than that of the US in 2009. So Europe needs to take a path towards recapitalisation that in some respects differs from the earlier US approach.

First, a credible stress test should assess the losses hidden on the balance sheet for each bank, as well as the likely cost of the removal of implicit guarantees of all liabilities. This will result in an estimated capital shortage, taking into account capital levels as required by international bank supervisors.

Second, supervisors need to assess whether the capital shortfall can be financed by international capital markets and/or governments. If the required amounts are too high, the bank must be entered immediately into a resolution and restructuring process imposing some losses on unsecured creditors (the Cyprus model). The legal basis for this would be an intervention law, which some countries may need to enact through emergency legislation. Most banks in Europe, unlike their counterparts in Cyprus, have significant financing by bondholders and can be recapitalised by imposing losses on holders of subordinated and common debt without infringing on savings deposits.

Third, in the event that capital shortfalls are relatively small, supervisors could instead implement the US model. This would mean banks being given a limited period of time to issue equity on international capital markets, after which national governments would step in to provide the remainder.

© Financial Times