06 June 2013

WSJ: Austerity isn't Europe's only burden

Arguments continue in Europe over whether governments should relax budgets to encourage growth. But some analysts argue this debate is drawing attention from something more important that is generating serious headwinds for the region's economies: Europe's broken financial sector.

Banks dominate finance in Europe, especially in the struggling south. Some 85 per cent of financial assets in Italy, 87 per cent in Spain and 96 per cent in Greece are held by banks and other credit institutions, compared with less than 30 per cent in the US. So when the banks don't lend, European economies can't grow. Analysts say policy mistakes by European governments have stymied lending.

In 2008, they assumed their banks were largely unaffected by a crisis sparked in the US. When this proved untrue, they failed to perform credible "stress tests" to assess the banks' needs for new capital. The reason was that the truth wasn't pretty, and they thought they could get away without biting that bullet when their budgets were already under pressure.

Where banks were recapitalised, it was mostly by governments, which injected the minimum of new capital. Banks that were ordered to rebuild their capital ratios did so not by issuing new shares, but by shedding assets. Loans to the nonbank private sector thus peaked in 2009 and have fallen every year since then.

In some cases, national bank regulators in Europe have made things worse, Mr Borges [former European director of the IMF who is now at the Católica Lisbon School of Business and Economics] said. In their anxiety to make sure their domestic banks are not making risky bets abroad, they have encouraged them to stay at home. Such measures have prevented banks in the region's core economies from making generous returns by lending to credit-short enterprises in Italy and elsewhere on the periphery. Instead, funds are being bottled up in Germany and other "safe" economies, one reason why ECB's plentiful provision of funds to banks isn't benefiting private companies in Southern Europe. For a continent so dependent on banks, this is bad news. But it's worse than that, Mr Borges said. Not only have official policies stymied bank lending, they have also clamped down on a way out: the financial markets.

European authorities have hemmed in hedge funds and private equity funds, taken measures to curb short-selling and credit default swaps, regulated derivatives and exchanges, and proposed further measures for securities markets.

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