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The euro area’s biggest banks have reported record profits. [...] The vulnerabilities lie in the small and medium-sized banks, those with assets below €500 billion. Together these banks own 50% of the euro area banking system assets.
In our research, based on 130 euro area banks directly supervised by the ECB, we find that banks are often superficially well capitalized—their regulatory capital ratios and even their equity capital looks reasonable. Only one in ten small banks has equity less than 3% of its assets; one in six medium-sized banks has an equity/asset ratio below 3%. But banks are vulnerable either because they have a high share of non-performing loans or they have insufficient resources to cover for possible losses on the non-performing loans. This is a widespread problem but one that is especially acute in the countries that have faced high stress since the start of the crisis.
[...] about a third of small banks, with almost 40% of small-bank assets, would fall below the 3% equity threshold. Medium-sized banks would face similarly extensive stress. By comparison, only one of the euro-area’s 13 “large” banks would be considered stressed under our enhanced stress test.
Corroboration for our findings comes from bank share prices. While the stock prices of all banks are still well below their pre-crisis peaks, the small and medium-sized banks that we identify to be stressed have had particularly weak performance. [...]
For dealing with banking vulnerabilities, European policymakers seem wedded to a single response: to pump more capital into the banks.[...]
We also believe in well-capitalized banks—with the focus on equity rather than on fuzzy regulatory capital. But the real problem in Europe is that the banks in trouble have had long-standing governance problems. [...] The continuing problems in Europe’s smaller banks are sending a message: Europe has a problem of overbanking.
The bottom line is that the euro-area’s banking sector needs pruning. In the United States, hundreds of banks have been closed or merged since the start of the crisis—the bulk of such action was taken quickly so that the problems would not fester. In the euro area, after much effort, the authority to resolve banks has now been standardized across the member states. Yet, there has been little action. Despite rules to impose losses on banks’ owners and creditors, there remains a reluctance to do so.
It is well past time to aggressively restructure, consolidate and close the weakest euro area banks. Failure to do so will act as a drag on economic recovery, much as it did in Japan.
Full article on Bruegel (with charts)