The Euro and the state of EU banks


The Euro crisis is especially worrying given the state of the European banking system. In practice the EU member states stand behind their major banks. State finance and bank finance is almost one and the same thing. Problems in banks require state support, as recently seen in Ireland. The more the member states put money into their banks, the worse the deterioration in their own finances and the more strains are placed on their government bond markets.

The EU authorities understood this and undertook stress tests of the main banks in their system. They published the results in July 2010, showing  that seven banks out of 91 studied needed additional capital to have sufficiently strong balance sheets to withstand  a double shock. The Committee of European Banking Supervisors confirmed that no major bank studied was insolvent, and that all had sufficient capital to survive  even if the two shocks materialised.

The authorities envisaged the right kind of shocks. They proposed that there could be a double dip recession, with no growth in 2011. This may well happen in Portugal and Greece, on¬† the EU’s own forecasts. ¬†They argued that there could be losses on EU member states government bonds, commonly held by banks as assets.

The problem with the stress tests, mentioned extensively by commentators at the time, was they were not particularly stressful. The test to ensure banks could cope with a sovereign debt problem only wrote sums off the bonds held in banks’ trading books. The Regulators assumed that the longer term holdings of bonds by the banks were fine as they could hold them to maturity and would not therefore incur losses. The stress test assumed a 75 basis point increase in 10 year borrowing rates (an additional 0.75%) and another 70 basis points on top for the EU average to allow for markets pushing up the borrowing rates of weaker countries by more.

These figures led the testers to cut 23% off the value of Greek bonds, 12.3% off the value of Spanish bonds, 12.8% off the value of Irish bonds, 14% off the value of Portuguese bonds, 10.2% off UK bonds and 4.7% off German.

As we have seen in the Greek and Irish crises, the markets can be more punishing than this. Yields on 10 year Greek debt have risen to 12% and on Irish to over 9% compared to 2.5% on German. Banks do lose money on their holdings as well as on their trading books, if you mark the bond value to market prices. There is also an impact on confidence and the valuations of other assets like property in the affected countries which might also damage the banks.

The Stress tests revealed that five Spanish banking groups would have Tier One ratios below 6% if the conditions of the tests took place. Diada (3.9%), Espiga (5.6%), Civica (4.7%), Unnim (4.5%) and Cajasur (4.3%)  (figures assuming the double hit) were all thought to need extra capital. The German Hypo Real Estate bank and the Agricultural Bank of Greece also failed the test.  Several others were close to the 6% cut off, including Allied Irish and the Greek bank, Piraeus.

Investors in recent days have worried that a more severe test should have been applied. Banks could lose more on their government  bond holdings than imagined. In addition, the property sectors in Ireland and Spain are weak, with rising amounts of empty property and falling prices in many locations. Property remains a fundamental underpinning of banking activity, representing a high proportion of the collateral used for loans.

So what should the authorities do? In the short term there need to be reassuring statements from the European Central Bank that it stands ready to offer whatever liquidity these banks need. As all the main banks in the European system are said to be solvent and creditworthy according to their EU Regulators. Tthe Central Bank has to ensure they stay liquid even if the market loses confidence in them and withdraws funds.

In addition it looks as if the banking Regulators need to work  behind the scenes with the most vulnerable banks, and  agree an action programme with each to raise its ratios and cut its risks. Banks can do this by selling assets, making more profit, selling whole businesses to others, writing off bad debts and losses, raising new capital, merging with better capitalised  rivals and in a number of other ways. When they reach an agreement with a vulnerable bank about a clear way forward this should then be announced to the markets so they can see that their doubts and worries are misplaced.

All this will be easier if the economies of western Europe are growing. Consumer debt is less risky if people have jobs and can look forward to rising wages. Business loans are less risky if business is expanding and turnover rising. Property debt is less risky if property is in demand and rents have stopped falling.

We will look at the way to get faster growth  tomorrow.


  1. lifelogic
    December 2, 2010

    This is sensible but all needs to be achieved without the banks drawing back yet funds from good small and medium enterprises which is what is happening ever where.

    Growth is needed and will not happen unless these companies are able to fund it. They also need to know that if they do do well they will be allowed to keep a sensible proportion of the profits. Tax rates need to come down a lot, regulations reduced and made sensible and a market led cheaper energy policy.

    No sign of any of this from Cameron/Clegg

    1. lifelogic
      December 2, 2010

      Nor will growth be helped by everyone being forced on to new annoying light bulbs as is suggested by the UN at the Cancun summit.

      People can change when and if it suits them – anyway they make no sense in rooms rarely used and in others the “wasted” heat off them only heats the buildings anyway thus saving on central heating. Leave people alone to make their own decisions don’t let “intellectuals” like Lord Prescott take them for us and then try to force their mad ideas down everyone’s throats.

  2. ferdinand
    December 2, 2010

    That is a sound analysis but it has a preponderance of ‘if’s. The whole banking system still however is living on ‘if’s. We just have to hope that favourable outcomes exceed the unfavourable but the scene is rapidly getting out of the hands of professionals into the gloved hands of politicians.

  3. electro-kevin
    December 2, 2010

    It’s all very complex indeed and this complexity is at the heart of the Eurosceptic’s objections to the EU’s existence.

    By thinking in terms of it being a European problem and what ‘EU authorities’ must do next’ are we not at risk of capitulating to EU control ?

    A major force in the creation of this mess was our close involvement with the EU – our becoming un-British in our approach to our culture, control of housing stock, control of population levels and attitudes to debt – I’m sure that other European countries are faltering under the same artificial pressures.

    In even discussing this subject in this context and in a series of posts on ‘what the EU must do next’ are we not unwittingly validating an entity that NOBODY WANTS ?

    Reply As far as I am concerned none of this should apply to the UK. The parts of the EU in Euroland have a simpel choice – form a country to back their currency or abandon ship.

    1. Denis Cooper
      December 2, 2010

      But of course under the present EU treaties they don’t have either choice, and the danger is that treaty amendments will push them all in the direction of the first course without allowing any of them to take the second course.

    2. electro-kevin
      December 3, 2010

      Why you’re a politician (and a good one at that) and why I’m not.

  4. lola
    December 2, 2010

    Look, ‘reg-yew-lay-shun’ everywhere works as ‘nationalisation by regulation’. The banking sector is entirely a state sanctioned cartel, and has been since 1997 + the FSM Act 2000. It is the structures that are the problem. Whilst everyone, including you, bang on about what regultaors should do’ it continues to give their chaotic bureaucracy false credence. What is needed is the spontaneous order of the free market. So, to solve the banking crisis (which started as a real estate bubble crisis) you have to shut down most ‘reg-yew-lay-shun’ , and by ‘most’ I mean 95%. Then operate some simple capital requirements as you suggest.

    It’s the regulations and the structure of regulation that is the problem.

    1. Max Van Horn
      December 2, 2010

      Absolutely bl…dy spot on.

    2. Sally C.
      December 2, 2010

      It ‘s so good to see that the FSA has exonerated Sir Fred Goodwin and the rest of the RBS board. I feel a warm glow to know that our key regulator has been looking out for British taxpayer interests.

      1. Mark
        December 2, 2010

        I’d hate to think what you’d write when you really try to do irony! Truly shredding.

  5. Demetrius
    December 2, 2010

    And where pray is our Prime Minister today amidst all these pressing problems. Just what is he doing?

    1. lifelogic
      December 2, 2010

      Mistakenly hoping to bask in the glory of getting the world cup for the UK. That his happiness index, the royal bank holiday and other similar distraction/frivolities are his main concern in true PR style.

      That way he hopes to distract from the real problems of on over grown malignant state, his broken promises, absurd tax levels, broken banks the EU and the breakdown of any real UK democracy.

      But come the next election it will be results and real jobs that matter not his silly gimmicks distractions and pointless windmills.

  6. Gary
    December 2, 2010

    Isn’t it lucky that we have the Euro to deflect from our own crisis ? Worse than Spain by almost any measure, worst in the world by some measures. Here is chapter and verse and the sorry state of the UK finances(click the slide show) :

    1. libertarian
      December 2, 2010

      By any measure Gary? I think not ,

      UK unemployment 7.7%

      Spain unemployment 20%

  7. Stuart Fairney
    December 2, 2010

    Can anyone explain to me in simple terms why failing companies (whatever their sector) should not be left to die a natural death? This is a good thing, even if it causes pain short term since this is how capitalism eliminates failure.

  8. Gary
    December 2, 2010

    Why are rates on UK gilts still surprisingly low ? Because the Bank of England is buying them and underwriting them. The BoE “IS” the UK gilt market right now. This is default by stealth via inflation. This is even more insidious than outright default by bankruptcy, because default via inflation is a silent transfer from the solvent savers and pensions to the insolvent banks, while default by bankruptcy will clean out the insolvent banks, and that will be no bad thing.

  9. Sally C.
    December 2, 2010

    JR – Unfortunately, I think you are being too optimistic. By not forcing the Irish bank bondholders to take a severe haircut, Ireland is now in an impossible position. Presumably, the same approach will be applied to Portugal and Spain. The Euro will continue to decline in value and will drag Sterling down with it. This will benefit the German car manufacturers but could also result in revolution in the streets of Ireland and Spain – the result of unbearable levels of youth unemployment and the collapse in the purchasing power of the Euro.

  10. Anthony Adams
    December 2, 2010

    We have got to this situation because political leaders have recklessly stepped in and effectively taken banks over at taxpayers expense when they should have simply have guaranteed depositors and let banks go bust. How can it be right that the stock holders that stood to gain if investments were profitable can simply rely on taxpayers, who could make no profit, pay their losses?
    Now we’ve reached the point where the whole system could well collapse due to the greed and stupidity of bankers and politicians who, I have no doubt, have insulted themselves very well from the effects of a meltdown in currencies.
    The last ten years are an object lesson in the old adage that power corrupts.

  11. Mark
    December 2, 2010

    I can’t help feeling that the stress tests were worked out backwards – i.e. decide the amount of stress to test when you have informally discovered what would not be truly stressful. It always helps to know the answer before you ask the question.

    One of the ways in which banks can improve their solvency is to reduce the amount they pay in bonuses. The best way of negotiating for this is to instruct the BoE and ECB to warn that bailout funding will not be available to banks who pay out lavishly – taxes are far less effective than the threat of closing the business altogether.

    Property cannot be considered sound collateral when valued at bubble prices. Rising rental yields do not imply anything more than a tightening market for rental property, and are wholly consistent with falling property prices. The rental premium is no more than the extra cost of a put option on property values rising as the probability of price falls increases. We saw exactly this behaviour of rents accompanying the 1990s house price falls.

  12. Paul B
    December 2, 2010

    “Consumer debt is less risky if people have jobs and can look forward to rising wages. Business loans are less risky if business is expanding and turnover rising. Property debt is less risky if property is in demand and rents have stopped falling.”


    But are the levels of existing debt really sustainable? Not if interest rates were to go any higher.

    What are the long term effects of having such abnormally low interest rates going to be?

    Not sure. Do we look to Japan to find out?

    Credit (debt) is not a bad thing when priced accordingly and the risk of default is carried by lenders (not taxpayers). Existing bad debts also need to be recognised.

    Until then, I don’t think more debt is the answer.

  13. EJT
    December 2, 2010

    1. Unravel the inte-rgovernment bailouts. Present policy will eventually result in a massive, synchronised systemic failure

    2. Bank debt is not government debt. The depositor guarantee scheme was sufficient.

  14. Johnny Zero
    December 2, 2010

    I feel that the European Central Bank is now stuck in a strategy of quantitive easing. They will print whatever Euro money is needed to bail out the Sovereign State Members who are failing. The Germans are not going to agree to more taxes on their domestic economy so printing money is the answer. The Euro will then fall internationally particularly against Asian Currencies and bring on an export rise maybe? These Eurocrats are Fanatics and can never allow the Euro to fail as their Project fails with that currency. These people are no longer democratically accountable ( and have never been so) thus will act in their self interest and the Devil takes the Hindmost. The PIGS are going to be really battered in the next few months and may never recover. Germany of course will reign supreme when the financial bombs stop falling

    December 2, 2010

    You allowed us as an aside from the great matters of state a few weeks ago to comment on the way the men missed the logical business sense of the USA owners of Manchester United over the Rooney contract.
    Having watched nonsensical summaries of the failed England bid in the past 2 hours (mainly by male reporters we have to say) could we point out the logical fact that FIFA delegates clearly have different criteria from partisan dignitaries from our FA in selecting a host nation.
    Coming on the heels of Japan/Korea 2002, South Africa 2010 and Brazil 2014 wasn’t it likely that Russia 2018 and Qatar may be favoured as emerging nations?
    And with so many delegates coming from similar ‚Äėemerging‚Äô nations did it not seem likely that the voting might favour them?

    Before England or other established nations bid in future we suggest that the home authority should establish the criteria sought by FIFA and the weighting given to each factor. Is it too much for the chaps in the FA, FIFA and the media to establish the rules before throwing around as their default setting suggestions of vote rigging? (let alone taxpayers funds and hopes!).

    Incidentally before Qatar were declared as 2022 winners we heard nothing from the UK media of the amazing plan to erect stadia in the host nation and then demolish and re-site the buildings in under-privileged nations. What vision!

    To bring us back to the real world of this excellent site we just add that perhaps sports journalists have as little vision of their professed area of expertise as that of the financial media before the credit crisis?

    1. The ESSEX GIRLS
      December 2, 2010

      Further to our comments 2 hours ago after the bid announcement we’ve just watched a Prof Stefan Syzmanski on Jeff Randall who points out that FIFA clearly see their mission as to support nations who will invest in their country’s infrastructure for the common good of their people. Why did our experts and high profilers not understand this?

      We may not agree with FIFA but it’s a specific stance even if more suited to a World Bank or Development Agency than the promoters of the world game.
      Prof Syzmanski also pointed out rather sensibly that our economy will not suffer – certainly as not as much as these other nations will gain – and seemed to agree with our conclusion that England should count it’s blessings in having great football to watch and benefit from economically for 10 months every year rather than just for just 1 month every 48!
      So let’s hope the whingers change their sour grapes record soon and think it through like us….


    2. alan jutson
      December 2, 2010

      Essex Girls

      Exactly my thoughts.

      Before bidding for any contract (and that is what it was in effect) you read the small print and the legal pack, if not sure on a particular point, you ask for clarification. Your bid, and the merits of your case then need to satisfy the criteria set.

      Same as any job application, or contract proposal, you do not use exactly the same letter, CV or business prospectus for everything.

      Given that the Last World cup in Africa went to new massive infrastructure projects, as did the next in Brazil, if the next two were to be similar types of projects, then there was little point in showing stadiums which were already built, under the Mantra of “we could hold it next month”.

      Sad we lost it, thought our presentation was very good, but clearly the content criteria was not what was being sought by FIFA.

      1. APL
        December 3, 2010

        alan jutson: “Sad we lost it, ”

        We are already bankrupting ourselves for the Olympic games – why can’t they simply have a permanent venue in Greece? I am not sad that Russia has the cost to bear.

        I for one am tired of bread and circuses.

  16. Mike Stallard
    December 2, 2010

    Banks are where voters keep their capital.
    If, say, the TV shows a panic at Northern Rock, it can start a universal panic and then every bank in the country will fail, since none of them have capital enough to meet a 100% withdrawal.
    Also each bank is interrelated. This means that English banks invest in Spain, Portugal and Ireland too. If they loose too much they, too, will fail and the voters will get stroppy and panic. This will lead to even more banks failing.
    It is much easier to print more money.

  17. Denis Cooper
    December 2, 2010

    We take it for granted that a small private investor normally has to accept losses on an unwise investment which goes wrong, without any possibility of getting protection or compensation from public funds. However it appears that there are larger private investors who hold bonds issued by the private banks based in the EU who are so powerful that they can force the EU institutions and EU member state governments to use public money to protect them against any losses. Because the governments must borrow from much the same set of large and powerful private investors to fund budget deficits and roll over existing borrowings, those private investors have the whip hand and they can in effect “demand public money with menaces” to avoid taking losses on their holdings of the private bank bonds. Now that they’ve demonstrated that they can do this in the case of Ireland, it’s hard to see any reason why they won’t carry on and do it with all the other weaker eurozone countries in turn.

  18. Gary
    December 3, 2010

    Andrew Lilico in an article in the City AM this morning, says the EU plan is to throw huge amounts of money at the banks until 2013 and then cut them loose. In other words , they are giving the signal and the money for the senior bondoholders to take the taxpayer money and get out, and then let the banks go bust. IMO. If correct, the immorality of this is without end. These govts are determined to get the senior bondholders out without penalty on the backs of the taxpayers. This is not free market capitalism, this is (authoritarian government -ed) , by definition. Govts are not working for their people, but for the Big Bankers. And our govt is no different or why else did we help bail out Ireland ? We are still on the hook for $418 Billion to the PIIGS.

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