European Banks Are Highly Exposed to the Current Crisis

To what extent will European banks withstand the current crisis? This is a crucial question because the recession we are experiencing could be followed by a banking crisis that would affect the whole economy even more severely. A CEPII study, entitled "European Banks and the Covid-19 Crash Test", sheds an interesting light on this subject. 

While a liquidity crisis seems unlikely, given that the European Central Bank is open for business, a solvency crisis cannot be ruled out, say the editors. They make a quick calculation: "The aggregate assets of eurozone banks amount to 34 trillion euros, of which 11.7 trillion are loans to the economy and 5 trillion are securities. With equity (capital and reserves) amounting to 2.5 trillion, it would only take 21% (11.7*21% = 2.5) of the loans not being repaid to exhaust them completely".

If one in five bank loans is not repaid, European banks crash; a scenario that is not unlikely in the event of a prolonged recession. All the more so as this calculation accepts a broad definition of capital (official, which comes from the banks) since leverage, or the "unweighted ratio" (ratio of capital to total assets without risk weightings), is shown in this study at 5.8% for eurozone banks. In his analyses, JP Chevallier advocates a stricter approach and calculates a leverage effect of around 1/40 for French banks, i.e. 2.5%, half the CEPII figure, which means that defaulting on around 10% of their loans would send French banks crashing .

This rate of 21% is not at all implausible, the study says, bearing in mind that "non-performing loans" (the official name for defaulted loans, which are not lost in full, however) were 8% in Italy in 2018, after having reached 15% in 2015. On average in the eurozone, they rose from 7% at the end of 2014 to 3% at the end of 2019. The countries most affected by the recession (France, Italy, Spain) could dangerously approach the red zone.

The study also points out that the 21% figure "is the result of static reasoning that does not take into account the contagion and amplification effects that could accelerate the increase in default rates". Indeed, a single large European bank falling would trigger a domino effect, as well as bank runs in several countries. The banking crisis will occur long before this figure is reached.

And then what? There are two aid mechanisms at the European level: the SRF (Single Resolution Fund), which could be mobilized to the tune of 40 billion euros, and the ESM (European Stability Mechanism) of 60 billion euros. This represents less than 5% of the banks' own funds, in other words, nothing. We would have to go through the BRRD directive, which we spoke about as early as 2015, that is to say the removal of depositors' accounts by banks threatened with bankruptcy. The governments could then intervene in order to protect depositors who are also voters but, as the study states, "the vicious circle between banking risk and sovereign risk, which the Banking Union intended to break, could reappear since the burden would fall on each government". We would face a European sovereign debt crisis, but one that would be much more serious than in 2011.

What is the probability of this black scenario happening? The CEPII is not optimistic: "On the scale of disasters, this health crisis is even more serious than a systemic financial crisis because of the way it simultaneously affects all economic activities at the global level." We will have to watch how growth returns, or not, because "if the crisis were to continue beyond 2020, it is highly likely that major European banks would be hit by the crisis in turn". So, as in the 1929 crisis, we would be in for ten years...