A “Major Concern”

The European Banking Authority EBA, which (we guess) is fighting for its survival after the ECB has become the sole supervisor of Europe’s “systemically relevant” banks, has recently issued a comprehensive report on the European banking system (this included the unintended revelation that its employees have yet to master the intricacies of Exel).

As an aside, we have little doubt that this bureaucracy will survive. Has there ever been a case of an EU bureaucracy not surviving and thriving? We don’t recall one off the cuff, but perhaps we are mistaken. We’re sure some reason will be found to preserve this particular zombie sinecure as well.


eba_2Hey guys! We’re still issuing reports! See how important it is to keep us well-funded?


Among the things the EBA’s report apprises us of, is that European banks continue to be submerged in bad loans, in spite of all the bailouts and extend & pretend schemes that have been implemented in recent years. As Reuters reports:


“The scale of bad loans held by banks in the European Union is “a major concern” and more than double the level in the United States, despite an improvement in recent years, the EU’s banking regulator said on Tuesday.

Non-performing loans (NPL) across Europe’s major banks averaged 5.6 percent at the end of June, down from 6.1 percent at the start of the year. But that compares with an average of less than 3 percent in the United States and even lower in Asia, according to the European Banking Authority (EBA).

The total of NPLs across Europe is about 1 trillion euros ($1.1 trillion), equivalent to the size of Spain’s annual gross domestic product (GDP) and 7.3 percent of the EU’s GDP.

Tuesday’s figures were the first time detailed data on NPLs, defined as a loan that is more than 90 days overdue or where problems are spotted earlier, have been released in Europe. The EBA data covered 105 banks, spanning 20 EU countries and Norway.

Some 16.7 percent of loans at banks in Italy were designated as NPLs, equivalent to 17.1 percent of the country’s GDP. Spain’s banks had an average NPL ratio of 7.1 percent, or 15.8 percent of its GDP. Banks in Cyprus fared even worse, with half of their loans classified as bad, followed by Slovenia (28.4 percent), Ireland (21.5 percent) and Hungary (18.9 percent).


(emphasis added)

€1.1 trillion is certainly a lot of moolah. As the above list shows, as a percentage of total economic output bad loans are astonishingly large in a number of countries. You may also have noticed that Greece isn’t even mentioned, but with more then €90 billion in NPLs, the condition of its banking system relative to the economy’s size is actually in the by far worst in Europe. However, a third bailout is already in the works, so there’s absolutely no reason to worry.

The above is of course just what is officially admitted to. One must not lose sight of assorted “extend and pretend” strategies that are employed in order to mask the true extent of the problems. The creativity of banks and governments in this context is pretty much unlimited.


1-EBA risk exposure chartsA page from the EBA’s interactive stress test mapping tools, which can be found here: 2014 stress test results – click top enlarge.


Measures to Improve Capital and NPLs

Two points have to be made to this. Firstly, European banks have indeed done a lot to improve their capital ratios, primarily because they are under pressure from tighter regulations. Unfortunately, these regulations have also been used to impose a specific form of financial repression, by declaring government debt a “risk free” asset that requires no capital to be set aside.

As a result, much of the fresh capital supporting bank balance sheets in Europe consists of debt instruments that are anything but “risk free”. The chutzpa regulators have displayed by introducing this definition of risk so shortly after the euro area’s sovereign debt crisis is truly amazing. Just ask the banks in Greece and Cyprus how “risk free” Greek government debt turned out to be for them.

Still, one has to acknowledge that the banks have made quite an effort to improve their capital position within the constraints of the regulatory corset that has been imposed on them. Of course this doesn’t alter the essential fact that fractionally reserved banks are de facto insolvent at all times.

Occasionally, this fact is “suddenly” discovered, but then they can still rely on the backstop provided by the central bank, which can and does create as much money ex nihilo as needed, and can buy assets no matter how illiquid or dubious they are. All that is required is to keep up appearances by putting lipstick on them, for instance in the form of “government guarantees”.

We have previously discussed how this was e.g. done in Italy (see: “The ECB’s LTRO – a Giant Inflationary Push” for details), where an insolvent government has propped up insolvent banks by using the central bank as a middle-man. It is as if Worldcom had propped up Enron with the help of their own central bank.


2-Backdoor-bailoutThe creative Three Card Monte between Italy, its banks and the ECB. This was implemented on occasion of the 2012 LTRO.


Moreover, even while “Basel III” regulations have tightened capital adequacy requirements, assorted European governments have altered their own capital-related regulations, by e.g. allowing banks to transform “deferred tax assets” into credit that counts toward their capital – a major make-believe/ extend & pretend measure, that essentially serves to mask the real situation by legalizing extremely dubious accounting manipulation.

The other point worth considering is the actual level of NPLs. To this it must be kept in mind that a sizable amount of NPLs has been hived off, so as to make them disappear into the memory hole of various “bad bank” structures. One of those is Spain’s SAREB (which has relieved Spain’s banks of €50 billion in bad loans) – the losses of which have incidentally doubled in 2014, even as Spain’s real estate sector recovered. These particular dud loans and the losses associated with them are no longer part of bank balance sheets, but they haven’t magically disappeared altogether. Instead they have merely been shifted around.


3-NPLsEuro area NPLs – a tiny improvement has been recorded, but it’s really nothing to write home about yet.


These are however not the only measures that have been taken. We have last visited this particular topic two years ago, when we described how e.g. Spain’s banks have swept souring mortgage loans under the rug by simply refinancing them (see “Spain’s Banking Woes” for details). As we noted at the time, shortly after the EU had arranged the €100 billion bailout for Spain’s banks the WSJ reported:


“It has puzzled Spanish bank analysts for years: Why did the country’s mortgage delinquency rate rise so slowly even as unemployment soared above 26%? A big part of the answer—revealed by a spate of bank earnings reports in recent days—is that Spanish lenders had been making their loan books look healthier than they really were by refinancing big numbers of loans to struggling homeowners and businesses. The lower interest rates and easier terms of refinancing helped hundreds of thousands of Spaniards like Juan Carlos Díaz, who stopped making mortgage payments more than a year ago, remain in their homes and keep their businesses afloat longer than otherwise would have been possible. It has also helped banks bury a growing risk in their credit portfolios and avoid recognizing losses on debts they are unlikely to recover.


(emphasis added)

To be sure, regulations have been tightened with respect to these practices, so current disclosures are probably a good sight more truthful. We are only bringing this point up to show that banks are of course eager to disclose as few problems as they can get away with. This is in a way understandable in light of the “freezing” of the banking system during the 2008 crisis, when banks ceased to even trust each other (this was by the way a very telling episode; in a fully reserved banking system, there would have been little reason for such distrust to emerge).

We should also mention that the very low NPL ratios, resp. low levels of distressed assets more generally that are currently reported in the US and many parts of Asia are at least partly also a result of accounting gimmickry. In the US mark-to-market accounting has been done away with. The banks were eager for the practice to remain in place as long as it helped them to artificially inflate their reported earnings, but as soon as it began to produce losses, they suddenly discovered what a horrendously “inadequate” accounting practice it was! A few intense weeks of lobbying were all it took to throw the previous accounting principles overboard – not that those were much better, mind.


4-provisoions and NPLsProvisioning, write-offs and NPL levels globally.


We have recently also discussed credit conditions in China (see “I’ll Raise You One Sweden” for details), an example that serves to illustrate that one has to assume that Asia is not necessarily a fount of the most conservative and honest banking accounting practices either.

In fact, our assessment of the situation would be that what has been done globally in the wake of the last credit crisis is a mixture of obscuring the extent of the problems, shifting losses as far as possible onto the back of society at large (i.e., tax payers and savers), while concurrently bailing out the system by means of truly massive monetary inflation. What there has been very little of is what one could broadly term “honest accounting” and “letting the market work”.

Tighter capital adequacy regulations may at least to some extent represent a small improvement compared to the previous situation, but this pales compared to the potential problems that are accumulating due to yet another period of massive monetary pumping.

Naturally, no government wants to return to a free market system with free banking and a sound market-chosen money, completely free of government interference or central economic planning. We are told that the free market is simply too dangerous, and the serfs deserve better!



The way we see it, there are two possibilities. One is that the echo bubble central banks and governments have set into motion since the GFC will implode before commercial banks have a chance to fully recover from the effects of the previous crisis. In this case they will face an avalanche of new problems, combined with old problems worsening again, from a position of weakness.

The other possibility is that the echo bubble persists for longer, which would undoubtedly help with inflating away the legacy problems of the previous boom-bust cycle (this seems to be the ECB’s plan at present). At the same time though, such a development would be apodictically certain to vastly increase the already scary inventory of potential new problems.


5-Junk yieldsTrend in US junk bond yields since 2011 – click to enlarge.


In the major currency areas the biggest of these potential problems are today posed by corporate debt and government debt. However, there are still numerous real estate bubbles and the associated mortgage and consumer credit bubbles extant in the “periphery” as well (from the UK to the Scandinavian countries, to Canada and Australia). So the next crisis is likely to create an interesting mixture of catastrophes, varying from region to region.


But who knows, maybe Krugman’s space aliens will arrive just in time to bail us out.


aliensMankind’s last hope – an intergalactic bailout

Image credit: ADG


Charts and tables by: EBA, Wall Street Journal, IMF, St. Louis Federal Reserve Research



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