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Europe’s Zombie Banks

Published: July 11, 2013
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Source: Project Syndicate

What is wrong with Europe’s banks? The short answer is that the sector is too large, has too little capital, and contains too many players that lack a viable long-term business model. It is the combination of the last two factors – an overabundance of banks with no sustainable way to turn a profit – that constitutes the most serious and most difficult problem.

The banking sector’s size is a cause for concern because, with total liabilities amounting to more than 250% of the eurozone’s GDP, any major problem could over-burden public budgets. In short, the banking sector in Europe might be too big to be saved.

Undercapitalization can be cured by an infusion of new equity. But the larger the banking sector, the more difficult this might become. More important, it makes no sense to put new capital into banks that cannot return profits for the foreseeable future.

The difficulties in southern Europe are well known, but they differ fundamentally from country to country. In Spain, banks have historically issued 30-year mortgages whose interest rates are indexed to interbank rates such as Euribor, with a small spread (often less than 100 basis points) fixed for the lifetime of the mortgage.

This was a profitable model when Spanish banks were able to refinance themselves at a spread much lower than 100 basis points. Today, however, Spanish banks – especially those most heavily engaged in domestic mortgage lending – must pay a much higher spread over interbank rates to secure new funding. Many local Spanish banks can thus stay afloat only because they refinance a large share of their mortgage book via the European Central Bank. But reliance on cheap central bank (re)financing does not represent a viable business model

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