Market Turmoil a Reminder of Enduring European Banking Problems

Jerome Levy economists David Levy and Srinivas Thiruvadanthai contend that regardless of how the euro zone copes with the fiscal emergency in Greece, the problems of European banks will tend to grow over the next few years.


The recent days’ turmoil in European financial markets may reflect more than growing doubts about the financial, economic, and perhaps political stability of the European Economic and Monetary Union. There is growing concern about the solvency of European banks, and there may be newly emerging questions about the collective resolve of the euro zone nations and their central bank to do whatever is necessary to backstop their financial system. The banking sector in the broad European economy has serious balance sheet problems to begin with. The prospect of either more economic stress or sharp losses on banks’ considerable holdings of government bonds — or both — would jeopardize a large number of institutions.

Srinivas Thiruvadanthai and David Levy

Srinivas Thiruvadanthai and David Levy


Greece might be a relatively small country within the euro zone, but its debt is held mostly by banks in other European countries, which are in no position to withstand further losses. Under the circumstances, two news items last week, Germany’s hesitancy to ratify the new IMF-euro zone emergency loan program for Greece and the public recommendation by Germany’s ruling coalition that member countries should pursue a policy of “orderly default,” struck a nerve in the banking sector and in the financial markets. The possibility of defaults by the Greek, Portuguese, Spanish, or Irish governments — or even the possibility of their debt being written down substantially — introduces a new layer of worries about the adequacy of European bank capital.

Fear of counterparty risk among banks during the crisis in 2008 led to the blowing out of the TED spread and comparable spreads in other currencies until extraordinary international government actions restored confidence. Now the specter of counterparty risk is again rearing its ugly head in Europe. CDS spreads on European financial firms have been rising sharply in May. The reactions in interbank lending markets have not been nearly as severe as in 2008, but there is no question that European banks are looking at each other with renewed skepticism.

In April, the International Monetary Fund lowered its estimate of pending European bank losses because the financial crisis had eased, the IMF’s assessment of the economic outlook had improved, and some securities’ prices had bounced back. However, these judgments will undoubtedly change again, and over the next few years they will in all probability be changing for the worse. The losses on real estate loans to Eastern Europe and to boom markets in Western Europe will continue to accumulate, adding to the holes in bank capital opened up by losses on U.S. mortgage-backed assets.

Moreover, the severe fiscal medicine due to be imposed in Greece, already imposed in Ireland, and likely to be imposed before long in other euro zone states represents a serious drag on profits in the euro zone and broader European economies. Austerity measures will deepen the slump and lead to escalating default rates on private debt. The prospect that bank holdings of government bonds could also yield large losses completes a not very pretty picture.

The euro zone’s legal structure, it is widely apparent by now, hardly makes it a perfect political-economic machine. The ECB was an active participant in the rescue of the global financial system in 2008 and 2009, but many rescue efforts were left up to the national governments and were loosely coordinated at best. Stability was restored, but lingering doubts were left concerning the strength of Europe’s fledgling institutions and their ability to respond to crises.

Now, Greece’s predicament and the difficulties of the euro zone countries in coming to grips with it are undermining confidence once again. Without unquestioned power in the hands of a central government, and without a clear commitment of the currency union members (and notably, of the largest member) to backstop even the weakest member countries, questions begin to surface about the limits of the ECB’s function as lender of last resort, the sanctity of government debt obligations, and the euro zone’s ability to effectively protect its financial architecture from disaster.

Regardless of how the euro zone copes with the fiscal emergency in Greece and the other pressing fiscal problem areas, the problems of European banks will tend to grow over the next few years. Much of Europe, like the United States, faces considerable balance sheet contraction in the years ahead. Under the circumstances, with fiscal tightening to boot, the prospects for the economy, profits, employment, personal income, and debt performance are poor. So are the prospects for the values of real estate, corporate equities, and other assets. Disinflation and perhaps some deflation will further aggravate debt performance in some areas.

Thus, banks face more defaults, bigger losses on real estate loans as the collateral depreciates, and widening holes in their capital. Moreover, programs of severe austerity are not going to fix the region’s fiscal problems, leading to more resistance among stronger countries to bailouts of weaker ones and more social unrest in the weaker ones. The threat of a sovereign debt default, or at least devaluation through abandonment of the euro, will recur.

David A. Levy, Chairman and Director of the Jerome Levy Forecasting Center, is a leading expert in applying the Profits Perspective to economic analysis, with over 30 years of professional forecasting experience. Srinivas Thiruvadanthai is the Director of Research.