No Wonder Europe Isn’t Growing
Post-crisis reforms have forced banks to become far too risk averse, starving the European economy of credit. The result is the stability of the graveyard.
It’s one of the great puzzles in the global economy. Why is America growing so much faster than Europe? This great divergence has taken almost everyone by surprise. The US economy powered ahead by 2.5 per cent last year, while the eurozone managed to eke out a mere 0.5 per cent. This year the outperformance is set to continue, with America forecast to grow 2.7 per cent, three times faster than the eurozone which is only expected to grow by just 0.5 per cent, according to the International Monetary Fund’s latest World Economic Outlook. Britain is forecast to grow by 0.5 per cent, but only because of a rising population. On a per capita basis, the IMF expects UK GDP to remain flat this year, after falling 0.3 per cent in 2023.
There are no shortages of explanations for this divergence. Some cite looser US fiscal policy, or America’s more flexible labour market, or its cheaper energy costs, or its lower taxes, or its greater exposure to faster growing, more productive sectors such as technology. Conversely, others argue European growth is being held back by onerous regulation, or weak demographics or market fragmentation. A new report by Enrico Letta, a former Italian prime minister, calls for greater single market integration in sectors such as finance, energy and digital services to boost competitiveness. A report due later this year on ways to boost EU productivity by Mario Draghi, another former Italian prime minister, is likely to reach similar conclusions.
All of these are important. But there is one factor behind Europe’s weak growth that is rarely discussed: its broken banking system. Of course, the European banking system is far from broken the way it was in 2008, when it was overwhelmed by first the global financial crisis and then the eurozone debt crisis, which resulted in many lenders requiring a government bailout. Banks now have robust balance sheets and are generating substantial profits. Instead, the system is broken in the sense that it is no longer doing its job properly. Astonishingly, British banks have delivered zero net loan growth in 15 years, and eurozone banks have done little better, notes Alastair Ryan, a European banks analyst at Bank of America.
The reality is that reforms to banking rules in the wake of the global financial crisis have left lenders far more risk averse. That was of course the intention. The crisis had exposed the extent to which banks had been taking reckless bets on poorly understood long-term risks using what turned out to be highly volatile short-term funding. But there was always a danger that in their zeal to create a safer, more stable banking system by requiring banks to hold far more capital and maintain substantial liquidity buffers, regulators would in fact deliver the stability of the graveyard. The evidence suggests that this is in fact what they have done.
One measure of how much more risk averse the banking system has become is that there are now 1.3 million fewer mortgages outstanding in Britain today than in 2008. That is despite a larger population and higher number of households. No wonder the average age of a first time buyer is 36 or that housebuilding has been so weak. It also explains why house prices have remained buoyant while bad debts have barely budged despite interest rates soaring to a 16-year high of 5.25 per cent. That is in contrast to all previous interest rate cycles. It is the same across Europe. Only the most creditworthy borrowers can get mortgages these days.
This risk aversion extends to business too. A recent survey by the Bank of England found that almost a quarter of small and medium sized businesses believed they had under-invested in recent years, citing an inability to access finance on reasonable terms and stringent bank collateral requirements as key factors. This is an even greater problem on the continent where SMEs account for 99 per cent of businesses, contribute two thirds of the workforce and more than half of the economy. These have traditionally had a symbiotic relationship with local banks who have detailed knowledge of the businesses and their owners to assess credit risks.
What has happened is that the post-crisis banking reforms have removed some of the discretion that used to underpin lending decisions, imposing far stricter rules for assessing how much capital a bank must hold against loans. Banks must also hold sufficient liquid assets to meet 30 days worth of expected withdrawals in a stress situation. What’s more, to pass severe stress tests, banks must keep buffers on their buffers. The result is that bank capital has more than tripled since 2007 to more than 15 per cent of risk-weighted assets, while banks are being forced to hold liquid assets equivalent to more than 150 per cent of worst-case outflows. As Ryan notes, that is €1.8 trillion of trapped liquidity that is not generating a commercial return.
This has rightly made the banking system safer for taxpayers. But it has had the perverse effect of making the sector more risky for investors, who face a far greater risk of regulatory intervention even with their new far higher capital and liquidity buffers, not least in the form of bail-ins of bondholders. This is reflected in a sky-high cost of equity - the return required by shareholders - which is an estimated 16 per cent in the EU and 18 per cent in Britain. To earn that kind of return on riskier loans, the banks would need to demand interest rates too high to be politically unacceptable. So European banks are instead returning capital to shareholders: a staggering £172 billion this year in the form of dividends and share buybacks.
What should alarm policymakers is that despite this extraordinary payout, which equates to a sector yield of 17 per cent, European bank shares are still trading on an average 6.9 times next year’s forecast earnings, says Ryan. That is the lowest multiple since the 1980s even after a 15 per cent rally in the STOXX Europe 600 banks index this year and compares to a multiple of 10.5 pre-crisis. The reality is that despite near record profits, fuelled by a combination of higher interest rates, which has boosted margins, and low levels of bad debt, the average return on equity is still just 13 per cent. Not surprisingly, all European bank shares are trading at a discount to book value - a clear signal to return capital rather than increase lending.
This matters much less in America where there is a plentiful alternative supply of credit. Since 2008, market-based lending by investment funds in the form of junk bonds, private credit and leveraged loans has soared to fill the gap left by retreating banks, hitting $2.1 trillion last year. In Britain, the non-bank sector contributed nearly all the £425 billion net increase in lending to the UK economy between 2008 and 2023. In the euro area, non-banks have increased their share of business lending from 15 per cent in 2008 to 27 per cent. But the lion’s share of the growth has been in America, which accounts for 70 per cent of all non-bank financial assets globally. The private credit market could balloon to $3.5 trillion by 2028, according to Blackrock.
Europe’s problem is that unlike America, its financial system remains deeply fragmented along national lines. The bond markets are in any case only really an option for large companies, not SMEs. What’s more, market-based lending requires a rich ecosystem - of investors, brokers and traders - and deep and liquid pools of capital. But the European investment banking ecosystem has been hit hard by the post-financial crisis regulatory rules which have made it expensive to commit capital to such a small profit pool, so that the market is now dominated by US banks who have the advantage of a large home market. The consequences can be seen in the exodus of businesses to America via stock market listings and private equity buyouts.
What can Europeans do? An obvious task is to review banking rules to ensure that they are striking the right balance between stability and risk and avoid some of the regulatory uncertainty that pushes up the cost of capital. Indeed, it is striking that the US Fed has signalled that it is likely to water down proposed Basel 3.1 banking reforms amid concerns about the impact on SME lending, while the European Central Bank is delaying full implementation until 2032. Recent changes to the way the ECB manages its balance sheet could free up around €1 trillion in liquidity, reckons Ryan. Meanwhile, policymakers should index the size of balance sheet that is deemed to make a bank globally significant - thus triggering more onerous capital and liquidity requirements - to reflect increase in the size of economies over the last decade.
But the most urgent challenge facing Europe is to develop and deepen its own sources of alternative non-bank finance. In the EU’s case, that means forging ahead with its planned capital markets union. This is a project that it has been debating for years, including at the most recent European Council. Yet EU efforts to replicate America’s deep and liquid capital markets continue to go nowhere, primarily because member states are unwilling to yield sovereignty to a European supervisor or harmonise insolvency regimes, which is vital to give investors confidence that contracts will be consistently enforced. This needs to change. If Europe cannot improve the supply of credit to its most dynamic businesses, it has no chance of closing the growth gap with America. It will instead have to reconcile itself to the stability of the graveyard.
Forgive me. And I say this as a COMPLETE ignoramus, but didn’t the last banking crisis start in the US?
All the mechanisms intended to prevent the banking crisis didn’t work. Nobody appeared to see it coming. Everyone was cock a hoop at all the exciting and innovative work of these masters of the financial universe…right up to the point they blew the world up in our faces and we all got stuck with the bill?
I’m probably completely wrong. I accept I have zero knowledge in this area. All I know is that I’ve heard all this before. Too many regulations. Free the market to do what it does best.
On the evidence I’ve seen, what it does best appears to be to take massive risks to enrich a very small cadre of people at the expense of everyone else.
But again. I’m probably wrong. You guys and girls are far better informed than me.
Just like you were last time. And the time before that.
Anyway, interesting read. Thank you.
Is part of the problem not also the continued closure of small, local branches, where the manager knew the local businesses?