Europe is ignoring the scale of bank losses

June 23, 2013 2:41 pm

Europe is ignoring the scale of bank losses

By Wolfgang Münchau

Consider the sheer number of crises in which lenders have lost money

It was another of those late-night agreements, which are as legally sophisticated as they are financially innumerate. Eurozone finance ministers agreed last week that the European Stability Mechanism could devote €60bn of its €500bn total lending ceiling to the recapitalisation of eurozone banks. If that is not enough, the rest of the money for the recapitalisation of the eurozone’s banks will have to come from national governments, or through bail-ins of investors and depositors.So how much recapitalisation can we expect? The French newspaper Les Echos last week produced an estimate of the total assets of the bad banks that have been set up to absorb losses from the housing crash and the US credit crisis. That estimate alone is more than €1tn – though it includes the UK. How much of these assets are ultimately underwater is anybody’s guess. But you could safely assume that quite a lot of this stuff will ultimately be worthless.

This estimate only relates to the bad banks. You have to add actual and hidden losses from the rest of the banking system. We do not know how big these are since hidden losses are, by definition, hidden. To disguise a loss, banks use tricks such as “pretend and extend”: lenders can decide to renew a non-performing loan that technically becomes good again the moment the new loan is struck – at which point the borrower will technically not be in default.

The reason I believe the amount of hidden losses in bank balance sheets is ultimately quite large is the sheer number and scale of the accumulated crises during which European banks managed to lose money in recent years: the US subprime crisis, a eurozone housing bubble, the Greek debt restructuring, the Cypriot bank failures and the short and sharp 2009 recession followed by the Great Recession of 2011-13, with no end in sight for southern Europe.

One would hope that an asset quality review by the European Central Bank, envisaged for next year, would provide clarity. But I am doubtful. In the past, bank transparency exercises were undertaken with the intention of hiding the truth. Remember the stress tests of 2011? Or the apparently independent audit of the Spanish banking system, which concluded that Spanish banks only needed a teeny weeny bit in new capital?

What makes me specifically doubtful about the ECB’s exercise is that I cannot see the central bank conceivably coming up with a number that is larger than the available capital.

So instead of waiting for these estimates, here is a quick and dirty, back-of-the-envelope calculation. It has an error margin approximately the size of the Italian economy, but it nevertheless produces an order of magnitude in which to think about this problem.

The total balance sheet of the monetary and financial sector in the eurozone stood at €26.7tn in April this year. How much of this is underwater? In Ireland, the 10 largest banks accounted for losses of 10 per cent of total banking assets in that country. The total loss will be higher. In Greece, the losses have been 24 per cent of total assets. The central bank of Slovenia recently estimated that losses stood at 18.3 per cent. In Spain and Portugal, the recognised losses are already more than 10 per cent, but the numbers will almost certainly be higher. Non-performing loans are also rising rapidly in Italy.

Germany is an interesting case. The German banking system appears healthy at first sight. It certainly fulfils its function of providing the private sector with credit at low interest rates. But I still find it hard to believe that the German banking system as a whole is solvent.

The country has been running large current account surpluses for a decade, currently at about 6 per cent of gross domestic product. This means German banks must have been building up huge stocks of foreign securities – a large yet unknown proportion of which are likely to default, especially if the main crisis resolution tool turns out to be a bail-in of investors.

On their own, the bad banks constitute about 5 per cent of eurozone banking assets. If you add another 5 per cent from hidden losses, the losses still being generated by the double-dip recession, and future losses through the bail-in of investors, you arrive at €2.6tn. Not all of these losses will have to be made good through a recapitalisation. Some banks may have some capital reserves. Other banks may be closed. But that just distributes the losses from one end of the banking sector to another.

Assume now that my estimate is wildly wrong, and deduct the size of the Italian economy from that back-of-the-envelope number. You still end up with €1tn. With this order of magnitude it mattered relatively little whether the ESM could contribute €60bn, €80bn or zero. Europe’s national governments are clearly incapable and unwilling to fill the gap. And without the money for bank resolution, it barely matters whether the European Commission will become the resolution authority that does not do the job or whether someone else does not do it.

That leaves a long period of regulatory forbearance as the most likely outcome – a policy version of pretend and extend. They pretend not to see the losses, and extend the crisis.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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