“Given the risks to the outlook, I consider it appropriate for the [Federal Open Market] Committee to proceed cautiously in adjusting policy,” Fed Chair Janet Yellen told the Economic Club of New York Tuesday, citing slower growth in the US and China and weak commodity prices. Her opposite number at the European Central Bank, Mario Draghi, knows better: on March 10 he announced that the ECB would buy corporate bonds to continue quantitative easing, the first time a major central bank has put large amounts credit risk on its balance sheet in living memory.
Draghi feared a collapse of confidence in Italian banks, who in turn own 405 billion euros of Italian government debt, or more than a fifth of the total. The trouble is that the Italian banks probably are insolvent by a wide margin. Non-performing loans stood at about 18% of Italian banks’ total loans at the end of 2014 and the total probably has increased since then.
The Fed’s threat to raise US interest rates sent world stock markets into a tailspin during the first six weeks of the year. Markets snapped back after the US, European and Japanese central banks responded with monetary ease and the promise of more. The central banks are right to worry. The European banking crisis of 2012 was never resolved, just swept under the carpet. It threatened to erupt again in February.
Nonperforming assets are larger than shareholders’ equity in all the top four Italian banks. The basket case is Monte dei Paschi, the third-largest private commercial bank, with non-performing assets at more than 500% of equity. Depending on recovery value, Unicredito and Intesa San Paolo, the two largest banks, might be solvent, presuming that they aren’t lying about their non-performing assets. By contrast, Bank of America and Citigroup have non-performing assets valued at 3% to 4% of their equity.
Chinese banks–the subject of endless scrutiny by foreign analysts–reported nonperforming loans of just 1.6%, and the Hong Kong brokerage house Reorient Group estimated NPL’s at 4.2% of bank assets in a recent report.
If Italy’s banks go down, so does the Italian sovereign debt market, and with it the Euro. As Francesco Sisci reported March 18, Italian financial officials fear that political stress will undercut confidence in the European Community’s ability to sustain the bailout.
Europe’s banks haven’t recovered from the Eurozone crisis of 2012. In dollar terms, the Euro Stoxx bank equity index is trading at just 40% of its level of five years ago while American bank stocks are 20% higher.
At the peak of the February financial mini-panic, the cost of insuring subordinated European financial companies’ debt spiked to levels not seen since the 2012 crisis. It fell sharply after Draghi announced that the ECB would buy corporate debt.
Europe’s banks have nowhere to go. The European Central Bank pushed interest rates below zero in the hope of forcing banks to lend their money rather than hoard it in money-losing investments. Italian bank loan books are shrinking because they have no creditworthy customers, and their liquid assets are losing money. They can’t earn their way out of the hole. Italy’s GDP is still 10% smaller in real terms than it was before the 2007 crisis.
The good news is that an Italian bank crisis, and even an Italian government debt crisis, aren’t enough to topple the world financial system. The rest of the world has had plenty of time to reduce its exposure to the weakest institutions. But a new financial shock out of Europe would push down the Euro, force up the value of the dollar, and send a deflationary wind through world markets.