The agony at Deutsche Bank is over­shad­ow­ing the pain else­where in the Euro­pean bank­ing sys­tem—but pain there is.

Financial Mirror (Cyprus) - - FRONT PAGE -

Last week Com­merzbank, Germany’s sec­ond largest bank and big­gest Mit­tel­stand lender, an­nounced 9,600 job cuts and sold its Frank­furt head­quar­ters to Sam­sung of Korea. Yes­ter­day ING said it would lay off some 20% of its Dutch and Bel­gian head­count and trim its branch net­work, while in re­cent days banks else­where in the eu­ro­zone have laid out plans to axe an ad­di­tional 5,000 staff in a bid to cut costs in the face of squeezed prof­itabil­ity.

To a cer­tain ex­tent this is what the Euro­pean Cen­tral Bank wants to see. In its role as bank­ing reg­u­la­tor the ECB has long ar­gued for sec­tor con­sol­i­da­tion and a switch away from tra­di­tional de­posit-tak­ing and lend­ing-driven busi­ness mod­els. Yet the cur­rent round of cost-cut­ting and con­trac­tion lays bare the con­tra­dic­tion at the heart of ECB pol­icy.

Neg­a­tive in­ter­est rates and quan­ti­ta­tive eas­ing were in­tended to lower bor­row­ing costs and to en­cour­age banks to step up their lend­ing to the real econ­omy, so sup­port­ing eco­nomic re­cov­ery.

But the re­sult­ing yield curve-flat­ten­ing has com­pressed in­ter­est mar­gins and hurt prof­itabil­ity so se­verely that banks are be­ing forced to cut costs by shrink­ing their op­er­a­tions: hardly con­di­tions con­ducive to an ex­pan­sion in lend­ing.

The ECB is right that the eu­ro­zone is over-banked. Germany has over 1,500 banks and Italy over 600. But its in­sis­tence that banks should di­ver­sify their rev­enues away from in­ter­est in­come and more to­wards fee and com­mis­sion­based busi­nesses is in part an ad­mis­sion that growth and in­fla­tion prospects in the eu­ro­zone are so poor that banks can­not count on a steeper yield curve to bol­ster earn­ings any time soon.

In­fla­tion in the re­gion rose to the high­est in more than two years in Au­gust, but that was due to the fad­ing ef­fect of last year’s oil price fall rather than any pick-up in core in­fla­tion. With neg­a­tive rates and QE in place for the fore­see­able fu­ture, Europe’s bank­ing sec­tor is set to re­main un­der pres­sure.

If the ECB is in­deed hop­ing its poli­cies will lead to a pro­duc­tive round of bank­ing sec­tor con­sol­i­da­tion, it faces a few prob­lems:

1) The ECB it­self is re­spon­si­ble for keep­ing zom­bie banks alive with liq­uid­ity op­er­a­tions that guar­an­tee in­def­i­nite ac­cess to free fund­ing. Italy’s Banca Monte dei Paschi de Siena is a case in point. Over the last five years it has raised EUR 15bn in new cap­i­tal, yet its mar­ket cap­i­tal­iza­tion has fallen to just 546mn. Chief ex­ec­u­tives have come and gone but the bank con­tin­ues to stum­ble along, fail­ing stress tests, and fail­ing to clean up its balance sheet.

2) Re­struc­tur­ing Euro­pean banks is dif­fi­cult. New rules gov­ern­ing the re­cov­ery and res­o­lu­tion of fail­ing banks dic­tate that pri­vate sec­tor bond-hold­ers (and po­ten­tially de­pos­i­tors) must be bailed in be­fore pub­lic money can be in­jected. As Italy has found, this con­di­tion makes swal­low­ing the medicine of bank re­form po­lit­i­cally un­palat­able, es­pe­cially with elec­tions or ref­er­en­dums on the hori­zon. With plen­ti­ful liq­uid­ity on of­fer, al­low­ing the zom­bies to live on is the ex­pe­di­ent op­tion.

3) While large scale bank re­struc­tur­ing, re­mod­el­ing, and con­sol­i­da­tion would be in the eu­ro­zone’s long term eco­nomic in­ter­ests, the process would threaten to un­der­mine the re­gion’s near term prospects of eco­nomic re­cov­ery. The re­cent cuts demon­strate that as ECB poli­cies squeeze the prof­itabil­ity of tra­di­tional lend­ing busi­nesses and erode the abil­ity of banks to sup­port cap­i­tal ra­tios in line with reg­u­la­tory de­mands, the banks will be­gin to shrink their op­er­a­tions, cut­ting lend­ing to riskier bor­row­ers. Nat­u­rally these tend to be job-cre­at­ing small and medium sized busi­nesses that drive growth.

4) Calls for banks to shift away from tra­di­tional lend­ing and to­wards a more cap­i­tal mar­kets-based busi­ness cut lit­tle ice. Euro­pean cap­i­tal mar­kets re­main frag­mented and un­der­de­vel­oped. Reg­u­la­tory and le­gal ob­sta­cles per­sist, as do dif­fer­ences in tax­a­tion, in­sol­vency, com­pany law and mar­ket rules. Europe’s pro­posed Cap­i­tal Mar­kets Union is in­tended to over­come these dif­fi­cul­ties. But a wan­ing ap­petite among Euro­pean politi­cians for fur­ther fi­nan­cial in­te­gra­tion as Euroskep­tic par­ties gain popular trac­tion—not to men­tion com­pli­ca­tions thrown up by the Brexit vote—is mak­ing the planned 2019 im­ple­men­ta­tion less and less likely.

In short, the ECB’s stance is deeply con­tra­dic­tory. Its pol­icy of neg­a­tive in­ter­est rates to­gether with quan­ti­ta­tive eas­ing is in­tended to en­cour­age bank lend­ing to the real econ­omy.

But the ef­fect threat­ens to be the ex­act op­po­site, as de­clin­ing prof­itabil­ity pushes banks to cut costs by shrink­ing their op­er­a­tions. More­over, the ECB’s ex­hor­ta­tion on banks to switch to a cap­i­tal mar­kets-based busi­ness model is un­likely to work given the un­fa­vor­able state of the reg­u­la­tory en­vi­ron­ment. With lit­tle sign at the mo­ment ei­ther of a soft­en­ing in op­po­si­tion to pub­lic bail-outs or of a re­ver­sal in ECB pol­icy, ex­pect the pain in the Euro­pean bank­ing sec­tor only to in­ten­sify.

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