The Mind-Game Of “Fixing” Europe’s Big Zombie Banks

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Danièle Nouy, chair of the Single Supervisory Mechanism (SSM), the ECB’s newfangled bank regulator that doesn’t exist yet, had the perfect term for how they’d fix the teetering European banks, hermetically sealed black boxes whose cover no one is allowed to peel off: “establish our credibility and reputation” and “do whatever has to be done” so that the banking sector “is seen as sound and safe and transparent.”

“Is seen as….”

Perception and confidence, founded on “credibility and reputation.” Forget reality. Because if reality were allowed to appear, many of these banks, stuffed to the executive floors with decomposing “assets,” would collapse, and the largest ones among them could tear up Spain, Italy, and even France. But some of the smaller ones would be allowed to fail – she didn’t have “any idea how many”; it would build the “credibility and reputation” of the regulator and spread the perception and confidence that the surviving banks would be, you know, “seen as sound and safe and transparent.”

Alas, these banks in her new bailiwick have been dogged by rotting loans. Companies that can’t service their loans anymore would normally go bankrupt to shed them and force banks to write them off and take their losses. Exactly what these over-leveraged banks cannot afford to do. Instead, banks convert loans to deadbeat companies into new loans with longer terms and lower interest rates or into equity of dubious value to avoid having to recognize and write down these nonperforming loans. When the companies can’t service those loans either, the bank extends a new loan and pretends everything is hunky-dory on its balance sheet all over again.

Outsiders never know what’s really on a bank’s books. In the few cases when someone pried open a corner and allowed the reek of asset putrefaction to billow from it, the whole bank collapsed. It’s only then that outsiders are allowed to poke through the detritus, and what they find is a gaping hole that taxpayers are shanghaied to fill.

So the amount of these extend-and-pretend loans – the forbearance – is mostly secret in Europe for fear that any public knowledge of just how huge it is could topple some of the banks, eat into the claimed profits of others, and leave executives who were showered with love and record compensation packages red-faced. While some banks disclose snippets, about a third of the 39 largest banks in the Eurozone, including four of the top 10 – Societe Generale, BNP Paribas, and Credit Agricole in France plus bailed-out Commerzbank in Germany – according to Bloomberg, don’t disclose anything about their extend-and-pretend mega-portfolios.

Banks show profits by, among other strategies, attaching a creative value to their assets. Valuing bad loans at face value is one of the tricks. In better times, when the bank has more capital to take the loss, it could quietly come clean in bits and pieces. That’s the hope. Meanwhile, the bad loans clog up the bank’s balance sheet and crimp new lending. The zombie bank is born.

Now the ECB wants to bring chaos to this established order, crack the whip on the 128 largest Eurozone banks, and extract information about forbearance and loans they consider “nonperforming.” It doesn’t help that banks in different countries have defined “forbearance” and “nonperforming” however it suits them. But by yearend, they’ll be required to adopt common standards. And dour-faced ECB inspectors will pore over this data.

And there will be stress tests. But this time, they won’t be jokes. Before, banks collapsed within months after passing stress tests. This time, the goal will be to make sure banks are, as Ms. Nouy said so eloquently, “seen as sound and safe and transparent.” Seen as…. Same as before.

The new regulator, however, has a few more loose teeth to persuade the doubters. Turns out, 27 banks are at risk of failing this stress test, whose results will be published in October. Among them: eight German banks including bailed-out Commerzbank; such luminaries as bailed-out National Bank of Greece; Italy’s Credito Valtellinese, Banca Carige, and bailed-out Monte dei Paschi di Siena; and Liberbank in Spain, where a €41-billion bank bailout already pushed the country to the brink. But that’s just a guess cited by Bloomberg. No one really knows.

Banks that fail the test would have to raise money, first from investors – including a bail-in of uninsured depositors? – and then public money, “which is available,” ECB Vice President Vítor Constâncio reassured the doubters. Because public money is always available to bail out banks. “The objective is no more doubts about European banks,” he said.

What little these European banks have disclosed so far is already bad enough: nearly €1 trillion in nonperforming loans as of last June. Or 6.7% of total loans! Up 6% from prior year. And the six largest banks that provide any information at all on their extend-and-pretend loans disclosed €115.6 billion in forbearance at the end of 2012. One of them, Spain’s largest bank, Banco Santander, under pressure due to Spain’s banking sector bailout, confessed that 7.7% of its loan portfolio consisted of restructured loans as of 2012. In 2013, it reclassified a bunch of those as nonperforming, which nearly doubled its bad loans to 7.5% of its total loans!

Who knows what else might come out of the woodwork….

At Italian banks, nonperforming loans reached 9.1% of all loans, admitted Bank of Italy Governor Ignazio Visco. These banks have been desperately trying to raise money by selling more shares, selling assets, and cutting costs to increase their capital so they could survive the whiffs of reality. But it may still not be enough to save the banks, and Mr. Visco warned of “more ambitious interventions.” Taxpayers are already clinging to their wallets.

Meanwhile, the European Commission is feverishly working on solving the problem from its end of the spectrum. It’s now reviewing the “appropriateness” of its capital and liquidity rules with the goal of watering them down further. And it’s reviewing how bank assets should be valued, with any notion of fair market value for long-term assets, what little is left of it, likely to go out the window. Doctoring bank balance sheets is still the most efficient way of kicking the can down the road. Ms. Nouy, endowed with all the eloquence of an accomplished Eurocrat, had said it so well: “do whatever has to be done” so that the smoke and mirrors of the banking sector are “seen as sound and safe and transparent.”

French megabanks are faced with an economy that shriveled or had no growth in five of the last eight quarters. While the dominant government sector is doing well, businesses are failing in record numbers. Read…. No Crisis? France’s Private Sector In Deeper Trouble Than In 2009

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