The financial crisis in Europe is supposed to be getting better, and with it sovereign and bank balance sheets are supposed to have started to heal, if ever so slightly. Interest rates on much of the debt from the region has fallen, a sign that global capital market investors see less risk there. However, the worst may not be over or a number of banks. That could draw the financial networks in the European Union into another debacle.
In the European Central Bank's recently issued "Financial Stability Review May 2013," one of the largest risks the organization sees is:
A further decline in bank profitability, linked to credit losses and a weak macroeconomic environment. Continued and prompt progress in proactively tackling bank balance sheet problems is needed.
Put simply, the quality of the loans many banks hold today is terrible. The perspective that trouble with the EU financial system has rotated from worst to worse may be true for sovereigns. Financial firms are another matter. For some of them, the worst may be ahead.
Across the loan portfolios of banks in the region, particularly those in the weakest nations like Greece and Spain, there are at least two serious challenges. Many of the financial firms continue to hold residential real estate loans. There is no sign that the housing market in most of these areas has improved, so more defaults are inevitable.
The other problem, ironically, is that as banks try to clean up their balance sheets, they withdraw from making risky loans. This, in turn, deprives businesses of capital. In another turn, businesses without capital undermine crippled national business environments. It is not exactly a domino theory about damaged companies spoiling economies that then take down better financed ones, but it is close. Healthy companies succumb as nations' economics continue to fold. The process opens debate not unlike the one about whether sovereigns benefit more from stimulus that austerity. The unemployment and GDP figures in the most troubled nations speaks in favor of stimulus.
As for financial aid and stimulus, the banking system would benefit from the same approach.
Filed under: 24/7 Wall St. Wire, Banking Tagged: featured