Thursday 29 September 2016 6:00 pm

The new sick man of Europe is the continent’s entire banking sector

The “sick man of Europe” has been a popular phrase for describing countries in Europe beset by economic woes since the mid-nineteenth century. The UK, Italy, Germany, France and Greece, among others, have all borne this unwanted diagnosis at some point.

But in 2016, this moniker can no longer be solely applied at a country level. It has become abundantly clear that the patient is the European banking industry.

It goes beyond just a couple of institutions currently in the news: European bank shares, measured by the Euro Stoxx Banks index, are down by nearly 30 per cent since the start of the year. Profitability is lagging. These banks are trading at 0.7x book value. Symptoms didn’t improve in the first half earnings season and the European Banking Authority annual stress tests in July served only to renew focus on the malaise affecting European banks.

At first glance, the stress test exercise suggested that banks are simply suffering from acute illnesses; illnesses that can be prescribed and treated with relative ease and speed. But scratch beneath the surface, and there are signs that the banks have some significant health concerns ahead.

Only two of the 51 banks analysed in the stress tests showed return on equity above the cost of capital. There wasn’t a single bank that added shareholder value under the tests’ adverse scenario. The remedies aren’t simple, but they are necessary. Each European bank must actively put in place plans to restructure their prices, costs and overall business models.

Exposure to non-performing loans is becoming a chronic ailment for European banks. Investors and governments alike are concerned that many European banks have a very high ratio of non-productive assets on their balance sheets. The concern is justified. Countries like Italy and Ireland have 17 per cent of their banks’ books tied up in non-performing loans. Compare that to banks in the United States, which only have 2 per cent exposure to such loans.

Read more: Rising rates will kill off the zombie firms – but this may hurt SMEs too

It is crucial that European banks exert exceptional amounts of energy to proactively accelerate the unwinding of the trillions of non-performing loans. They must learn their lessons in terms of new lending to avoid creating more non-performing loans and thus perpetuating the sickness. These unproductive assets generate high operating, funding and capital costs and they constrain profitable new lending.

But for all the focus on the banking sick men of Europe, we shouldn’t dismiss the debilitating disease of the parties that are supposed to be the medics: the regulators.

Issues such as transparency on capital requirements continue to be unresolved. Indeed, the Association for Financial Markets in Europe (AFME), which represents large investment banks, recently warned that the Basel Committee on Banking Supervision is planning to increase capital requirements. The Basel Committee has previously pledged there will be no “Basel IV”, or a rise in the capital requirements that banks face under the Basel III legislation.

Capital opacity is not reserved for the Basel Committee alone. The European Central Bank softened its prescription on the capital requirements arising from the European stress tests. This wasn’t necessarily wise. The lack of corresponding calls for capital action and a clear pass or fail made this year’s stress test results less binding for banks.

Read more: Bank stress tests "worse than useless" says Adam Smith Institute

In contrast, the choices made by the US banking regulators have led to the banks under their jurisdiction being diagnosed and discharged. The stress tests in the US had greater influence because they had binding constraints. This severity contributed to greater bank strength and credit growth. In the last quarter, US banks grew by 10 per cent. European banks grew by just 1 per cent.

Market confidence is plaguing regulators too. This year’s stress test exercise was a missed opportunity to resolve market doubts about the health of particular banks and countries. The ECB must improve its timing, process and tools if it is to assure markets – the most discerning of doctors – that the pain is definitely acute, not chronic.

Banks are tied closely to the economic health of the countries they operate in. It is therefore up to a host of stakeholders, including governments, the banking sector and its supervisors, to align towards long-lasting structural solutions that fully restore credit flows into the economy.

Only then can European banks pass the sick man of Europe baton onto its next victim.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.