Zombie Banks

How the Undead Weigh Down Europe's Economy

Zombies-Lede

Zombies are stalking Europe — zombie banks that are solvent in name only. The phenomenon is not new. Zombies weighed down Japan for almost 20 years after a real estate bust. They are usually born of financial panics, when loans go bad, capital flees and the value of assets tumbles. There are no good choices when zombie banks are on the march. Shutting them down can cause further panic. Restoring them to health can require hundreds of billions of dollars. But letting them fester can cripple an economy for years, because zombies don’t make the loans healthy businesses need to grow and consumers need to spend.  No place has been cozier for zombies since the 2008 global financial crisis than Europe, and no economy has been slower to recover.

The Situation

The euro zone is finally facing up to the problem, after sagging banks threatened to pull down indebted governments. The troubles are concentrated in Italy, Ireland, Greece and Portugal. Even after multiple rescues and capital injections, almost a fifth of 130 banks failed a European Central Bank stress test announced Oct. 26, with a total capital shortfall of 25 billion euros ($32 billion). The ECB was given the job of figuring out which banks are healthy, which should die and which could recover with a transfusion of capital before it takes over as the banking regulator Nov. 4. Even that triage is a delicate matter, as the central bank tried to avoid scaring away investors by grading too harshly, or losing credibility by repeating the too-easy test of 2011, which cleared some banks that later failed. To prepare for the new tests, European banks raised capital through stock and bond sales and unloaded assets including bad loans at deep discounts. Most of the lenders that failed have already raised funds, but 11 still need more capital or they could face a shutdown within nine months.

Source: European Central Bank
Source: European Central Bank

The Background

One thing about old-fashioned bank runs — when they killed banks they stayed dead. The panics that followed, however, could bring down healthy banks as well, so tools for supporting banks grew up, most notably deposit insurance. Those developments brought with them a thorny question — when to pull the plug. The term “zombie banks” was coined by Edward J. Kane of Boston College in 1987 to refer to U.S. savings and loans institutions that had essentially been wiped out by commercial-mortgage losses but were allowed to stay in business, as regulators put off the pain of shutting them down in the hope that a market rebound would make them whole. By the time they gave up and cleaned up the mess, the losses of the zombies had tripled. In Japan, zombie banks propped up zombie companies rather than write down their loans, while the banks themselves were kept alive through “regulatory forbearance” — a tacit agreement by the government to pretend that their bad loans were still worth something, an approach that kept the markets calm but contributed to a “lost decade” of economic stagnation. The prime example of a tough approach is Sweden, which in the 1990s responded to a financial crisis by nationalizing its ailing banks — and quickly rebounded.

 

"These institutions have very distorted incentives, just as the zombies do in the horror movies," Edward J. Kane.

The Argument

After the 2008 crisis, Iceland let its three largest banks fail. The U.S. was not as harsh as that. It pumped $300 billion into U.S. banks, but it also conducted stress tests that were more rigorous than Europe’s and forced low-scoring banks to raise private capital. In the end, the Treasury recovered almost all of its investment. In Europe, the latest round of stress tests in may provide more credible. In the past, Germany not only fought European regulators who sought to shut down the weakest banks — it added 287 billion euros ($392 billion) in debt to keep its financial sector afloat. Ireland made such a sweeping bailout pledge to its big banks that it ended up needing a bailout itself, while Spain had to ask its neighbors for 100 billion euros to save its banks. Critics of Europe’s approach point to its double-dip recession and an unemployment rate stuck near a record high. Others say the U.S. approach had hidden costs, like the zero percent interest rates that hurt savers, plus the risk that the cheap money that the Federal Reserve has pumped into the economy may be fueling a new bubble — that could start the cycle all over again.

The Reference Shelf

First Published Jan. 14, 2014

To contact the writer of this QuickTake:

Yalman Onaran in New York at yonaran@bloomberg.net

To contact the editor responsible for this QuickTake:

John O'Neil at joneil18@bloomberg.net