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.
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.
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
- Excerpt from the 2011 book Zombie Banks: How Broken Banks and Debtor Nations Are Crippling the Global Economy by Yalman Onaran.
- Commentary in the Financial Times on Europe’s zombie problem.
- The New York Times calls the ECB “zombie hunter.”
- The Economist highlights the blight of the living dead.
- Bloomberg News article on German zombies.
- Bloomberg News QuickTake on Stress Tests.