Summary

Over the past two years, the European Union has created an environment in which member states
facing economic problems can borrow at relatively low interest rates. Because of the European
Central Bank's promise of intervention in debt markets, a sovereign debt crisis similar to what
Greece experienced in 2010 seems unlikely. High unemployment and weak economic activity,
however, continue to undermine the banking sectors of several EU countries, where a growing
number of households and companies are struggling to pay back their bank loans.
While it is impossible to predict exactly when and where Europe's next banking crisis will take
place, trouble is more likely in states such as Italy or Greece. Outside the eurozone, banks in
Hungary, Romania and Bulgaria will also struggle to reduce their portfolio of nonperforming
loans. Since a banking crisis is essentially a crisis of confidence, a relatively small event in a
secondary country could trigger EU-wide fears of a generalized crisis.

Analysis
In recent weeks, tremors in Portuguese and Bulgarian banks reignited fears of an escalation of
the EU financial crisis. First, political problems in Bulgaria culminated in banking panics in late
June. Then in early July, news began to surface that the parent company of the Portuguese bank
Espirito Santo was in financial trouble. Taken together, these stories reveal the fragility of
confidence in the European banking sector.
Several things have changed since Greece, Portugal, Ireland, Spain and Cyprus were forced to
request bailouts from the European Union and the International Monetary Fund. First, the
European Central Bank's promise to intervene in debt markets has calmed these markets. Even if
countries such as Spain and Portugal have difficult times ahead, their governments are currently
borrowing at record-low interest rates.
This reduces the possibility of another sovereign debt crisis in the short term but comes with
inherent risks. Local investors, mostly banks, hold most of the government debt in Italy, Spain
and Portugal. Banks are attracted to this sovereign debt because the interest rates are higher than
in Germany or the United Kingdom, and they have confidence that the European Central Bank
will back the bonds if it becomes necessary. As a result, banks in the European periphery are
increasing their holdings of government debt while limiting credit to households and companies.
This process lowers the prospects for a sustainable economic recovery. And as governments find
it increasingly easy to sell debt, they will be tempted to postpone economic reforms and over-
borrow again.
The European Union has also worked to break the link between fragile banks and central
governments. In November, the eurozone will implement the first stage of the banking union in
which the European Central Bank will start to oversee the largest banks. The second stage of the
union -- the creation of a "single resolution mechanism" to handle banks in trouble -- has also
seen progress. The rationale behind the second stage is to free central governments of the burden
of saving failing banks and to prevent banking crises from dragging these governments down, as
happened in Ireland.
Because Germany has the largest economy in Europe and carries the greatest share of the
economic burden in bailing out the eurozone, it is at the forefront of this change of approach to
banking crises. The German government approved draft laws July 9 introducing a system in
which shareholders and customers will have to take losses when a bank encounters difficulties --
a process commonly known as "bail-in." Berlin hopes to implement the system, which would
protect taxpayers from having to fund rescue packages for banks, in 2015, a year before similar
EU rules would take effect. Germany's lower house, the Bundestag, must still approve the draft
laws by the end of the year. In the coming months, Berlin will push other EU member states to
approve similar measures in an effort to bring clarity to the procedure should a banking crisis
occur.
Lastly, the European Central Bank has combined the offer of cheap long-term loans for banks
with the application of stricter supervision. The bank has promised to be rigorous with its
ongoing stress tests in an attempt to send a message to markets that banks are solid and under
close oversight from Frankfurt. The central bank will announce these results in October.
Banking Crisis Versus Sovereign Debt Crisis
At the moment, another sovereign debt crisis in Europe seems unlikely. However, although the
environment in financial markets has improved substantially since November 2011, when record
high levels for Italian bond yields generated widespread fear that a eurozone collapse was
imminent, things have actually gotten worse for many households and companies in Europe. The
same is true of the banks that lend them money, a reality that could undermine many of the
measures that the European Union has recently introduced.
Unemployment remains extremely high in Greece, Spain and Croatia and is also dangerously
high in Italy and France. High unemployment means that in many European countries it has
become increasingly difficult for families and companies to repay their debt. In some cases,
borrowers simply cannot pay their mortgages or consumer loans. Others are "strategic defaulters"
who are betting that their national government will offer schemes or moratoriums to relieve their
debt.
Outside the eurozone, where the unemployment problem is not as dramatic, banks face other
problems. In Hungary and Romania, individuals are having trouble paying their foreign-
denominated loans, while in Bulgaria the combination of political instability, social unrest and
friction between politicians and bankers has hurt the country's banking sector.
The European Union has successfully mitigated the threat of another debt crisis but has so far
failed to address the problem of massive unemployment and its indirect impact on bank loans.
Nonperforming loans continue to increase in European banks, and lenders have enjoyed only
modest success in getting rid of them. At the peak of the economic crisis in the United States, the
rate of nonperforming loans in U.S. banks was 5.6 percent; most European countries are still
considerably above that level. The ratio of nonperforming loans is particularly high in Bulgaria,
Cyprus, Greece, Croatia, Hungary, Ireland, Italy, Romania and Slovenia.


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The European Union is at a moment of uncertainty. The banking union has yet to begin
operations, and markets, banks and customers are not sure how the continental bloc would react
to another banking crisis. Perception is as important as reality during times of uncertainty. It may
take nothing more than negative data from any of the banks in these countries to generate new
fears of another banking crisis.
Risk Factors Across the Map
It is impossible to know where the next banking crisis will be, but data from recent months
provides indications of which nations are most at risk.
Italy's large banking sector and weak economy make it a key place to watch. The Italian Banking
Association warned July 11 that bad loans in the country had risen to 290 billion euros ($390
billion), up from 87 billion euros at the end of 2008. In the past three years, the top 40 Italian
banking groups have posted average negative profits. The Bank of Italy warned July 8 that credit
conditions continue to tighten in the country while unemployment continues to rise. Italy's
largest banks, including UniCredit and Intesa Sanpaolo, have been selling some of their
nonperforming loans, but smaller banks have not been able to do so.
Greece will try to mitigate some of its banking problems in the next couple of months. Athens is
putting together a plan to address growing private debt and is expected to present measures by
mid-August. Unpaid private debt in Greece is believed to have reached 160 billion euros (88
percent of gross domestic product) and consists primarily of nonperforming loans held by Greek
banks in addition to unpaid taxes and social security contributions. Nonperforming loans present
the most serious difficulty, and more than a third of all loans in the Greek banking sector are
more than 90 days overdue -- the highest ratio in the European Union outside of Cyprus. At the
end of March, nonperforming loans stood at 77 billion euros and more than half were corporate
loans.
Athens' new measures will reportedly be applied to companies first and households at a later
stage. While the details of the plan are unknown, media outlets have reported that Athens is
studying an out-of-court mechanism in which creditors would negotiate with debtors on the most
appropriate package of debt settlement and payment. Greek officials have said the new measures
would not include debt write-downs but would focus on extending installments and lowering
interest rates. In the coming weeks, Greece will be dealing with the urgent issue of private debt
while also negotiating with its lenders on longer maturities for its massive public debt.
Slovenia narrowly avoided a bailout in late 2013 by pumping some 3.3 billion euros into its
banks, most of which are state-owned. The country's political environment remains fragile, and
the next government will have to act quickly to ensure further financial stability. The situation is
even more difficult in Cyprus, where more than a year after receiving financial aid, the Bank of
Cyprus, the island's largest lender, needs additional recapitalization. According to the European
Commission, more than half the loans in the bank are nonperforming. With unemployment at
15.3 percent in May (the fourth-highest rate in the European Union) and an expected decline of
4.8 percent in gross domestic product this year, the island will remain in crisis for some time.
Outside the eurozone, several countries are addressing the problem of rising nonperforming
loans in different ways. Romania, where more than a fifth of bank loans are nonperforming, is
trying to send positive signals to financial markets. On June 25, Bucharest announced plans to
join the European Union's "single supervisory mechanism," which gives the European Central
Bank power to supervise the stability of banks in participating countries, in 2015. For months,
the Romanian central bank has been pushing banks to make large additional provisions for
nonperforming loans, and these provisions are cutting into the banks' profitability.
Bulgaria, where the recent banking crises were mostly related to political clashes between
bankers and politicians, is doing something similar. In mid-July, Sofia also announced plans to
join the single supervisory mechanism. While this mechanism is primarily meant for eurozone
banks, Bulgaria wants to signal that it will comply with the European Union's best practices and
submit its banking sector to tighter control by the European Central Bank.
Hungary, however, has reacted to its banking problems in a completely different way. Budapest
is preparing legislation to convert all foreign-denominated loans back into forints. The
Hungarian government has yet to announce whether this conversion will be done at market rates
or at special rates, as has been the case in the past. For now, foreign banks operating in the
country insist they will stay, but Hungarian authorities have repeatedly said they want a larger
part of the country's banking sector to be in Hungarian hands. This new legislation is unlikely to
put an end to friction between Budapest and foreign banks.
Europe is at a point where it is seeing some incipient economic growth but without a substantial
reduction in unemployment. Banks have reacted to the crisis by severely restricting lending and
boosting their capital in an attempt to clean up their balance sheets. While this has temporarily
stabilized Europe's banking sector, it has also deprived the economy of credit. This is a key
element of economic growth, especially in Europe, where most companies rely on bank loans for
funding. At the same time, austerity measures have reduced the purchasing power of families
living in nations on the European periphery, hurting domestic consumption and further
weakening prospects for solid economic growth. This vicious cycle of governments that do not
spend, households that do not consume and banks that do not lend will continue to undermine
Europe's real economy and create fertile ground for banking crises.
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