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Summary

Over the past two years, the European Union has created an environment in which member statesfacing economic problems can borrow at relatively low interest rates. Because of the EuropeanCentral 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 growingnumber 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 takeplace, trouble is more likely in states such as Italy or Greece. Outside the eurozone, banks inHungary, Romania and Bulgaria will also struggle to reduce their portfolio of nonperformingloans. Since a banking crisis is essentially a crisis of confidence, a relatively small event in asecondary 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 oftheEU financial crisis.First,political problems in Bulgaria culminated in banking panicsin lateJune. Then in early July, news began to surface that the parent company of the Portuguese bankEspirito Santo was in financial trouble. Taken together, these stories reveal thefragility ofconfidence in the European banking sector.

Several things have changed since Greece, Portugal, Ireland, Spain and Cyprus were forced torequest 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 ifcountries such as Spain and Portugal have difficult times ahead, their governments are currentlyborrowing at record-low interest rates.

This reduces the possibility of another sovereign debt crisis in the short term but comes withinherent risks. Local investors, mostly banks, hold most of the government debt in Italy, Spainand Portugal. Banks are attracted to this sovereign debt because the interest rates are higher thanin Germany or the United Kingdom, and they have confidence that the European Central Bankwill back the bonds if it becomes necessary. As a result, banks in the European periphery areincreasing 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 centralgovernments. In November, the eurozone willimplement the first stage of the banking unioninwhich the European Central Bank will start to oversee the largest banks. The second stage of theunion -- the creation of a "single resolution mechanism" to handle banks in trouble -- has alsoseen progress. The rationale behind the second stage is to free central governments of the burden

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of saving failing banks and to prevent banking crises from dragging these governments down, ashappened in Ireland.

Because Germany has the largest economy in Europe and carries the greatest share of theeconomic 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 inwhich 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 wouldprotect taxpayers from having to fund rescue packages for banks, in 2015, a year before similarEU rules would take effect. Germany's lower house, the Bundestag, must still approve the draftlaws by the end of the year. In the coming months, Berlin will push other EU member states toapprove similar measures in an effort to bring clarity to the procedure should a banking crisisoccur.

Lastly, the European Central Bank has combined the offer of cheap long-term loans for bankswith 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 underclose 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 theenvironment in financial markets has improved substantially since November 2011, when recordhigh levels for Italian bond yields generated widespread fear that a eurozone collapse wasimminent, things have actually gotten worse for many households and companies in Europe. Thesame is true of the banks that lend them money, a reality that could undermine many of themeasures that the European Union has recently introduced.

Unemployment remains extremely high in Greece, Spain and Croatia and is also dangerouslyhigh in Italy and France. High unemployment means that in many European countries it hasbecome 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 theirdebt.

Outside the eurozone, where the unemployment problem is not as dramatic, banks face otherproblems. 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 farfailed 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 onlymodest success in getting rid of them. At the peak of the economic crisis in the United States, therate of nonperforming loans in U.S. banks was 5.6 percent; most European countries are still

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considerably above that level. The ratio of nonperforming loans is particularly high in Bulgaria,Cyprus, Greece, Croatia, Hungary, Ireland, Italy, Romania and Slovenia.

Click to Enlarge

The European Union is at a moment of uncertainty. The banking union has yet to beginoperations, and markets, banks and customers are not sure how the continental bloc would reactto another banking crisis. Perception is as important as reality during times of uncertainty. It maytake nothing more than negative data from any of the banks in these countries to generate newfears 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 monthsprovides indications of which nations are most at risk.

Italy'slarge banking sector and weak economymake it a key place to watch. The Italian BankingAssociation warned July 11 that bad loans in the country had risen to 290 billion euros ($390billion), up from 87 billion euros at the end of 2008. In the past three years, the top 40 Italianbanking groups have posted average negative profits. The Bank of Italy warned July 8 that creditconditions continue to tighten in the country while unemployment continues to rise. Italy'slargest banks, including UniCredit and Intesa Sanpaolo, have been selling some of theirnonperforming 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 isputting together a plan to address growing private debt and is expected to present measures bymid-August. Unpaid private debt in Greece is believed to have reached 160 billion euros (88percent of gross domestic product) and consists primarily of nonperforming loans held by Greekbanks in addition to unpaid taxes and social security contributions. Nonperforming loans presentthe most serious difficulty, and more than a third of all loans in the Greek banking sector aremore than 90 days overdue -- the highest ratio in the European Union outside of Cyprus. At the

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end of March, nonperforming loans stood at 77 billion euros and more than half were corporateloans.

Athens' new measures will reportedly be applied to companies first and households at a laterstage. 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 mostappropriate package of debt settlement and payment. Greek officials have said the new measureswould not include debt write-downs but would focus on extending installments and loweringinterest rates. In the coming weeks, Greece will be dealing with the urgent issue of private debtwhile 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 itsbanks, most of which are state-owned. The country's political environment remains fragile, andthe next government will have to act quickly to ensure further financial stability. The situation iseven more difficult in Cyprus, wheremore than a year after receiving financial aid,the Bank ofCyprus, 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 at15.3 percent in May (the fourth-highest rate in the European Union) and an expected decline of4.8 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 nonperformingloans in different ways. Romania, where more than a fifth of bank loans are nonperforming, istrying to send positive signals to financial markets. On June 25, Bucharest announced plans tojoin the European Union's "single supervisory mechanism," which gives the European CentralBank 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 fornonperforming loans, and these provisions are cutting into the banks' profitability.

Bulgaria, where the recent banking crises were mostly related to political clashes betweenbankers and politicians, is doing something similar. In mid-July, Sofia also announced plans tojoin the single supervisory mechanism. While this mechanism is primarily meant for eurozonebanks, Bulgaria wants to signal that it will comply with the European Union's best practices andsubmit its banking sector to tighter control by the European Central Bank.

Hungary, however, has reacted to its banking problems in a completely different way. Budapestis preparing legislation toconvert all foreign-denominated loans back into forints.TheHungarian government has yet to announce whether this conversion will be done at market ratesor at special rates, as has been the case in the past. For now, foreign banks operating in thecountry insist they will stay, but Hungarian authorities have repeatedly said they want a largerpart of the country's banking sector to be in Hungarian hands. This new legislation is unlikely toput 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 substantialreduction in unemployment. Banks have reacted to the crisis by severely restricting lending andboosting their capital in an attempt to clean up their balance sheets. While this has temporarilystabilized Europe's banking sector, it has also deprived the economy of credit. This is a key

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element of economic growth, especially in Europe, where most companies rely on bank loans forfunding. At the same time, austerity measures have reduced the purchasing power of familiesliving in nations on the European periphery, hurting domestic consumption and furtherweakening prospects for solid economic growth. This vicious cycle of governments that do notspend, 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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