Just How Stable is Eurozone Banking?

Written by John Lounsbury

I have seen several discussions about just what the leverage is for Eurozone banks in general and Cyprus banks specifically. One measure that has been discussed is the ratio of bank deposits in a country (or the Eurozone) to GDP. Sometimes bank assets have been mentioned and at times I haven’t been able to determine what was being compared. Some of the numbers that I have heard or seen: Bank deposits in the Eurozone are 3.5 times GDP; bank deposits in Cyprus are 4 times GDP; bank deposits in Cyprus are 8 time GDP; and bank deposits in the U.S. are 1 times GDP.

For this discussion I’ll take the numbers for Europe overall and for Cyprus from Reuters:

The size of the banking sector in Cyprus is more than eight times the size of the economy, compared to around 3.5 times in the EU.

For the U.S. I’ll call on the Fred data base at the St. Louis Fed. The following shows the growth of total assets of all U.S. commercial banks since the early 1970s.

The following shows the ratio of total assets of all commercial banks to GDP.

The often mentioned number for the U.S. (banking sector about the same size as the economy) seems quite reasonable as the ratio of banking assets to GDP is 0.85 or slightly less.

Cyprus Banks in Trouble

Why are Cyprus banks in trouble? The latest data available from The World Bank indicates that Cyprus banks have a capital to assets ratio of 6.7% (2011). Ratios for some other European countries (for 2011 unless otherwise specified): Germany 4.6%, France 4.4% (2010), Spain 6.2% (2010) , Italy 9.3% (2010), Greece 6.3%, UK 5.4% (2010) and Sweden 5.0% (2009). The ratio for the U.S in 2011 was 11.3%.

In looking at the above numbers remember that the higher the capital to asset ratio the better. The U.S. ratio (11.3%) corresponds to a leverage of 8.8 to 1. By comparison the leverage for Italian banks is 12 to 1, for Greek banks 16 to 1, for German banks 22 to 1 and for French banks 23 to 1.

The leverage ratio for Cyprus banks is 15 to 1.

If the Cyprus banks are in danger of going under then there must be some problem with their assets relative to the other banking systems with leverages in the 11:1 to 23:1 range. If assets need to be marked down then capital is reduced dollar for dollar with the asset loss.

If Cyprus banks had to write off 6.7% of their assets that would consume all of their capital. That is what a capital to assets ratio of 6.7% (leverage of 15:1) means.

Comparison to the U.S.

Last week the stress tests results for the 18 largest U.S. banks was reported by the Federal Reserve. The U.S. regulations require that a stress test capital ratio be better that 5% (20:1) and banks in the 5% to 7% range under stress were considered weak.

These results were not for the current financial conditions but the simulated result if a severe economic downturn occurred. The numbers cited above for European banking systems are for current economic conditions.

What Would Further Stress Do to European Banks?

If things get worse in Europe how well can those banking systems survive? Will they all be Cypruses tomorrow?

How can the ratio of banking to GDP be justified at 3.5 to 1? Isn’t the U.S. financial system bloated at less than 1:1?

Isn’t the idea of banking that it should serve the economy? It seems that banking has grown for the purpose of serving banking rather than the economy. The ratio of banking assets to GDP was around 1:2 for decades in the U.S. (55%). Why should it be any higher? Only to support financial speculation?

More credit to support speculation is the only reason evident to this observer for the expansion from 55% to 85% to have occurred.

The problem seems to be much bigger for Europe. Just how stable can European banking be?

Reuters reported a follow-on analysis to the EU banking stress tests of 2011. Just 18 months ago that analysis indicated a stress test shortfall for Cyprus banks of €4.4 billion. This month that has grown to €10 billion.  A demonstartion of the inadequacy of the 2011 stress test is Barry Ritholtz statement that the €10 billion has been known since June 2012.

For more details on the Cyprus crisis read GEI News.