As European Central Bank leader Mario Draghi drags his feet over QE in the EU, analysts are coming to a consensus about the state of Europe’s lenders: they’re coming up short. I, Jason Galanis, am worried about this prospect.
Let’s be clear: many of Europe’s banks are loaded with cash, having amassed a hoard of it during the aftermath of the financial crisis. Even with all that extra “dry powder,” Europe’s banks are still not able to cover all the bad debts left on their books. The ECB has been investigating the over-extension of European bank capital since late 2013, and is set to publish its report cards for Europe’s lenders in mid-October. The report will no doubt make use the so-called “Texas ratio” to judge the health of its subjects.
The Texas ratio was invented after the collapse of many of the Lone Star state’s lenders in the late 1980s and early 1980s after the weight of bad mortgage loans. The ratio tests whether banks have sufficient capital to cover bad loans and continue making new loans, and is a pretty effective determinant of success or failure in the long-run.
Draghi has fought hard against quantitative easing in the EU, saying that it is a weapon of last resort to prevent deflation. The ECB president has already taken some extreme measures to encourage lending, to no avail.
Europe’s banks seem to be preparing for a reckoning of bad debt. The first bank to start lending again could be the first taken under by bad old debts and capital shortfall. No matter what Mario Draghi does, no bank manager wants to be the first penguin to leap into an uncertain and frothy lending environment. Following October’s report, Draghi will either order the first round of QE, central bank purchases of bad assets, or new regulations and capital requirements to weed out the weak penguins. Let’s hope it won’t be a Red October.