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Economists Warn of Long-Term Perils in Rescue of Europe’s Banks

Jack Ewing|The New York Times
Monday, 13 Feb 2012 | 8:43 AM ET

FRANKFURT — Few would begrudge Mario Draghi his boast last week that he and the European Central Bank had prevented a disastrous credit crisis by showering banks with cheap loans in December.

European Central Bank
European Central Bank

But beneath the gratitude toward Mr. Draghi, the president of the central bank, lurks a fear that the easy money could simply be creating the conditions for another banking crisis several years from now.

Because of the central bank’s cheap financing, some economists warn, sick banks now face less pressure to confront their problems — to clean out bad loans and other impaired assets, or even wind down operations if there is no hope of a turnaround. The European Central Bank , they say, could inadvertently spawn a cohort of “zombie banks,” burdened by nonperforming loans and assets that remain on the books, like the ones that helped make the 1990s a lost decade for Japan.

“It’s a huge bet,” said Charles Wyplosz, a professor of economics at the Graduate Institute in Geneva. “If the crisis ends up well, the ECB will have pulled off a miracle. If things go wrong, then commercial banks will be in a much worse situation than they were before.”

Professor Wyplosz said the central bank might be making the banking system more fragile by encouraging institutions to load up on risky assets, especially government bonds from troubled euro zone countries like Spain or Italy. Banks can use those assets as collateral for more loans from the central bank.

In December, the ECB invited banks to borrow money at the benchmark interest rate of 1 percent for three years, compared with a previous maximum maturity of one year. Banks could borrow as much as they wanted provided they posted collateral. They jumped at the opportunity: 523 banks borrowed 489 billion euros, or $647 billion.

The central bank will offer another round of three-year loans at the end of this month, and last Thursday it loosened its collateral rules to encourage smaller banks to join in. According to some predictions, banks may draw on the cheap credit even more enthusiastically than they did in December.

Last Thursday, Mr. Draghi urged banks to take the money, and even ridiculed top bankers who have bragged they did not need the central bank’s charity. “I would describe some of the statements made as ‘statements of virility,’ ” Mr. Draghi said at a news conference in Frankfurt. “The three-year facilities are there to be used.”

The cascade of cash has lifted sentiment in the euro zone, and may even help the region avoid a serious economic downturn. But it is not yet clear how banks are using the money, and whether they will spend it wisely. Some banks — no one knows how many — are bound to use it to cover up past mismanagement and books full of bad assets.

“It’s like taking medicine, it sometimes has side effects,” said João Soares, a partner at Bain & Company, the management consulting firm, who specializes in financial services. “One side effect that is not good,” he said of the central bank’s lending, “is that it removes pressure to clean up balance sheets.”

As the experience of Japan showed in the 1990s, zombie banks tended to keep lending to troubled borrowers to avoid recognizing losses from bad loans. As a result, the healthiest and most productive companies struggled to find credit.

“Zombie banks support zombie companies,” said Nicolas Véron, a senior fellow at Bruegel, a research organization in Brussels. “Zombie banks will not extend credit to borrowers that need it. This is bad for the economy.”

Mr. Véron said he believed the central bank was aware of the risks, but had no other alternative as long as governments like Italy or Spain were struggling to regain investor confidence.

“Banks need to be on life support even if it keeps alive zombie banks,” he said. “I’m convinced the E.C.B. has no illusions about the downside of this policy.”

The central bank intends for banks to use the money to lend to businesses and support the economy. That is especially crucial in Europe, where banks, rather than capital markets, are the main source of credit for corporations.

But analysts suspect banks are using much of the cash to buy government bonds. That would help explain why interest rates on Spanish and Italian bonds have plunged in recent weeks.

Borrowing from the central bank at 1 percent and using the money to buy bonds paying many percentage points more is a nice trade for the banks — as long as the issuers remain solvent. And it raises the chances that Italy or Spain will be able to continue servicing their debt, by holding down their interest payments.

Mr. Draghi argued Thursday that lower rates on government bonds would help businesses, too, by driving down interest rates for private borrowers. But he conceded it is not yet clear what banks are doing with the money.

“We are looking with great intensity at current developments to see if what we do makes a difference from the point of view of credit to the real economy,” Mr. Draghi said.

Jörg Rocholl, president of the European School of Management and Technology in Berlin, said there was a danger that the central bank cash would encourage weak banks to take outsize risks in a desperate bid to make up losses. They may load up on high-yielding debt from say, Portugal, when they should be reducing their exposure to government bonds.

In the academic world, the phenomenon is known as “gambling for resurrection.” Mr. Rocholl said: “Banks that are in a difficult situation don’t think about prudent loan decisions. They start to gamble.”

How does one distinguish a dead bank walking? Often it is impossible.

Speculation focuses on the usual suspects, like some of the German publicly owned institutions known as landesbanks, or the Spanish thrift banks called cajas. Banks in Greece, Ireland and Portugal have been on life support from the ECB for several years, though in some cases they would be solvent if not for the woes of their home governments.

Bank failures typically come as a surprise to outsiders. The Franco-Belgian bank Dexia passed an official stress test in July last year, three months before it required a government rescue.

Some experts say they do not think zombie banks are a serious problem, in part because regulators are pushing banks to raise the amount of capital they hold in relation to the amount of money they borrow. That pressure will eventually expose the weak banks.

“The banks that should really die postpone their deaths,” said Eduardo Martínez-Abascal, professor of financial management at the IESE Business School in Barcelona. “That would be the main problem, but in my opinion it is not a big one. Compared to the risks, it is rather small.”

“At the end of the day they will die, or be absorbed by bigger, safer banks,” he said.

The European Banking Authority said Thursday that banks were on track to raise 100 billion euros ($132 billion) in new capital by June, more than required. At the same time, the authority said it would not impose a stress test on banks during 2012, which will reduce pressure to restructure.

Even as economists and analysts fret about the possible distorting effects that the central bank cash could have on the banking system, most think the central bank had no choice, especially since most European countries do not have mechanisms for winding down sick banks.

Now, the onus is on governments to regain the trust of investors. That will automatically improve the health of banks by increasing the value of their holdings of sovereign bonds, which in many cases are enormous.

“We have come to a point we have never should have,” said Harald A. Benink, a professor at Tilburg University in the Netherlands. “But given the fact we have reached that point, we need to take unconventional measures.”

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