Almost out of the blue, a combination of diverse factors has elicited a run on bank stocks and junior and senior debt, raising the specter of a renewed systemic bank crisis within the European Union. The policy response cannot come from the ECB but, instead, must consist of regulatory responses capable of dispelling the uncertainty over future prudential capital requirements, relaxing the rules on state aid cum bail in that had ignited the crisis.
Of course, financial instability has multiple roots, from the slowdown of the Chinese economy, to the dire straits of the emerging countries, the fall in oil and commodity prices and its repercussions on the health of the financial system, and fresh fears (probably overplayed) of a new recession in advanced economies. However, the banking system, notably in Europe, suffers from specific weaknesses that have played an important role in the investors’ rout and are in part policy-induced. Bank profitability has taken a hard and durable hit from higher capital requirements imposed in response to the 2008 financial crisis, and there is still considerable uncertainty as to the impact of the ongoing review of risk-weighting models by Basel supervisors on regulatory capital. Quantitative easing and negative deposit rates at the ECB are squeezing returns even further, leaving thinner margins for meeting internally rising capital requirements over the coming years, which promises more share issues in capital markets. The equity of some large banks appear barely able to satisfy current prudential requirements, thus leaving insufficient room to restructure the stockpile of non-performing loans (NPLs, some 900 billion, out of which about 350 billion are held by Italian banks) and potential losses from large level-three (toxic) assets and derivative positions (especially in German and Swiss banks). This further feeds fears of bail in of bank creditors in case of large write offs eventually requiring injections of state funds.