Credit conditions in the euro area’s periphery continue to deteriorate. Despite the recent marked improvement in banks’ funding positions, highlighted by the large-scale LTRO repayments in January, loans to non-financial companies in the periphery contracted, on average, by 6.8%Y/Y in January. In July, before ECB President Draghi came to the single currency’s rescue, bank lending in the periphery was “only” down by 4.5%Y/Y.

Of course, without the ECB’s intervention and recent moves to restructure the Spanish banking sector, the situation would have been incomparably worse. Indeed, the ECB’s latest bank lending survey suggests that access to market funding and banks’ liquidity positions are no longer restraining credit flows in a meaningful way. Since September peripheral banks have issued €34bn in new bonds, more than three times the amount of the previous six months.

Despite these improvements, credit remains unduly expensive, choking economic recovery. In January, Spanish and Portuguese firms had to pay an annual effective rate (AER) of 6.9% and 6.0% respectively for a new loan with a maturity between one and five years – barely less than six months ago. In Germany, by contrast, rates for an equivalent loan came down by 50bps to 3.5% over the same period.

This divergence in lending rates is likely to reflect continued pressure on bank deposits in the periphery. Although signs of a deposit flight have generally eased in the wake of the ECB’s bond-buying plan, private deposits in Spain were still down by more than 8% in January compared to a year earlier. In Portugal, the pace of deposit flight has continued to accelerate, from -6.2%Y/Y in July to -10.3%Y/Y in January.

This has forced peripheral banks to retain exceptionally high deposit rates. While German banks are currently offering 0.9% for short-term household deposits, Spanish banks in the past six months had to pay, on average, 2.8% to compensate for the lack of confidence in the domestic banking sector. Amid exceptionally high unemployment, falling house prices and prolonged recessions, non-performing loans (NPLs) have continued to increase in the periphery, eating into banks’ capital provisions.

In Spain and Italy NPLs now account for more than 10% of total outstanding loans. And delinquencies will undoubtedly continue to rise as the recession extends throughout 2013 and into next year. Peripheral banks also remain more leveraged than their peers in the core. At the end of 2012, non-bank loans accounted for 132% of non-MFI deposits in Italy and 111% in Spain, compared to 96% in Germany.

All of this suggests that confidence is unlikely to return over coming quarters in the absence of new initiatives to place periphery banks on a more sustainable footing. And given the costs that such moves could imply for governments, more robust and credible steps towards a true banking union – which would potentially socialise some of those costs across the euro area – are in order.

But euro area leaders have mistakenly retreated from their previous commitment to break once and for all the vicious bank-sovereign nexus. Pleased with the recent improvement in market sentiment, German finance minister Schaeuble said that he wants to limit the ESM’s scope for future direct bank recapitalisations to €80bn – hardly enough to restore confidence, not least as troubled legacy assets will remain on national governments’ balance sheets.

Large-scale direct bank recapitalisation, however, would only be one, albeit important, pillar in a true banking union. A common resolution framework and a true euro area-wide deposit insurance scheme – not just a harmonisation of standards as currently discussed – would arguably be of even more importance for resolving the current credit crunch, which will otherwise continue to impede the periphery’s recovery from the crisis.

The impact of the new initiatives would likely be potent. Pressure on bank deposits would ease rapidly following the launch of a common deposit scheme, allowing banks in the periphery to align their deposit rates more closely with those of their peers in the euro area’s core. Lower deposit rates, meanwhile, should further reduce peripheral banks’ funding costs, increase the scope for cuts in lending rates and thereby help to stimulate loan demand, which is essential for investment and job creation. And by fostering a more homogenous transmission of monetary policy across member states, it would also ease the ECB’s task of maintaining price stability.

But, perversely, unless pressure in financial markets re-emerges, none of this will happen. So, once again, it will be up to the ECB to fill the void of government inaction. And this might come sooner than expected. Indeed, despite Draghi’s more cautious tone last week, Governing Council member Liikanen this week suggested that the ECB is considering implementing additional non-standard measures to reduce funding costs for small and medium-sized companies. But the initial failure of the Bank of England’s Funding for Lending Scheme to prompt a recovery in lending in the UK suggests that this will be no panacea.

So, just as the 2010 physics Nobel prize winner Andre Geim hoped that “astrophysicists find a huge cosmic rock on course to hit Earth in 50 years” for mankind to develop the new knowledge and technologies necessary to safeguard our planet’s future, renewed turmoil in euro area financial markets – say, prompted by fears of an Italian exit – might well prove to be the single currency’s cosmic rock that finally forces policymakers to put in place the necessary policy framework – including a true banking and fiscal union – required to safeguard the single currency’s future. Sadly, however, whether countries in the euro area core, in particular Germany, would be willing to embrace such closer political integration at a time when Italy looks ungovernable must be in significant doubt.

Tobias S. Blattner
Euro area Economist