COLUMN-Euro banks and the de-globalization of capital flows: James Saft

(The opinions expressed here are those of the author, a columnist for Reuters)

By James Saft

Feb 27 (Reuters) - Euro zone banks are increasingly reluctant to extend credit to banks in other euro zone countries, illustrating not just the growing strains on the currency union project but potential risks if events turn volatile.

Loans between euro zone banks in different countries fell by 6 percent in the year to January, according to European Central Bank data released on Monday, having hit their lowest since 2004 in December. Lending between banks in the same euro zone country rose 11 percent in the year to January, but an increasing unwillingness to take risks outside of one’s own country is a worrying sign.

The vast majority of the time, how banks finance themselves, and who will extend them credit, is not a matter of pressing interest. When it does matter, as in 2007 and 2008, it matters urgently. Monday’s data suggests not just that banks have their doubts about the health and stability of banking systems in places like Italy and Greece, but that they perhaps fear how their interests would be protected by euro zone governance if push comes to shove.

Cross-border loans between euro zone banks were down 6 percent year on year to 1.26 trillion euros.

“The entire future of Project Europe may be decided by elections in Holland, France, Germany and Italy within the next year,” Carl Weinberg of High Frequency Economics wrote in a note to clients, arguing banks will be cutting risks in the euro zone.

"After all, what bank wants to lend to borrowers in countries where grass-roots parties that want to dismantle Project Europe stand a non-trivial chance of winning national elections?”

A diminution of cross-euro-zone bank funding may well reflect just that, an uncertainty over who will be making and enforcing rules.

From a broader perspective, what is happening in the euro zone is reflective of broader global trends, just as many fear that Brexit and the election of President Trump may prove predictive of political developments in Europe. Cross-border lending and capital flows have been in contraction, on and off, since the great financial crisis, which taught many bankers, and bank regulators, that while their risks were global their control and government backstop were local.

Cross-border capital flows have fallen by 2.6 trillion dollars over the past two years, according to data from the Bank for International Settlements, or about 9 percent of global lending. While global cross-border lending grew 0.5 percent in the third quarter compared to the quarter before, this masked a marked drop in cross-border euro claims, according to the BIS.

DE-GLOBALIZING MEANS BUNKER BANKING

There are two angles to this story: what it shows, which is heightened perception of cross-border intra-euro-zone risks by banks; and what it may make more likely, which is a funding gap, or funding crisis, if events turn out badly.

On some level it doesn’t really matter if it is a banking crisis causing a euro crisis, or a euro crisis causing a banking crisis, things will be much harder to manage and risks harder to mitigate if banks don’t want to lend cross border even within the single currency zone.

“The reduction in cross-border lending makes the banking sector more fragile. And we know that after the global financial crisis in 2008, that willingness of banks to lend across borders declined significantly – something that amplified crisis conditions in the banking systems starved of foreign credit,” analyst Edward Harrison of Credit Writedowns writes. (https://pro.creditwritedowns.com/2017/02/the-re-nationalization-of-eurozone-lending.html)

“Now we are seeing the same thing happen within the euro zone. In the event that elections in the Netherlands, France, or Italy create financial turmoil, the balkanization of intra-euro-zone lending will make the potential for a real crisis that much greater.”

To be sure, the ECB has many tools with which to mitigate these risks. So too do national governments, and the European Union, if the will exists.

Yet the overarching trend is towards a self-reinforcing set of shocks, set off by the great financial crisis. First the crisis produces economic misery, which in turn produces strains in arrangements like those of the euro zone. Those may be papered over, as we saw in Greece, but the underlying sense of grievance sets the stage for populist or nationalist political programs, as in the U.S. and Britain. Awareness of this, and of the risks uncovered by the crisis, makes the banking system vulnerable.

The euro zone will likely make it through its upcoming elections intact, but its banking statistics do not indicate that the project is currently healthy.

(Editing by James Dalgleish) )