This has been a major factor in the euro crisis. German Chancellor Angela Merkel's policies have been in major part designed to avoid public recognition and appropriate governmental action to address the weaknesses of the private banks.
Merkel's austerity policies are keeping the "periphery" eurozone countries in depression, which puts continuing pressure on the banking system, as well.
Here are some excerpts from Chapter 6, The financial system at a crossroads which addresses (my emphasis in bold):
Looking forward, high indebtedness is the main source of banks’ vulnerability. Banks that have failed to adjust post-crisis face lingering balance sheet weaknesses from direct exposure to overindebted borrowers and the drag of debt overhang on economic recovery (Chapters III and IV). The situation is most acute in Europe, but banks there have stepped up efforts in the past year. Banks in economies less affected by the crisis but at a late financial boom phase must prepare for a slowdown and for dealing with higher non-performing assets. (p. 103)
Key trends for banks include stronger capital positions and a reduction in risk-weighted assets (RWA). The sector has made progress in rebuilding its capital base primarily through retained earnings, supported by a recovery in profitability. This progress has not been uniform, however, as some banks (especially in Europe) remain under strain. The reduction in RWA reflected in some cases outright balance sheet shrinkage but in many others a decline in the average risk weight of assets. Given banks’ track record of overly optimistic risk reporting, the latter driver raises concerns about hidden vulnerabilities. (pp. 103-4)
Banks assign to their own sovereign a considerably lower risk weight than do banks from other countries. The “home bias” is particularly pronounced for Portuguese, Spanish and Irish banks and somewhat less so for French, UK and Austrian banks. (p. 108)
In the immediate crisis aftermath, banks in the hardest-hit economies pulled back from credit extension in order to nurse their balance sheets back to strength ... Subsequently, these banks’ lending to households remained flat, while that to the corporate sector declined, especially in Europe. Anaemic demand from overly indebted households and a weak economic recovery partly explain the stagnation of credit growth. But supply side factors also played a role. Banks with weak balance sheets were more reluctant to expand their activities ... (p. 111)
International banking conducted through local offices in foreign countries has proved to be more resilient than cross-border banking over the past five years. This is evident in the positive relationship between the share of locally conducted intermediation in a banking system’s foreign claims and the overall growth in these claims (Graph VI.5, right-hand panel). As a case in point, the foreign claims of Australian banks have increased markedly on the back of growing activity by offices in New Zealand and emerging Asia. Similarly, robust conditions in Latin America have allowed Spanish banks to increase their foreign claims, despite general pressure on European banks to reduce foreign lending in order to preserve capital for their home markets. (p. 113)
Despite post-crisis capital-raising efforts, doubts remain about the quality of certain banks’ balance sheets. More fresh capital has supported an upward trend in banks’ market capitalisation, both in absolute terms and relative to the book value of liabilities (Graph VI.8, right-hand panel, red lines). However, the capacity of capital to absorb future losses is severely undermined by unrecognised losses on legacy assets. Unrecognised losses distort banks’ incentives, diverting resources towards keeping troubled borrowers afloat and away from new projects. And as these losses gradually come to the surface, they raise banks’ non-performing loan (NPL) ratios. In the euro area periphery countries, NPL ratios have continued to rise, almost six years after the apex of the crisis (Graph VI.9, left-hand panel), while new lending has remained subdued. Similarly, banks in central Europe have reported stubbornly high and, in some cases, rapidly increasing NPL ratios since 2008 (Graph VI.9, right-hand panel). (p. 119)Tags: angela merkel, austerity economics, eu, euro, european union