Demonstrators hold placards and demand their money back during a protest outside the headquarters of Bankia SA in Madrid, Spain. Image Credit: Angel Navarrete/Bloomberg

Dublin: An accelerating flight of deposits from banks in four European countries is jeopardizing the renewal of economic growth and undermining a main tenet of the common currency: an integrated financial system.

A total of €326 billion (Dh1,5 trillion) was pulled from banks in Spain, Portugal, Ireland and Greece in the 12 months ended July 31, according to data compiled by Bloomberg. The plight of Irish and Greek lenders, which were bleeding cash in 2010, spread to Spain and Portugal last year.

The flight of deposits from the four countries coincides with an increase of about €300 billion € at lenders in seven nations considered the core of the euro zone, including Germany and France, almost matching the outflow. That’s leading to a fragmentation of credit and a two-tiered banking system blocking economic recovery and blunting European Central Bank policy in the third year of a sovereign-debt crisis.

“Capital flight is leading to the disintegration of the Eurozone and divergence between the periphery and the core,” said Alberto Gallo, the London-based head of European credit research at Royal Bank of Scotland Group “Companies pay 1 to 2 per centage points more to borrow in the periphery. You can’t get growth to resume with such divergence.”

The erosion of deposits is forcing banks in those countries to pay more to retain them - as much as 5 per cent in Greece. The higher funding costs are reflected in lending rates to companies and consumers. The average rate for new loans to non- financial corporations in July was above 7 per cent in Greece, 6.5 per cent in Spain and 6.2 per cent in Italy, according to ECB data. It was 4 per cent in Germany, France and the Netherlands.

Some of the decline in deposits is because German and French banks are reducing their exposure. They cut lending to their counterparts in the four peripheral countries plus Italy by $100 billion in the 12 months ended March 31, according to the latest data available from the Bank for International Settlements. ECB data count interbank lending as deposits, as well as money being held for corporations and households.

Banks in the core countries also have been reducing their holdings of Spanish, Portuguese, Italian, Irish and Greek government bonds. At the same time, lenders in the periphery have been buying more of their own governments’ debt. That has further contributed to the fragmentation of credit along national lines, as banks collect deposits from people and companies in their own countries and lend internally.

Organizations such as the International Monetary Fund have warned about the danger of such fragmentation. Financial disintegration along national lines “caps the benefits from economic and financial integration” that underlie the common currency, the IMF wrote in an April report.

The disintegration can fuel a cycle of deteriorating economic conditions and weakening banks, said David Powell, a Bloomberg economist based in London. The more banks pay for deposits the less profitable some of their businesses are, he said. A Spanish lender that borrows at 4 per cent from depositors and is limited by Europe-wide interest rates to charging only 2.5 per cent for a mortgage is losing money.

“The financial divergence is a symptom of the underlying economic divergence, but they feed on each other, making it harder to break out of,” Powell said. “Until companies and individuals are convinced that the euro will survive, they won’t invest in the periphery, and that will keep funds away.”

The ECB has taken the place of depositors and other creditors who have pulled money out over the past two years, largely through its longer-term refinancing operation, known as LTRO. The Frankfurt-based central bank was providing €820 billion to lenders in the five countries at the end of July, data compiled by Bloomberg show. Irish and Greek central banks loaned an additional €148 billion to firms that couldn’t come up with enough collateral to meet ECB requirements.

Because central-bank financing is counted as a deposit from another financial institution, the official data mask some of the deterioration. Subtracting those amounts reveals a bigger flight from Spain, Ireland, Portugal and Greece. For Italian banks, what appears as a 10 per cent increase is actually a decrease of less than 1 per cent.

When financing by central banks isn’t counted, the data show that Greek deposits declined by €42 billion, or 19 per cent, in the 12 months through July. Spanish savings dropped €224 billion, or 10 per cent; Ireland’s €37 billion, or 9 per cent; Portugal’s €22 billion, or 8 per cent.

The pace of withdrawals has increased this year. Spanish bank deposits fell 7 per cent from the beginning of January through the end of July, compared with a 4 per cent drop the previous six months. The decline in Portuguese savings accelerated to 6 per cent from 1 per cent, while Irish deposits fell 10 per cent compared with almost no change in the last six months of 2011.

Banco Santander SA, Spain’s largest bank, lost 6.3 per cent of its domestic deposits in July, according to data published by the nation’s banking association. Savings at Banco Popular Espanol, the sixth-biggest, fell 9.5 per cent the same month.

Eurobank Ergasias, Greece’s second-largest lender, lost 22 per cent of its customer deposits in the 12 months ended March 31, according to the latest data available from the firm. Alpha Bank, the country’s third-biggest, lost 26 per cent of client savings during that period.

The ECB data include items such as deposits by securitization funds that Spanish banks say they don’t rely on for financing their businesses. Household and company deposits nationwide are stable if financing from instruments such as commercial paper sold to retail clients is included, Banco Bilbao Vizcaya Argentaria said in a September 4 report.

Irish Banks

Irish government officials and bank executives say deposits at three government-backed banks have stabilized after almost three years of outflows. Bank of Ireland Plc, the largest lender, saw its customer deposits rise by 11 per cent in the year ended June 30, according to regulatory filings. Ireland also hosts dozens of foreign institutions that use Dublin as an offshore base to benefit from lower tax rates and whose movements of funds would show up in the ECB’s Irish data.

Ireland nationalized almost all of its domestic banks in 2010, forcing them to recognize losses on real-estate lending, and injected 63 billion euros to keep them alive. Spain has resisted a similar cleanup that could cost several hundred billion €s, according to some estimates. After agreeing to 100 billion €s of potential assistance from the EU in June, the Spanish government still hasn’t decided how much of that to tap or what to do with its troubled lenders.

Plugging Holes

ECB cash may have plugged holes at lenders that otherwise would have had to sell assets at fire-sale prices as they lost private financing. The aid didn’t prevent funding costs from rising for the rest of the banks’ borrowing, including deposits.

While Italian lenders arrested the decline in deposits this year, they paid a high price to do so, with average deposit rates jumping 50 per cent to 3.1 per cent in July from a year earlier, ECB data show. That’s more than the 2.4 per cent paid by Spanish banks, whose deposit wars were halted by a rate cap last year. Those limits were lifted last month, and Spanish firms have begun raising interest rates on deposits again.

The average deposit cost at German banks in July was 1.5 per cent. Two years ago, Italian and German deposit rates were the same, at 1.3 per cent.

Loan Pricing

The difference in funding costs is reflected in loan pricing. Italian rates on consumer loans of less than one year, at 8.2 per cent on average, exceeded even those in Greece and Portugal, ECB data show. Spanish consumers had to pay 7.3 per cent to borrow from their banks, compared with 4.5 per cent for German borrowers.

Another blow to financial integration is the localization of borrowing and lending. Units of German, French and Dutch banks in Spain, Italy and other peripheral countries also borrowed from the ECB to reduce the need for funds from their parent companies. Deutsche Bank, Germany’s largest bank, said last week it had cut the reliance of units on financing by the Frankfurt-based firm 87 per cent through ECB loans.

While the largest banks say they’re protecting themselves against currency redenomination in case a country leaves the union, such moves help exacerbate divisions between the periphery and the core. A locally financed Deutsche Bank unit can’t make loans that reflect the cheaper funding sources of its parent in Germany.

By taking over the financing of weak banks, the ECB is in effect bailing out their creditors in the core, according to Edward Harrison, an analyst at Global Macro Advisors, an economic consulting firm in Bethesda, Maryland. If Irish or Spanish lenders burdened with losses from their nations’ housing busts were allowed to fail, German and French banks would lose money on loans to financial institutions in Europe’s periphery.

The ECB’s latest plan to buy the sovereign bonds of some countries will continue the trend of bailing out German and French banks, Harrison said.

“The leaders of the core countries won’t let the periphery countries write down their debt because then they’d have to capitalize their own banks losing money from those investments,” Harrison said. “This is a good backdoor bailout of their banks, but it still doesn’t solve the solvency issue of Spain or Italy.”

The rescue shifts default risk from private shareholders of core banks to the ECB and, in effect, to euro-area taxpayers. When Greece restructured its debt earlier this year, so much of it already had been transferred to the public that losses by European banks outside Greece were cut in half. Because the ECB and other government lenders wouldn’t take any losses, the debt load wasn’t reduced enough to make it sustainable.

The ECB’s offer to purchase Spanish and Italian government bonds - if those countries ask for help and agree to conditions imposed in exchange for the assistance - would reduce yields, which have fallen in expectation of the move. Still, the purchases won’t bring down borrowing costs for companies and consumers in those countries because banks will continue to pay higher rates for their funding, according to RBS’s Gallo.

Unlike in the US, where the Federal Reserve’s buying of securities in 2009 and 2010 brought down mortgage rates immediately, there isn’t as strong a connection in Europe between bond yields and loan rates, Gallo said.

Increased funding costs for Italian banks are purely a reflection of the sovereign’s borrowing costs, not weakness in the banking system, according to Bank of Italy Deputy Director General Salvatore Rossi. When Italian government-bond yields decline, banks’ funding costs should too, he said.

“Our banking system was in good shape before the crisis,” Rossi said in an interview in New York. “If the spread goes down, credit-market conditions would ease, contributing to halt a vicious cycle, which is hampering economic activity.”

That spread, the difference between the yields of Italian sovereigns and the German bunds, fell to 342 basis points yesterday from a high of 536 in July. One basis point is 0.01 per centage point.

While Italian banks are affected by their government’s debt overhang, some increased funding costs result from a rising level of bad loans, Gallo said. The ratio of nonperforming loans to total lending in Italy has almost tripled since 2008 to 5.6 per cent in May, Italian Banking Association data show.

European Union leaders have acknowledged the dangers of a two-tiered banking system, which is accentuated by deposit flows from south to north and diverging borrowing costs.

“We cannot pursue price stability now when we have a fragmented euro zone,” ECB President Mario Draghi told European lawmakers September 3.

Draghi has said that the central bank’s plan to buy sovereign bonds addresses the divisions. Euro-area leaders also have responded by attempting to establish a banking union. Shared deposit guarantees, a central regulator and a resolution mechanism for bad banks backed by common funds from member states could reduce concerns that customers will lose money when lenders fail, halting the deposit shift from south to north.

The European Commission unveiled its proposal for such a banking union last week as directed by leaders in June. The commission is initially focused on a centralized supervisor, with other elements such as the deposit guarantee to come later.

Even the supervision proposal has generated controversy. While there’s agreement the ECB should play a key role overseeing banks, EU members are divided about how it will interact with national regulators and the scope of its powers.

Germany, which spent about 50 billion € to rescue its failed lenders in 2008, has opposed placing all banks under ECB supervision. At an EU finance ministers’ meeting in Cyprus last weekend, Germany was joined by the Netherlands in warning against a hasty move toward central supervision, while non-euro members such as Sweden criticized the plan for not protecting those outside the common currency.

While a banking union is seen as a first step toward a more fiscally united euro zone, getting there will be politically challenging and take longer than initially envisioned, according to Alexander White, European political analyst at JPMorgan Chase & Co. in London. Euro-area leaders had called for the establishment of a central supervisor by January, a date which now looks unlikely, White said.

“We’re still left with very big political questions about who pays for all this, how the backstops work and so on,” White said during a conference call with clients last week. “The proposals are going to be quite difficult for quite a lot of member states. It’s going to be a difficult road ahead.”