Here’s the “massive cover-up” in Europe’s ridiculously large banking sector

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Here’s one reason why the future of Europe’s economic growth looks so bad. It still has way too many banks—or rather, too much banking.

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As you might guess by the tiny countries at the extreme left of this chart, having a banking system that’s laughably larger than your country’s entire economic output is not exactly a plan for long-term economic success. (Iceland’s banks defaulted setting off a massive currency collapse back in 2008. The Irish government—which took on ballooning debts of its banks during the crisis—would have defaulted if it didn’t get a bailout from the European Union.)

But why is that bad exactly? Aren’t banks a good thing? Don’t they lend lots of cash to people who want to buy houses and start businesses?

Not really. Overbanking means there’s not enough profitable business to go around. As a result, banks then compete is by making riskier loans or operating on skimpy beds of capital—or in the case of many banks, both. The shortness of capital means that as banks accumulate bad loans, they’re reluctant to declare them. So instead they “evergreen” the loans—continually restructuring them, pushing out the payback dates. That makes the banks look healthier but creates an inefficient banking system, as it ties up capital in those loans that could otherwise go to healthy companies that could generate growth. That’s what some people think has been happening in Europe. As Citigroup economist Willem Buiter said back in May:

Unlike the American banks and to a certain extent the British banks, Europe did not recognize—continental Europe—the [losses of our]  banking system in the earlier crisis. There has been a massive cover-up, evergreening… lender forbearance made possible by regulatory forbearance of the forbearing lenders. And it has been sort of conspiracy of obfuscation.

So that’s why excessively big banking systems are bad. But shrinking them is a problem too. To do that you have to deleverage, either making the banks sock away a larger cushion of cash or cutting the amount of loans and investment they are making. (Or again, both.) That too is a massive headwind for economic growth, because bank credit is part of the fuel that makes the capitalist engine roar, or at least meow a bit. But there’s no alternative: banks, and the economies, will have to take the pain.

And the remaining bad news is that the impact won’t be confined to Europe. The IMF reckons that European banks need to dump some $4.5 trillion worth of assets through 2013. A lot of the assets to be dumped will be in the emerging markets, where European banks had been big investors ahead of the financial crisis.