Another long summer is ending for European banks. Despite reassuring European Banking Authority stress tests, the euro area banking system remains under pressure. The problem of non-performing loans in peripheral countries is increasing the sector’s capital needs. Italy’s Monte dei Paschi is a case in point, but certainly not the only one.

Since early 2016, the European Union’s ‘bail-in regulations’ have sent shockwaves through the market. European bank stocks have declined by 30% on average, with a further collapse following the UK vote to leave the EU. By contrast, the market as a whole has lost only 10% of its value; the heavy downturn due to the UK vote has been countered by solid growth in the oil and gas and industrial sectors.

A negative confluence of regulatory uncertainty, more than two years of ultra-low interest rates and a high level of non-performing loans has resulted in a credit crunch that has hampered the manufacturing sector’s ability to recover, often in an environment in which the bank lending channel was the only means of funding small and medium enterprises.

This credit crunch has been reflected in a sizeable decline in the amount of disbursed loans and a spike in borrowing costs, decimating the SME manufacturing base in peripheral countries, particularly Italy. The impact on the European corporate sector has been less severe.

Nevertheless, positive developments have begun to surface in the ECB data. An initially weak recovery of loans to the non-financial sector is gathering pace, while interest rates on new loans are falling steadily, especially in southern Europe.

The data from the last five years confirm a narrative of decline and recovery, though this has been substantially confined to peripheral countries – for example, loan growth was stronger in Italy than Germany in the first half of 2011. However, the tide quickly turned as confidence surrounding the sustainability of Italian debt collapsed in mid-2011.

Loans continued to contract in subsequent years as austerity policies weighed on aggregate demand. The pace of the decline in lending to the non-financial sector reached a record low of 7% year-on-year in December 2013.

In Germany, lending volumes continued to rise until the end of 2012. This trend was only briefly disrupted during the European recession of 2013-14. But even in that year German total loans only fell by 2% year-on-year, a considerably milder decline than in Europe’s periphery.

The credit collapse ended in mid-2014 when the ECB, following a period of sustained inertia, decided to actively fight the credit crunch by launching its targeted long-term financing operations programme. The programme guaranteed European banks a broad base of cheap liquidity to be mandatorily lent to the non-financial sector.

Despite this support and further unconventional monetary expansion programmes, including quantitative easing, the credit recovery did not take off immediately. In Germany, the amount of financing to businesses continued to contract until May 2015. In Italy, it persisted until November 2015.

The credit recovery has strengthened further in Germany in 2016 (annual growth stood at 2.9% in July 2016), but there has been no equivalent pick-up in Italy. Growth has fluctuated around the zero mark in the most recent data (+0.2% in June, -0.1% in July), though the 2016 trend has been mildly positive.

The divergent nature of the credit recovery was also present in the case of interest rates. Following years of relative co-movement, the explosion of the sovereign debt crisis led to a rapid rise in the cost of bank loans in peripheral countries in June 2011. In Italy, rates on new loans rose by around 1 percentage point in just over six months.

The spread on corporate loans widened further as interest rates in Germany began a long descent, with rates on government debt eventually turning negative. This was mirrored in the corporate bond sector, benefiting German industry. The volume of loans in Italy continued to fall until mid-2014, and rates were 1.6 percentage points higher than German rates on average over the period. This acted as a financial penalty for Italian companies competing in terms of cost in the European market.

The ECB’s shift in policy in June 2014 was a game-changer, setting in motion a clear trend towards convergence of interest rates on new loans to the non-financial sector. At least for the euro area as a whole, the convergence process to German rates can be considered almost complete, with a negligible difference between the euro area average and rates in Germany.

However, a significant spread of more than 0.3 percentage points persists in the case of Italy, while not all the new data look rosy. According to a study by Centre for Economic Policy Research, around a fifth of new loans  to the Italian non-financial sector is supplied to ‘zombie’ enterprises with little prospect of making a profit, following political interests. This means that these loans carry a high risk of non-repayment, reinforcing a vicious cycle that drags the economy down.

Euro area peripheral countries appear to be exiting a four-year credit crunch with some shadows remaining.