Banks deleveraging in a liquidity crisis

What’s at stake: A combination of factors seems to converge to create an important wave of global liquidity withdrawal with potential important consequences for economic activity. One can trace the origins of this new leg of deleveraging to the European debt crisis and to the on-going European bank recapitalisation effort. Both issues have either not been addressed or have been addressed in the wrong way and are therefore self-reinforcing elements of the crisis that is now dragging the European economy down.

Banks deleveraging

In an open letter to EU leaders, Finance Watch called on European leaders to urgently make bank deleveraging the subject of supervision in order to protect the supply of credit to European businesses and households. Expectations of higher bank capital requirements and a mark-down of sovereign debt may lead to a shortfall in European bank capital reported to be in excess of € 100 billion. Large banks are expected to shrink their way to compliance rather than raise equity at current low prices, raising the prospect of a significant credit contraction at a time of weakening economic growth.

Brad Delong notes that in September 2007, George Akerlof and Peter Diamond pointed out that while each individual bank didn't care at the margin whether it reduced its leverage by shrinking its assets or raising its capital, the rest of us collectively had a mighty interest that they raise their capital. If Wall Street banks reduce their euro risk now the net risk-bearing capacity of the private market will be diminished, and that in the current situation a reduction in the market's risk-bearing capacity widens spreads and is contractionary. What Washington should be doing right now is saying: We will bear some of the eurorisk, and we – as your regulators – require that you raise more capital so that you can cope with and bear the rest.

Mark Carney - Governor of the Bank of Canada and new Chairman of the Financial Stability Board – argues that the current European bank recapitalisation plan for instance will have dramatic effects on global liquidity. The new requirement to raise core Tier 1 capital to 9 per cent by next June can be met through a combination of retained earnings, capital increases and asset sales. In the extreme, if only asset sales were used, up to €2.5 trillion of disposals would be required in coming months. Based on last year’s earnings and assuming no dividends are paid, the lower bound for asset sales would be €1.4 trillion.

Deleveraging and contagion to the core

Michael Derks at fxpro argues that the shrinkage on the assets side of bank balance sheets that has now been unleashed that is the true source of this latest bout of contagion in European bond markets. Europe's banks are now either selling assets in bulk (ergo government bonds and other securities) and/or have decided not to reinvest once assets mature and/or have decided to reinvest coupons into safer bonds such as Bunds and Gilts. Many banks are selling eurozone bonds not only because they need to for capital adequacy purposes, but also because they fear that some of these sovereigns will soon suffer ratings downgrades, potentially of many notches.

Free Exchange argues that the liquidity problem for banks is at least somewhat mitigated by the fact that the ECB accepts European government bonds at relatively generous haircuts. However, as Mr Davies and Jag Yogarajah write in a BNP Paribas note, the banks have no certainty that the ECB will continue with its policy to accommodate any financial need of banks. In the absence of encouraging refinancing perspectives, they “use the balance sheet” for that purpose. That means deleveraging: that is, selling of assets, which in turn will contribute to further liquidity strains.

Felix Salmon writes that the ECB is facing a dual liquidity crisis: not only within the European banking system, but also at European sovereigns. James Macdonald puts in historical perspective the liquidity problems that European sovereigns face. Before World War I, countries considered borrowed on terms that are unrecognizable nowadays. The vast majority of their debts were in the form of perpetual annuities, where the government was committed to paying a fixed interest, but principal was repaid only when the borrower chose to do so. In 1900, for example, France had a public debt amounting to 105% of GDP; but over 96% of it was in the form of perpetual annuities, and less than 4% in the form of short-term Treasury bills. Therefore the country’s annual funding requirement was only 4% of GDP. Since those halcyon days, however, western governments have raised their debts on a far shorter-term basis. It is quite normal nowadays for public debts to have an average maturity of 5-6 years. This means that France, with a public debt of 86% of GDP, now has an annual funding requirement equivalent to over 20% of GDP. The result is that the sovereign borrowers that the markets have been accustomed to think of as “risk-free” have become a little similar to banks. Their credit may be considered investment grade, even triple A, but in the end it is dependent on the continued confidence of their creditors.

Deleveraging and the European recapitalization efforts

The EBA in a recent a Q&A session tried to quell the worries about a large deleveraging taking place as a result of the design of the recapitalisation plan. It argued that deleveraging was already in train but that thanks to the current plan, each national supervisor would monitor the plans of its banks and avoid disorderly deleveraging that could lead to a credit crunch. But this approach misses the point that national regulators will certainly approve all plans that shelter national lending at the expense of others. Eurointelligence furthermore reports that according to Frankfurter Allgemeine Zeitung, European banks are worried that the current ad hoc stress tests will lead to higher additional capital requirements than the initially announced €106bn. The main reason for this worry is that the EBA will no longer allow to offset potential losses banks may have realized with their holding of Italian government bonds with gains on German bunds.

Bloomberg BusinessWeek writes that banks in Europe are undercutting regulators' demands that they boost capital by declaring assets they hold less risky today than they were yesterday. The practice, known as “risk-weighted asset optimization,” allows banks to boost capital ratios without cutting lending, selling assets or tapping shareholders. Regulators in Europe, seeking to stem the region's sovereign-debt crisis, ordered banks last month to increase core capital to 9 percent of risk-weighted assets by the end of June. Lenders, facing a 106 billion-euro shortfall, are reluctant to plug the gap by cutting dividends or bonuses and are struggling to sell assets or raise cash in rights offerings. Politicians are trying to stop banks from the alternative, cutting back lending, because it could trigger a recession. European firms, governed by Basel II rules, use their own models to decide how much capital to hold based on an assessment of how likely assets are to default and the riskiness of counterparties. The riskier the asset, the heavier weighting it is assigned and the more capital a bank is required to hold.

Beggar-thy-neighbor lending policies

Here is the city warns that political and financial pressure will force European banks to retreat to domestic markets. The retreat to home turf marks a U-turn from the early years of the euro, when cross-border mergers were common and Brussels envisaged a single pool of capital and liquidity to match the single currency. But already the syndicated loans market, in which banks make joint cross-border loans to corporate borrowers, is shrinking rapidly.

Erik Berglof sees risk that the current crisis could not only threaten the monetary union but also gains from financial integration and cross border banking in Europe. Although, the institutions to deal with coordination problems and systemic risks have been strengthened (ESRB, EBA), relationships between parent and subsidiaries, home and host countries could be challenged by the new round of deleveraging. All of this requires coordination. The European Banking Authority has a chance to establish itself. It must ensure that national interests do not undermine the integrity of the cross-border bank groups. Ultimately, we need a Europe-wide deposit insurance and bank-resolution authority that can take over and restructure failed banks.

The ECB Monthly bulletin highlights the challenges for European banks’ medium to long term funding which will become more prevalent with the implementation of Basel 3. The ECB sounds concerned that country specific rather than credit specific differentiation augmented and is likely to become a persistent feature of the banking landscape and could challenge financial integration and the transmission of monetary policy across countries.

*Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.