Europe's banks retreat into mini-credit crunch

The Guardian carried an excellent article on the coming credit crunch in Europe.  This credit crunch was and still is entirely avoidable!

What it would take to stop the credit crunch in its tracks is for European policymakers and financial regulators to stop focusing on the completely meaningless, highly manipulated accounting construct known as bank book capital.

Instead, European policymakers and financial regulators should:

1. Require all Eurozone banks to disclose their current asset, liability and off-balance sheet exposures on an on-going basis;
2. End regulatory forbearance and have Eurozone banks write down their assets and off-balance sheet exposures to values that they could realistically obtain if the positions were sold to independent third parties; and
3. End cash bonus payments and all but a de minimus level of dividends until such time as the bank has retained enough capital so that it has positive book equity again.

The focus on bank book capital and a 9% Tier 1 capital ratio means that banks are not able to perform their critical safety valve function which keeps the excesses of the financial markets from effecting the real economy.

The focus on bank book capital and a 9% Tier 1 capital ratio does not answer the question that has been with us since the beginning of the financial crisis on August 9, 2007:  which banks are solvent and which banks are insolvent.

Solvency is a point in time calculation that looks at the market value of the bank's assets and compares it to the book value of the bank's liabilities.  If the difference between these two numbers is positive, the bank is solvent.  If not, the bank is insolvent.

As this blog has said repeatedly, a bank being insolvent does not mean that there will be a run on the bank by depositors.  As a practical matter, this will not happen because of the sovereign debt guarantee on the deposits.  For those countries where the sovereign is facing a restructuring, the solution is to guarantee the debt using the European Financial Stability Fund.

The reason we need to have disclosure is so market participants can monitor the risk at each bank.

Banks will still be able to originate loans.  For insolvent banks, these loans can be funded either with covered bonds or through the securitization market (a market that would reopen with current disclosure of the underlying collateral's performance).

It will take years for the banking system to earn its way out of the losses that it has incurred.  That is okay.

What is important is that by recognizing the losses in the banking system, the real economy can be restored to a path where growth can occur.  The FDR Administration proved that what I am proposing worked to get the financial markets functioning and the economy growing again during the Great Depression.

By not pursuing this alternative, the European policymakers and financial regulators are marching forward in lock-step group think.  They are purposefully choosing to sacrifice their poor at the alter of a false god - bank capital.

That is just wrong.  No matter what the economists say about how higher bank capital is a social benefit.

By not pursing this alternative, the European policymakers and financial regulators are purposefully choosing to plunge the European economy into a downward spiral.  Unfortunately, this downward spiral is likely to prove contagious to the US and Asia.

Crisis-hit banks in Europe have begun retreating into beggar-thy-neighbour lending policies in an echo of the protectionism that scarred Europe in the 1930s depression. 

Commerzbank, Germany's second largest bank, is to start refusing any loans that do not help Germany or Poland, sending a shudder through other Eastern European countries where the bank used to be a major lender. Its chief financial officer, Eric Strutz, said: "We have to focus on supporting the German economy as other banks pull out." 

On Tuesday, Lloyds Banking Group admitted it had pulled back its exposure to banking groups in the eurozone, while City analysts warned political and financial pressure would force European banks to retreat to domestic markets. 

Stuart Gulliver, chief executive of HSBC, said he was concerned Asia could suffer if European banks came under further pressure in what is being called the "mini credit crunch". 

"We need to be careful to monitor the risk of a sharp withdrawal of credit by European banks as a result of events at home," he said. 

BNP Paribas and Société Générale, two of the French banks most under pressure, have revealed plans to offload €150bn (£93bn) in assets, with Soc Gen planning sweeping cuts to its networks in Russia, Romania, the Czech Republic and Egypt....

Lloyds, which acquired HBOS in 2008, is closing down and writing off billions of pounds in loans it made to Ireland in a near-complete withdrawal from the country. Lloyds said its core capital ratio, a key measure of its financial strength, had risen to 10.3% from 10.1% in the last three months. 

Other than financial regulators, nobody cares... The lesson of Lehman Brothers and Dexia is that financial firms with high capital ratios can be insolvent!!!

Evolution Securities head of banking research Ian Gordon said: "Did Lloyds raise capital? No. Is it able to take capital from profits? No. It is raising its capital ratio by shrinking its assets, which fell from £383bn to £372bn. It's clear the focus of banks such as Lloyds is on shrinking the balance sheet, so it's inevitable that if they prioritise lending through Project Merlin, then they will have a reduced appetite for lending outside of the UK." 

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. 

John Beck, international bond manager at Franklin Templeton, which manages $300bn in bonds globally, warned of a return to the autarky – or economic self-sufficiency – of the 1930s, when countries came off the gold standard and each tried to devalue their currency against the other....

The effective closure of wholesale lending markets also means banks across Europe are much more dependent on raising money from domestic savers and corporates through their home branch networks rather than relying on interbank borrowing within the eurozone. 

"When resources are tight you shrink back to your strongest footprint. Other banks face similar choices," said Matthew Clark, analyst with City broker Keefe Bruyette & Woods. 

Banks across the EU are under instruction from the European regulator to amass capital to withstand further losses from the eurozone. But the European banking authority last week admitted the outcome could be for banks to withdraw loans, cut dividends and reduce bonuses. 

The shrinking of loan books – or "deleveraging" – would be a prolonged dampener on economic activity across Europe, said Gordon. "Several years of shrinkage are now inevitable."

THERE IS ABSOLUTELY NO REASON THAT THIS HAS TO TAKE PLACE.  THERE IS A BETTER ALTERNATIVE.