Regulators as source of financial instability: bank de-leveraging risks exporting Europe's slump

In what can only be described as a case of the regulators generating financial instability, a Wall Street Journal article documents how the Eurozone's regulators focus on banks achieving a meaningless 9% Tier I capital target is causing havoc in the financial markets.

European banks have only just begun a huge process of deleveraging, but already concerns are being raised about the potential heavy impact on global economic growth. 

As part of its current "capital exercise"—a mini-stress test of sorts—the European Banking Authority will announce in the next week or two exactly how much capital the region's banks need in order to maintain a ratio of 9% of core Tier 1 capital relative to risk-weighted assets by the middle of next year....

But with almost all major bank stocks trading below their book value, capital is very expensive to raise on the markets, and most governments don't have the resources to inject fresh funds. A generous definition of capital is also not available in this instance, and the retention of dividends and bonuses will only go so far. 

Facing these hurdles, one sure way for banks to bring capital ratios up to 9% is to reduce assets. 

Analysts from Morgan Stanley estimate banks may need to shed up to €2.5 trillion. 

In normal times, banks could do that by selling some of their vast portfolios of securities and other assets. But today, too many of those securities are trading below their book value, and selling them would realize losses that would eat into regulatory capital. Analysts at J.P. Morgan note that BNP in its third-quarter earnings raised the cost of shedding €70 billion of risk-weighted assets to €750 million from an initial estimate of €400 million. 

As J.P. Morgan argues, the impact of such disposals will be even greater if everyone is doing it at the same time. The temptation will instead be for banks simply not to renew existing credit lines, and to refuse to extend new loans. 

Already, banks have scaled down their lending to governments through the bond markets, and the resulting rise in the cost of debt has hurt the credibility of one sovereign borrower after another. 

But a reduction in credit to the real economy could start its own destructive cycle: the more banks cut lending to the real economy, the more likely their remaining exposure is to turn sour, due to the aggregate drop in liquidity. 

The Institute for International Finance, a financial-industry lobbying group that has opposed higher capital requirements, estimates overall credit to the euro area would need to contract by 5% if banks were to rely only on capital conservation to reach the desired ratio. An acute recession, comparable to 2009, could be the result. 

This is the kind of scenario that Europe has been trying to escape for the past three years, and one that governments will be desperate to avoid having on their own turf. That reflex, of course, was responsible for the ill-coordinated policy responses at national level in 2008. With luck, the memory of that will ensure deleveraging plans are drawn up within the context of the European economy, rather than national ones, but there is no guarantee of that yet. For example, U.K. or French banks may guarantee credit availability at home by throttling back on clients elsewhere in the EU. 

The region most at risk, according to Morgan Stanley, is Central and Eastern Europe, where Western European banks account for three-quarters of the banking system. Given that many countries in the region have twin current-account and budget deficits, their main protection is their own economic linkage with the western half of the continent, and the memory in Western European capitals of the cost of political instability—in the Balkans, above all.... 

A report at the weekend by the BIS's Committee on the Global Financial System underlined that the liquidity created by banks far outweighs that provided by central banks in normal times, and that the flow of such private liquidity is highly pro-cyclical—that is, it dries up just when the economy stumbles. Emerging-market central banks may have to react aggressively to alleviate the shortage of liquidity caused by a withdrawal of European finance, a difficult proposition when overheating has been the bigger threat until recently. 

But if central banks in emerging markets have a responsibility to help keep the deleveraging process orderly, how much responsibility will fall on the European Central Bank? 

Euro-zone banks have €1.7 trillion in debt maturing over the next three years, says Morgan Stanley, and refinancing that will be impossible without some form of further backstops. As the market has lost faith in sovereign guarantees, some form of extra protection from the ECB may well be needed.