Despite ECB's efforts, Europe heads into credit crunch created by the bank regulators

According to a Bloomberg article, Eurozone banks are now depositing almost all of the money borrowed under the ECB's 3 year financing program back with the ECB.

For regular readers, this is no surprise as it was predicted on this blog.

• The Eurozone interbank lending market is frozen.  No banks trusts in the solvency of any other bank.

• At the same time, Eurozone banks are shrinking so they can meet the 9% Tier I capital ratio target set by the regulators.  One look at what happened to UniCredit, off 60+% when it raised capital, is more than enough to encourage management to find other alternatives, including shrinking the loan portfolio, for hitting the capital ratio.  The result is a credit crunch.

In Europe, we have a situation where not only is monetary and regulatory policy not coordinated, but it is actively working against each other.  Monetary policy is trying to promote growth while regulatory policy is limiting access to the loans needed for that growth.

I don't want to single Europe out as somehow unique.  In the US, the Fed oversees both monetary and regulatory policy.  

The Fed could require banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details (no ultra transparency, no access to myriad Fed programs).  The requirement of ultra transparency would trigger banks realizing the losses currently hidden on their balance sheets.  

This includes their losses on residential real estate.  Once the losses are recognized, the banks then have an incentive to pursue one of the courses of action laid out in the White Paper on the housing industry Chairman Bernanke sent to Congress.

As Chairman Bernanke pointed out, until the housing industry is addressed, the full benefits of current monetary policy will not be achieved.

Banks are hoarding the European Central Bank’s record 489 billion-euro ($625 billion) injection into the banking system, thwarting attempts by policy makers to avert a credit crunch in the region. 

Almost all of the money loaned to 523 euro-area lenders last month wound up back on deposit at the Frankfurt-based central bank instead of pouring into the financial system, ECB data show. 

Banks will use most of the three-year loans to meet their refinancing needs for this year and next, analysts at Morgan Stanley and Royal Bank of Scotland Group Plc estimate. 

“It’s illusory to think that the measure will translate into credit generation,” Philippe Waechter, chief economist at Natixis Asset Management in Paris, said in an interview. “It will assuage some of the anxiety banks have regarding their liquidity needs. But they’ve engaged into a massive overhaul of their strategy and shrinkage of their balance sheets, which is, coupled with the deteriorating economy, not compatible with increasing credit.”...

Governments are urging European banks to keep lending to companies and individuals while requiring them to raise an additional 114.7 billion euros of core capital by June to weather a deepening sovereign-debt crisis. 

Instead of raising equity, most lenders across Europe have vowed to meet capital rules by trimming at least 950 billion euros from their balance sheets over the next two years, either by selling assets or not renewing credit lines, according to data compiled by Bloomberg.... 

Banks account for about 80 percent of lending to the euro area, making them “crucial to the supply of credit,” according to recently installed ECB President Mario Draghi. By contrast, U.S. companies rely more on capital markets for financing, selling bonds to investors.

The ECB lending, and a follow-up loan offering on Feb. 28, won’t ease the pressure on banks to shrink, say analysts including Huw van Steenis at Morgan Stanley in London. 

“The ECB loans will largely be used to pre-fund 2012 and some of 2013’s bank refinancing needs, but it will not stimulate lending,” Van Steenis said. They will “just stop it falling off precipitously.”... 

With the ECB’s injection, “deleveraging may happen in a more orderly way, but it doesn’t mean it will be painless,” said Alberto Gallo, head of European credit strategy at RBS. Banks are faced with high long-term financing costs, a deteriorating economy and difficulties raising capital, he said. “It’s what I call the double punch: A combination of negative growth and banks’ deleveraging will affect lending activity.” 

Even the ECB’s Draghi, who has made it one of his priorities is to keep credit flowing into the economy, said the central bank’s loan offerings may fail to achieve that goal. 

“Monetary policy cannot do everything, but we’re trying to do our best to avoid a credit crunch that might come from a lack of funding,” Draghi said Dec. 19 at the European Parliament in Brussels. “We have to be extremely careful here, because there may be other reasons that create a credit crunch.”...

“The ECB loans are a kick-the-can measure that doesn’t fix the banks’ structural problems,” Gallo said. “Deleveraging needs to happen.”