The law of unintended consequences: Why European banks are sacrificing growth

In an interesting article, Bloomberg confirms that to achieve a meaningless 9% Tier I capital ratio not only are European banks shrinking by selling their best assets, but their risk is going up at the same time because they continue to hold their problem debt exposures.

Under pressure from regulators to bolster capital, European banks are selling some of their fastest-growing businesses to competitors from outside the region. The sales may leave them better able to withstand financial stress—and less able to boost future profits....

The inability to boost future profits of course makes the banks less attractive as an investment which in turn limits their ability to tap the capital markets for equity - a decidedly negative unintended consequence of the current push for higher capital ratios.

Such sales are an unintended consequence of the decision by European regulators to make banks increase capital—a buffer that protects against credit losses—to help them survive the worsening sovereign-debt crisis.... 

To reduce their reliance on the markets for funding, banks across Europe have pledged to cut assets by more than €950 billion over the next two years, according to data compiled by Bloomberg. 

About two-thirds of that will come from sales of profitable units and performing loans, says Huw van Steenis, aMorgan Stanley (MS) analyst in London. 

While it may be hard to get premium prices for those businesses in a crisis, other options for raising money are even less appealing. 

Lenders don’t want to issue additional shares because their stock prices are too low: The Bloomberg Europe Banks and Financial Services Index is down 33.5 percent this year. 

Exactly who would want to buy these shares given the current lack of disclosure?  Banks are a black box.

Selling troubled loans is also problematic. If the banks accept the low prices investors are willing to pay, the lenders would have to record losses on the loans, and those losses would erode their capital. As a result, distressed assets and souring loans will account for just 4 percent of asset reductions over the next two years, according to van Steenis. 

That leaves selling entire business units outside of their domestic markets. These are the most profitable parts of their business,” says Azad Zangana, European economist at London-based Schroders (SHNWF), citing Spanish and Portuguese banks selling assets in Latin America. 

“You begin to become a less profitable organization. Your business model stops working if you’re being forced to lend only to an economy that’s going through a very deep recession.” 

By shedding some of their best assets, the sales may make banks less stable. “Lenders are selling more liquid assets so they can get a price that avoids additional capital losses,” says Joseph Swanson, co-head of restructuring at Houlihan Lokey in London. “Unfortunately, this strategy can result in lower asset quality and increased earnings volatility.”... 

“When you sell an asset, there are always two sides of the coin,” says Stephane Leunens, a spokesman for KBC. “We focus on de-risking the company while trying to generate sufficient growth in our core markets.”...

Analysts say the banks are in a bind. “If they raise capital by selling crown jewels, the market will reward them in the short term because they’ll meet the regulator’s time frame,” says Will James, who runs the SLI European Equity Income Fund at Standard Life (SLFPF) in Edinburgh. The longer-term question, he adds, is “How do you grow in an environment where customers are unwilling to borrow? That’s the missing piece from the puzzle. In a low-growth or no-growth environment, banks that have sold good assets will continue to struggle.”