Wednesday, February 29, 2012

ECB's cheap money preserves zombie banks

In a Telegraph article, Harry Wilson looks at the impact of the ECB's Long Term Refinancing Program and concludes that it kicks the problem of banks recognizing their losses on toxic assets into the future.

Actually, it is not the ECB's funding that kicks the problem into the future, but rather the choice by the Eurozone policymakers and financial regulators of implementing the Japanese model for handling a bank solvency based financial crisis.

What Mr. Wilson discovered is that unless financial regulators require banks to recognize their losses, they will not do so.  Why should they given the impact of these losses on their bonuses?

Under the Japanese model, not only are the Eurozone financial regulators not requiring the recognition of losses, but they are actively blessing banks hiding their losses on and off their balance sheets (see RBS's Stephen Hester's confession).
Last year a well-known senior former investment banker travelled around southern Europe’s troubled banks offering them a simple trade. 
He knew their balance sheets were stuffed with billions of euros of toxic loans. He also knew the banks could neither afford to finance these assets any longer, nor had enough capital to recognise the full-scale of the losses they would have to take to sell them. 
Meeting with the banks he offered to buy not the odd loan here and there, but their entire toxic portfolios. The catch: well he wouldn’t offer them the face value of the loans, not even close, but he’d pay enough that it would be at a level where the bank could take a manageable loss. 
Everything was going well until December when the ECB launched the first three-year long-term refinancing operation, or LTRO, which saw eurozone lenders borrow €489bn (£414bn) from the central bank at a 1pc interest rate. 
Almost immediately the banker’s calls stopped being returned and meetings were cancelled. 
Buoyed by the ECB’s cheap money, the impetus for the previously cash-strapped banks to offload their toxic assets was removed and they were now in a position to adopt a wait and see approach. 
I do not expect many people to feel too sorry for the banker, but what his story demonstrates is the profound effect the ECB’s LTRO borrowing programme, which today has lent a further €530bn to eurozone banks, has had on the recipients behaviour. 
Losses that might have been recognised sooner will now be taken later. Problems that were on the cusp of being dealt with have been bought off for at least the next three years.... 
Across Europe hundreds of banks open their doors every day only because of Mr Draghi’s intervention. These lenders may look like banks, call themselves banks, and, to their customers, feel like banks, but they are in reality wards of the ECB, going through the motions of banking.
These banks can make little impact on the real economy, and their main purpose in life is merely to survive and maintain the status-quo. They cannot afford to make loans and be the agents of Europe’s economic recovery as they remain too bloated with toxic debt and are, to all intents and purposes, insolvent.
Actually, Mr. Wilson is wrong here.  As shown by the US Savings and Loans in the late 1980s, banks that are for all intents and purposes insolvent can continue to make loans.  Call it gambling on redemption.  In the case of the Savings and Loans, they invested heavily in commercial real estate and junk bonds and had a significant impact on the economy.
In Italy, Spain, Portugal and many other European countries, small and medium-size lenders, and many larger banks too, have tens of trillions of toxic debt still on their balance sheets. 
The ECB loans have bought time to begin fixing these problems, but it is not a cure in and of itself. 
Unpalatable as it may be, the European banking system’s toxic debt burden will not begin to be solved until lenders are forced to make the scale of writedowns that banks in Britain and the US have done over the last four years.
Actually, as Stephen Hester confessed, the banks in Britain have not been require to take the write-downs necessary to solve the problem.
Be under no doubts, the European banking system remains broken at its core. The LTRO is merely the full body plaster cast hiding the cadaver inside.

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