BIS confirms that financial regulators create instability

In a Financial Times article, the Bank for International Settlements (BIS) observed that financial regulators created instability in the Eurozone with their requirement that banks achieve a meaningless 9% Tier I capital ratio by the end of June 2012.

Regular readers know that financial regulators are a source of financial instability and your humble regulators described the capital ratio target as an example of this when the regulators announced it.

Calls by European regulators for banks to hold more capital exacerbated concerns over the health of the eurozone’s financial sector and led to fears of a squeeze in lending to businesses and households, the Bank for International Settlements said on Sunday. 

The BIS, often referred to as the central bankers’ bank, said the requirement, announced last October, for the region’s largest banks to buttress their capital buffers and raise their tier one capital ratios to 9 per cent by June of this year had destabilised the system by bringing fears of a drop-off in lending and a rise in asset sales “to the forefront of financial market concerns”.

It is nice to have confirmation that the regulators' action destabilized the system.

The 9% Tier I capital target did not just bring fears of a drop-off in lending and a rise in asset sales, it caused both of these to occur.

The funding strains that emerged in the second half of last year had “fuelled fears that European banks would be forced to sell assets and reduce lending, thereby weakening real economic activity”, the BIS said. 

The new regulatory measures had “added to those fears”. 

Eurozone banks sold assets and cut some types of lending, notably those denominated in dollars and those that attracted higher risk weights, in late 2011 and early 2012....

The BIS, which houses the Basel Committee on Banking Supervision, the body responsible for the far more stringent Basel III supervisory framework, has led calls for banks to hold more capital in the wake of the global financial crisis. However, under Basel III, banks would have been given more time to meet the additional requirements in full. 

The BIS praised the EBA’s statement in December that explicitly discouraged banks from shedding assets to meet the 9 per cent capital target. It also applauded the European Central Bank’s move to provide additional liquidity to the financial system through its two three-year longer term refinancing operations, which took place in December and at the end of last month and have provided more than €1trn of loans to banks in the region. 

I wonder what, if any, impact the 9% Tier I capital ratio requirement had on the ECB's decision to implement the Long-Term Refinancing Operation.  Was the banks shedding assets, including loans and sovereign debt, to shrink their balance sheets a factor?

The LTROs were, according to the BIS, behind the recent recovery in asset prices, bank funding conditions and the revival of activity in credit markets....

“The EBA explicitly stated that actions by banks to meet the capital requirements that impact lending to the real economy would not be allowed before the end-of-June deadline. Plans submitted by banks to meet the requirements are still being assessed. The process is ongoing,” a spokesperson for the EBA said.

Naturally, the banks have paid no attention to the notion of not cutting back on lending to the real economy as part of reaching the 9% Tier I capital ratio.

Lending cuts by European banks focused primarily on new syndicated and large bilateral leveraged and project finance loans. 

Lending for project financing and loans for trade, aircraft and ships declined more sharply for banks with less capital than for stronger lenders. 

European banks also cut lending to emerging markets, with consolidated foreign claims on emerging Europe, Latin America and Asia falling in the third quarter of last year.