So long as regulators focus on bank capital levels, no avoiding credit squeeze in EU

So long as regulators focus on meaningless bank capital levels, there is no avoiding the credit squeeze in the EU and the resulting damage to the real economy.

This is exactly what your humble blogger predicted and current experience in the EU confirms.  It is also why your humble blogger keeps pointing out that policy-makers and regulators could choose not to damage the real economy and instead could allow Wall Street to rescue Main Street.

Modern banking systems are designed so that banks can absorb the losses on the excesses in the financial system without effecting their capacity to support the real economy.  Specifically, the combination of deposit guarantees and central bank liquidity protects banks ongoing operation and makes them capable of supporting the real economy even when they have substantial negative book capital levels.

A Reuters' article describes how the focus on bank capital levels is hurting the real economy.

Europe's banks are aggravating the region's economic woes by rapidly adopting tough new rules for capital, raising the risk they will have no money left to lend to companies and support economic recovery. 

Bloated with risky loans and bad debts, banks are slashing their assets, but this has so far failed to convince investors, hurting the banks' ability to source the capital they need to lend to credit-starved customers.

First, as the OECD observed, current bank book capital levels are meaningless.  Given the suspension of mark-to-market accounting and regulatory forbearance, bank book capital is overstated.  So it is not surprising that higher capital levels are failing to convince investors.

Second, banks do not need capital to lend.

"The genie is out of the bottle. Banks are hellbent on shrinking balance sheets so that they can then start to focus on running their businesses rather than spending time dealing with regulatory matters," said Chris Wheeler, analyst at Mediobanca. 

The unintended consequences of the regulatory clampdown were flagged this week by the International Monetary Fund, which warned that deleveraging will squeeze credit availability in the euro area by 1.7 percent over the next two years. 

If economic conditions worsen, credit availability could contract by a further 4.4 percent, the IMF said.

Unintended, but as your humble blogger has shown, completely predictable consequence.

Italy, Spain and other weak economies in the euro zone - already grappling with slowdowns and huge budget deficits - will be hit hardest, while companies in stronger countries like Germany enjoy a surplus of willing lenders. 

Stringent new capital rules known as Basel III to be phased in from next year are hitting banks even harder than many in the industry had first feared. 

Lenders across the region have curbed new lending to focus on offloading toxic or non-core assets - reducing the denominator of the capital over assets ratio - in the hope of maintaining the confidence of fickle capital markets.

Non-core assets yes, toxic assets no.  It is only performing non-core assets for which there is a market.  No one wants the toxic assets at the price the banks would be willing to sell at.  At the price the buyers are willing to pay, the loss of capital by the banks more than offsets the benefit to the capital ratio from selling the asset.

But the banks still have to reduce assets by 30 percent if they cannot raise new capital - or a staggering 13 trillion euros - according to Ruediger Filbry, head of banking practice in Germany at Boston Consulting. 

Most analysts predict a more modest, but still painful, reduction of assets - a process known as deleveraging - of around 3 trillion euros of loans, or 5 to 7 percent of assets. 

Adding to their woes, Europe's banks don't have time on their side. By June, the European Banking Authority has demanded that they boost their capital by 115 billion euros. 

"(Regulators) are asking banks to do contradictory things. They are asking them to reduce their assets, rebuild capital and increase lending all at the same time. It's just an impossible cocktail," said John McNeill, investment manager at Kames Capital. 

"The combination of Basel-type regulation, with that of domestic regulation, has exacerbated the credit crunch."...

The IMF and the EBA have said they would prefer banks to raise fresh capital to recapitalise. But that's unlikely in the current environment, with sluggish returns for investors offering no incentive....

Actually, it is unlikely that investors will have any significant interest in buying new bank capital securities until the banks provide ultra transparency and disclose their current asset, liability and off-balance sheet exposure details.  Market participants need this information if they are to independently assess the risk of each bank.

In the absence of ultra transparency, banks are 'black boxes'.  So investing in new bank capital securities is just blindly betting.

Another problem is that the assets the banks are managing to off-load are typically the higher-quality ones. That leaves them stuck with more troubled assets that they need to sort out later, potentially increasing the "tail risk" of the crisis.

As predicted, it is the higher quality assets that the banks can sell.  This leaves the banks with the more troubled assets and increases the riskiness of the gamble to invest in them.

This cycle is self reinforcing.  The higher the capital levels the regulators require, the more high quality assets the banks sell.  The more high quality assets the banks sell, the riskier the banks become.  The riskier the banks become, the harder it is for them to raise capital from investors.  The harder it is to raise capital from investors, the more high quality assets the banks have to sell.

Not only is the cycle self reinforcing, but it is also damaging to the real economy.  When banks are busily selling their high quality assets, they are not busy making new loans or dealing with the bad assets on their balance sheet.

It is the latter two activities that benefit the real economy.  New loans is self explanatory.  Working through the bad assets ends any price distortion that is caused by not previously recognizing the losses.

"What is good and rational for the few may be disastrous for the many - deleveraging an over-extended institution or country works when there are those able to take up the slack but doesn't if everyone does it at once," Douglas Flint, Chairman of HSBC told a conference this week.

The bottom line:  so long as global financial regulators focus on bank capital levels, there is no avoiding the credit crunch and the resulting damage to the real economy.