Bank for International Settlements confirms 9% Tier I capital target is driving EU credit crunch

As reported in the Telegraph, the Bank for International Settlements confirms that the EU financial regulators' policy of requiring banks to achieve a 9% Tier I capital ratio has lead to a credit crunch precisely when access to loans is needed to help the real economy rebound from the financial crisis.

Regular readers know that when this capital ratio target and Basel III was first announced your humble blogger predicted they would a) result in a regulator induced credit crunch and b) would not restore confidence in the banking system.

The BIS and the current deposit flight across the EU to Germany confirm I was right on both predictions.

The Bank for International Settlements (BIS) said cross-border loans fell by $799bn (£520bn) in the fourth quarter of 2011, led by a broad retreat from Italy, Spain and the eurozone periphery. 

Lending to banks in the eurozone fell $364bn or 5.9pc, with drastic reductions of 9.8pc in Italy and 8.7pc in Spain. 

The BIS's quarterly report said the decline in lending was "largely driven by banks headquatered in the euro area facing pressures to reduce their leverage". 

Banks must raise their core tier one capital ratios to 9pc by the end of this month or face the risk of partial nationalisation. The global Basel III rules are also pressuring banks to retrench. 

It is not just EU financial regulators who have adopted policies that are creating a credit crunch.

The International Monetary Fund said banks will have to slash their balance sheets by $2 trillion (£1.6 trillion) by the end of next year even in a "best-case scenario". 

This could reach €3.8 trillion if Europe mishandles the debt crisis. 

Tim Congdon from International Monetary Research said regulators were making a grave mistake by forcing banks to cut lending during a slump. 

"What they are doing is frightening. If banks shrink their balance sheets, it destroys money. It causes a credit crunch and intensifies the recession. This is why we are facing a global slowdown," he said. 

Alastair Clark, a member of the Bank of England's interim Financial Policy Committee, said last month that regulatory pressure may have gone too far, "inadvertantly" causing banks to restrict credit.

Actually, regulators could not possibly have adopted a worse response to the financial crisis.

On the one hand, regulators engaged in forbearance and allow banks to hide losses on and off their balance sheet.  On the other hand, regulators require banks to achieve higher capital ratios.

The easily predictable results are that the banks refuse to make new loans (hence, the credit crunch) and sell of the performing loans on their balance sheets (lowering their risk weighted assets and boosting their capital ratios).

This leads to a situation where it is easier for a zombie borrower to access credit than a creditworthy borrower.

It also leads to a situation where the assets in the banking system are becoming increasingly toxic.

The BIS said French banks slashed their cross border assets by $197bn, and German banks cut by $181bn. The figures mostly predate the effects of the European Central Bank's liquidity blitz over the winter, which has had the effect of "Balkanizing" Europe's banking system. Analysts say the pace of withdrawal has since quickened.