The looming crunch de crédit | FT Alphaville

The looming crunch de crédit

Whatever happens in the eurozone this week, banks will have new capital ratio targets. They are not going to raise enough actual new capital to meet them.

Ergo they flip the ratio and start burning off risk-weighted assets.

They are going to sell loan books in extremis, it will cause a credit crunch, (already occurring of course) and deflation will ensue as the supply of money falls. Even the hard-money nuts at the ECB have to launch QE.

That argument, and these charts and bullet points via James Ferguson, banking analyst at Arbuthnot Securities (emphasis ours):

• Higher capital requirements, in the absence of fresh capital, necessitate asset contraction

• Forced ‘haircuts’, all other things being equal, also require contraction of assets

• Recapitalisation of an undercapitalised banking system will, over the intermediate term, merely fund the necessary asset contraction, just as it did in Japan (1998), the US and the UK (2008)

Ferguson’s Japan 1998 example is verrry interesting in particular.

Naturally, after the big bust of 1989, Japanese banks had already been lending nothing at all, because they lacked capital to write off existing bad loans, i.e. credit limbo and a “Japan premium” for borrowers in the interbank market, because no one knew when the losses would come.

(Parallels to the post-2008 secured-unsecured fragmentation of the eurozone interbank market? Just a bit we think. There’s even the same “gamble for resurrection”-type packaging of risky assets for funding, in the hope that the economy will recover faster than your lenders will catch on. We’ve seen lenders catch on to eurozone banks’ dollar assets.)

Roll on 1997 and 1998. Most of Asia of course finds itself in prolonged sovereign crisis, with one country after the next getting taken out and lenders in even the advanced economies of the region feeling the pinch. Ferguson argues this is what happened next:

However, following several large bankruptcies during the 1997 Asian Crisis recession, the government injected mandatory capital (0.4% of GDP) across all banks in March 1988. The following month, ‘prompt corrective action’ was introduced directing that internationally-active banks hold at least 8% capital to RWA (though ‘capital’ was very liberally interpreted), conduct adequate provisioning and exercise write-offs to a minimum standard. This is exactly along the lines of the euro zone proposals now being decided on.

Once Japanese government officials had had a chance to go through the banking sector’s books, a further 12% of GDP was set aside in October of that year to recapitalise solvent banks or nationalise failed ones. By March 1999, another 1.5% of GDP had been applied for by major banks, whilst LTCB and NCB had been nationalised. Crucially, it was only once taxpayer-funded recapitalisation began, that bank lending in Japan started to contract because it was only then that the imperative to repair balance sheets was combined with the fresh capital required to fund the whole exercise. The implications for Europe’s banks and hence her economy are clear.

So, it was the provision of additional capital in Japan that initiated bank balance sheet repair by facilitating the acceleration in loan loss provisioning, which went from 1% in 1997 to 2.5% in 1998. That set the stage for a sustained period of elevated loan losses and loan asset contraction that didn’t end until 2005. Loan contraction once begun, it would appear, will run its course. Throughout this period, broad money supply (M4) contracted. Japan’s CPI, which slumped below zero in 1999, stayed resolutely and intractably in mild deflation, despite or perhaps because of Japan’s half-hearted attempts at the money printing version of QE (Japan’s version of QE mainly consisted of boosting bank reserves, which has no impact on broad money supply).

Now, Richard Koo, Nomura’s chief economist, might argue a bit differently on the Japan 1998 point, we suspect. Koo also talked Japanese bank recapitalisations in a recent note on the eurozone. Japan’s problem was that banks refused the terms of government injections of capital for too long (the “bank examiner’s recession”). However, once capital injections were sorted, the credit crunch was shorter than it might have been — chart via Nomura:

But Koo’s basic point is in agreement, i.e. a credit crunch from banks selling assets to meet capital targets = Europe’s biggest danger. The solution is to simply chuck no-strings capital at banks. This will not happen in any conceivable political context, of course.

So, ECB QE. Back to Ferguson:

In a fractional banking system, the way money supply is created is through initial bank lending and then the workings of the money multiplier. When banks cease making new loans, money supply growth stops; when they start demanding the repayment of existing credit, the process goes into reverse and money supply is destroyed. To prevent deflation (defined as a contraction of nominal broad money supply) Japan, the US and the UK were all forced to carry out QE, thereby keeping money supply from shrinking, at least in the latter two cases. There is no reason to believe that the euro zone won’t be forced to react in the same way when faced with the same problem, at least once the ECB repo rate has first been cut to (near) zero. From a rate differential point-of-view, we believe this bodes extremely well for the value of the US$ against the euro over the next few years.

In terms of central bank action… while the impact of European banks selling assets is a huge issue for their lending to emerging markets (a subject for another post in itself) naturally there are those US dollar assets as well.

Too much of a coincidence that the Fed is considering buying MBS again?

Full note in the usual place.

Related links:
Struggling French banks fought to avoid oversight – WSJ
ECB said to weigh bigger loans for banks revealing more on loan collateral – Bloomberg