On Thursday, of course, arrived more details of the long-awaited European bank recapitalisation — we covered that specific part of the day’s outcome here, and mentioned that the EBA did its level best in the Q&A to quell worries that this would lead to widespread bank deleveraging and the ensuing crunch de crédit.
The language was tough and, to our eyes, vaguely threatening (emphasis ours):
Are you forcing banks to stop lending?
No. Some deleveraging is already under way due to the pressure on bank funding, stemming from the sovereign debt crisis. Therefore, a comprehensive policy response is needed to avoid a credit crunch and ensure continued lending to the real economy including SMEs. Sales of assets and refocusing the business model could be part of the bank strategies to achieve stronger capital positions. However, the process has to develop under close supervisory scrutiny: banks are required to submit to their respective national supervisors, plans detailing the actions they intend to take. In this respect, any deleveraging action will be done in an orderly fashion and under close scrutiny.
What will you do to avoid banks deleveraging in host countries?
National supervisory authorities, under the auspices of the EBA, will ensure that banks’ plans to strengthen capital do not lead to excessive deleveraging, including maintaining the credit flow to the real economy. They will take into account current exposure levels of the Group including their subsidiaries in all Member states cognisant of need to avoid undue pressure on credit extension in host countries or on sovereign debt markets.
Translation: we’re watching. (By the way, you might have noticed in the Q&A that contingent securities — the so-called “silent participations” favoured by the Germans — will count, but the EBA adds that it’s yet to work out the final details.)
Regardless, there seem to be at least a couple of issues here.
One is whether the levels of required capital raising — which will take place in an already challenging market, to be understated about it — will be enough to convince markets that the banks have enough to prevent contagion. We’ve written about a lot about this already, so before moving on let’s just say we’re not optimistic, especially given the uncertainty around eventual sovereign debt writedowns, and not just for Greek debt.
The second is whether the EBA and national supervisors can actually do much to stop the deleveraging, as they seem to be saying. We have no idea, but to the extent they can’t, the forced capital raising and, especially, whatever outright capital injections come out of this mess could make the problem worse in the short-term. And when the survival the eurozone itself is on the line, well, the short-term obviously takes on added significance.
This was the point FT Alphaville made a while back — that if recent history offers any clues, previous instances of mandatory capital infusions have accelerated the process of banks’ reducing risk-weighted assets.
We recalled the example of Japan circa 1998, when a combination of government-infused capital and mandatory capital requirements led to a surge in loan loss provisions. The irony then was that only once the Japanese government finally injected capital into the banks did the credit crunch actually begin, as it finally gave banks the wherewithal (and the mandate) to start writing down bad assets. And as we know now, the BoJ’s quantitative easing measures at the time were insufficient to stave off further deflation.
The moral of that story seems to be that the amount of capital forced onto the banks needs to be so overwhelming as to both sponsor the writing off of toxic assets and still have enough to be fortified against further shocks. And perhaps more crucially, that it helps a lot if such capital-raising happens during a period of strong economic growth.
Of course, we needn’t go back to late-90s Japan for another example of a banking system dropping RWAs en masse, though the lessons from this one appear slightly different:
In the US the Treasury Department morphed the October 2008 Troubled Asset Relief Program (TARP) from an fixed income asset buying program into a financial institution Capital Purchase Program (CPP). The US government purchased $250 billion of noncumulative, perpetual senior preferred shares plus warrants. This stabilized markets at the time, but the TARP came with strings such as executive compensation limitations, which helped to incentivize firms to issue common equity to repay the government. It also led to banks reducing risk. …
A significant raising of capital and/or a “de-risking” of balance sheets (reducing risk weighted assets) of banks tends to lead to a lack of credit growth, slower economic growth, and lower valuations on risky assets of all ilk. This has become quite relevant given the discussions in Europe over bank capital ratio increases, during which times banks have tended not to lend.
That’s from a recent note by Credit Suisse, which we’ve posted in the usual place and includes a host of other charts that show the change in total and risk-weighted assets in the US banking system since 2008. See again our point about economic growth above.
But there’s obviously something left out of this story.
A big chunk of the RWA “management” in the US unsurprisingly consisted of selling private-label MBS and, more recently, a steep decline in dealer holdings of corporate bonds. There was also a sharp initial fall in interbank and repo lending that later flattened off. But even as RWAs declined, total assets have actually stayed roughly flat since mid-2009 …
… as dealer holdings of agency MBS and US Treasuries holdings climbed.
You get no points for making the connection that the assets held on to by the banks are also what the Fed bought as part of QE. But you might get some points for noting that its efforts make the ECB — which met internal resistance when it bought Spanish and Italian bonds; forget about its contributing to whatever EFSF vehicle comes out this — look impotent by comparison.
There are, of course, some big differences between the US and European banking systems — most of them illustrating the more complex and fragile situation on the Continent. One difference is simply that leverage is much higher in Europe. Another is that the European bond markets are already so much more saturated with securities issued by financial institutions. Let’s not even get into funding issues.
Lest you accuse us of thinking the US official response has been appropriate, we’ll quickly acknowledge that Tarp sure as hell could have been implemented a lot better: it left us with an over-consolidated financial sector and made both the too-big-to-fail and moral hazard issue far worse.
And yet, the deleveraging of the US banking system would have been much worse without it — and also without the Fed staving off deflation and providing a price floor under the securities that banks held onto. (Yes, the causation runs both ways, probably, and there were other reasons why the Fed did what it did. Whether or not it should keep keep expanding its balance sheet at this point is a completely separate matter that we won’t get into.)
So none of this is an argument against forcing banks, over time, to hold a lot more capital. We think that’s rather a good idea (whether now or later, whatever economic effects we get from a drawn-out crunch du credit probably pale in comparison to another financial crisis). It’s simply to emphasise the extent to which this kind of pro-cyclical policy has inescapable consequences, and Europe is unlikely to avoid them, no matter what you heard yesterday.
Oh, and to close on an ever dourer note… when you see a list of options for a bank to improve its capital ratio, it typically looks like this:
1) Raise equity capital.
2) Have equity capital injected into it.
3) Reduce RWAs.
These are the options we’ve been discussing above. But we’ve seen a couple of reports — both in our own humble rag — of other, more creative options starting to percolate. Tracy Alloway and Sam Jones, last week:
Banks are striking deals with private equity groups, hedge funds and insurance companies in an effort to preserve their precious regulatory capital.
A growing number of investors is moving to provide beleaguered lenders with special targeted transactions to help them share their risks – for lucrative fees – through a fast developing class of “regulatory capital relief” funds.
And from a column titled “Banks turn to financial alchemy in search for capital”, by the FT’s US banking editor, Tom Braithwaite:
A senior executive at a third bank told me that it was scouring its balance sheet, looking for assets that could be structured differently to achieve lower risk weights. And, as the FT reported this week, hedge funds and insurers are actively involved behind the scenes, seeking new structures to buy or guarantee a slice of risk on banks’ books.
So by financial alchemy, assets can be transmuted from garbage to gold – and, therefore, require less capital. A senior regulator tells me officials are fully expecting various nefarious schemes to circumvent the rules, including structured transactions that do not reduce their risk but do reduce their RWA.
We’ll see how far this goes.
But if it becomes widespread, history might prove a poor guide to what happens next.