Keeping an Eye on Banks

Banks. They’re so easy to hate. And yet they’re so important to the functioning of the economy. If the euro crisis is going to have a significant impact on the US, the channel through which it will do so is the banking sector. We’re not in a full-fledged banking crisis, but the signs of stress are real, and growing.

Return of the credit crunch: caught in the grip

Banks are the traditional suppliers of credit – to governments whose debt they hoover up; to rivals through interbank lending; to companies, from sole traders to corporate behemoths; and to individuals. Banks provide the oil needed to run the economic machine; without that lubrication the machine seizes up. But to carry out that role, the banks themselves need money. And that is where the whole model is breaking down.

…As fears over the integrity of the eurozone have deepened, European banks have found it expensive, difficult or in some cases impossible to raise funding in the bond markets. So far they have covered barely two-thirds of the amount of outstanding funding that falls due in 2011. For most banks, the bond markets have been closed for months.

…The few banks that have plenty of money are holding on to it, or depositing it with super-safe institutions such as the US Federal Reserve or the ECB. That means the third key mechanism for bank funding – interbank lending – is also drying up.

…The nervousness surrounding many European banks is rooted in fears about losses they face, particularly on their sovereign debt holdings. Bankers recognise the concerns but complain that the effect is being compounded by regulators’ insistence that the banks should meet tough new capital ratios. The European Banking Authority, which oversees bank regulators across the continent, has identified a total €106bn ($143bn) gap at 70 banks that it stress-tested for their exposure to eurozone sovereign debt. Rather than raise fresh capital in turbulent equity markets to bridge that gap, many are opting instead to shrink their balance sheets and comply with the capital ratios that way.

Regulators, policy-makers, and most observers agree that in order to boost confidence in the banking system (as well as to reduce the odds of a major bank going bust), many of Europe’s banks need to increase their capital ratios, which is the amount of core capital they have to work with divided by the amount of loans they have made. But there are two ways to get to a higher capital ratio: by increasing the numerator, or by decreasing the denominator. Bankers argue that given the amount of capital they currently have, calls to increase their capital ratios force them to reduce their lending activities and shrink their loan portfolios. But that is exactly the opposite of what policy-makers intended, of course: the hope was that banks would maintain their portfolios of loans while raising more capital.

In the absence of specific, enforceable requirements that banks meet capital ratio requirements by raising more capital, there’s no reason to expect Europe’s banks to reverse the current tendency to try to meet capital ratio targets by reducing the size of their loan portfolios. After all, it’s expensive to raise capital, and the current ethos of risk-aversion means that extending new loans is not at the top of the list of things that banks want to do. The depressing similarities with the events of 2008 continue…

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