Bankers are not stupid. For all the controversy surrounding the financial sector, everyone can agree on that. For decades banks have shaped their businesses to maximise profits, given the regulatory rules that exist at the time. And when the rules change, smart bankers change what they do.
New rules being introduced for European banks make huge swaths of traditional bank lending unprofitable, partly mimicking the regime that has been in place in the US for many decades.
If Europe’s banks responded by reshaping their business to resemble their US rivals’ then bank lending in Europe would collapse, from €45tn to €15tn. That is an extreme scenario but the risk of even modest moves in this direction should alarm policy makers. It would dwarf the €1tn or €2tn of quantitative easing rumoured to be coming from the European Central Bank this year.
It has been more than 25 years since the first international banking rule book, known as Basel I, decreed that banks could extend more mortgages for a given amount of capital, making mortgage lending much more profitable. Fifteen years later, Basel II increased the profits to be made by lending to the strongest corporate customers. Bankers quickly set to work selling more mortgages and corporate loans.
In Europe, where regulators enthusiastically embraced these new rules, banks now hold assets equivalent in value to three times the size of the economy. In America, where regulators stuck to simpler (and generally harsher) rules, banks hold assets that are about on a par with the size of the economy. Before the Basel rules were introduced in the late 1980s, the American and European banking sectors looked more or less the same.
It is not that American consumers and companies now have far less debt than Europeans. Rather, American leverage rules meant it was not attractive for banks to do the lending.
Banks account for only one-third of personal and corporate lending in the US. Most mortgages are effectively financed by the US government, via the Freddie Mac and Fannie Mae finance agencies. Unsecured consumer loans come from the asset-backed securities market and mutual funds. Companies finance themselves in the bond market. None borrow much from banks.
Which brings us to the latest update of the banking rule book, known as Basel III. Thanks to the new leverage rules, the profitability of European mortgages will now fall by about two-thirds, while the profitability of lending to the strongest corporate customers will fall by three-quarters. Smart bankers will curb their enthusiasm for both activities.
© Financial Times
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