25 March 2012

Simon Nixon: Why Europe's banks trail in deleveraging process

Writing for the WSJ, Nixon compares the US banking system, which almost five years after the start of the global financial crisis has just been given a virtually clean bill of health, with the eurozone where much of the banking system remains on life support, and where lending growth is weak.

How does one explain such a marked divergence? The conventional wisdom is that the US was far quicker to tackle the problems in its banking system, recognising losses and injecting fresh capital, ensuring banks quickly regained investor confidence. But this doesn't give a complete picture. Parts of the eurozone banking system may still be undercapitalised and the market is putting pressure on banks to comply with the new Basel rules early. But it is hard to argue the recent European Banking Association stress test was too easy: Banks are required to hold 9 per cent core Tier 1 capital on a Basel 2.5 basis after marking sovereign bonds to market prices; the recent US stress test only required banks to hit a 5 per cent Tier 1 threshold on a Basel 1 basis—a far less demanding target.

Indeed, if one compares the capital strength of the US and European banking systems on a Basel 3 basis, they are very similar. The differences only emerge when one looks at total balance sheets. The ratio of tangible equity to total assets at US banks is around 6 per cent, almost double that of European banks. That reflects big differences in the composition of their balance sheets, with US bank assets considered more risky and therefore attracting higher risk weights under the Basel process than those of European banks. Of course, it may be those risk weights are wrong and that the entire Basel framework lacks credibility; the zero risk weighting for government debt is one frequently-cited anomaly. But unless one believes that all bank assets should be treated as identically risky, a comparison of total balance sheet leverage is not particularly helpful.

The question for European policy-makers is whether the European banking model is now permanently broken as a result of the crisis—as the US banking model was broken by the crises of the 1930s and 1980s. Or is the current refusal of markets to fund parts of the European banking system a temporary phenomenon that will pass once the sovereign debt crisis eases? There's some reason to hope the latter: While there is little correlation between bank capital ratios and funding costs, there is a strong correlation between the cost of bank funding and government funding. For example, BBVA, one of the best capitalised banks in Europe, must pay far more for bond market financing than Deutsche Bank, one of the eurozone's most thinly capitalised banks.

But what if funding markets don't recover? The ECB's Long-Term Refinancing Operations bought time, providing banks with cheap three-year loans to replace lost bond market financing. But if time doesn't prove a great healer, the eurozone will face unpalatable choices. It could try to create a US-style system, reducing high bank LDRs by encouraging far greater use of capital markets. But this may require the creation of euro Fannie and Freddie, surely a political non-starter. Or it could brace itself for a repeat of Japan's experience with banks continuing to deleverage until LDRs reach US levels—a process that could take six years and would require them to shed up to €4.5 trillion of assets, reckons Morgan Stanley. Or the ECB could continue to fund the shortfall with yet more LTROs. But that would mean the European banking system remaining in intensive care for years—and doubts over the health of the economy never fully going away.

Full article

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