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Investor trust in European banks has dwindled, first, in light of the economic and financial crisis, then the European sovereign debt crisis, and with it the worsening economic outlook. As tightening refinancing conditions for European banks span out of control in summer and autumn 2011, the European Council agreed on a set of policy measures to address the pernicious triangle of sovereign debt, banking system health and economic growth. Of all measures, the European Banking Authority’s (EBA) recapitalisation exercise became the far most contested. Fears of a European-wide credit crunch, fuelled by banks shrinking their balance sheets, became policy priority number one.
In this column, authors Heiko Hesse, Claus Puhr, Stefan W Schmitz and Ralph Spitzer investigate balance-sheet growth, capitalisation and deleveraging of European banks since the end of 2008 and show that based on existing empirical evidence, banks have so far reduced their leverage (i) markedly and (ii) mainly by raising capital rather than reducing exposure to the real economy. In doing so, banks have been able to address two concerns at the same time: One related to their fundamental soundness (“banks are undercapitalised”), the other related to potential harm done to the economy at large (“banks are causing a credit crunch”).
The authors define deleveraging as the reduction of leverage, i.e. a decrease in banks’ total-assets-to-capital ratios. Banks can achieve it by raising capital and/or shrinking total assets. Moreover, they refer to excessive deleveraging as a contraction of lending to the real economy to achieve deleveraging, such that creditworthy non-financials (companies and households) are credit constrained.
Hesse et al believe that banks’ choice is less between deleveraging and non-deleveraging, than between orderly and disorderly, excessive deleveraging. Without deleveraging, bank funding markets would be unlikely to stabilise, especially following the eventual unwinding of ECB liquidity measures, which would result in even greater and potentially uncontrolled deleveraging by banks. It is also to be welcomed from a financial stability angle.
Thus, restoring confidence and securing access to sustainable funding markets is a necessary precondition for the sustainable supply of loans to the real economy. So far, the deleveraging process was driven by increases in capital and reserves, as well as a reduction of external assets and non-Monetary Financial Institution shares, but not by the reduction of intermediation to the eurozone real economy. Unless a tail risk scenario materialises, the authors expect this trend to continue for the near future. Both the evidence from banks’ disclosure and considerations concerning relative pricing power and franchise value point in this direction.