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Banks crippled by loss-making loans can't generate enough earnings to meet ever-rising regulatory capital targets, let alone generate capital to support new lending. And banks that can't generate an economic return on equity and offer no prospect of revenue growth tend to be valued at well below book value, making it very hard for them to raise equity. Worse, bond markets tend to be wary of lending to banks that can't increase their revenues or raise equity, often forcing banks that can't borrow from the markets to rely on central-bank facilities. And since central banks tend to be reluctant to lend long term, that puts banks under pressure to accelerate their deleveraging plans to reduce their need for market funding, which hurts the economy and therefore undermines the credit-worthiness of the entire loan book, putting more pressure on capital ratios.
This is the vicious spiral that now threatens large swaths of the European banking system—not only in those countries that experienced the biggest booms such as the UK, Spain and Ireland, but also in those that didn't experience a housing bubble but where borrowing costs have risen dramatically as a result of the crisis, such as Italy.
Regulators are struggling to find a response. Their initial response consisted of tough love: encouraging banks to write down problem loans and boost their capital ratios. But this only deepened the economic downturn. More recently, central banks have tried to soften the impact of bank deleveraging by offering longer-term central-bank facilities such as the ECB's Long-Term Refinancing Operations and the BOE's Funding for Lending Scheme. But these facilities only last for three years, whereas mortgages can have maturities of 20 years or more. That is why when Ireland was devising its bank bailout, it initially requested a 10-year ECB funding facility but was refused. But that request fell on deaf ears: central banks rightly fear that if they offer such long-term funding there would be little incentive for banks to restructure broken business models.
One option is to remove these performing but unprofitable assets from bank balance sheets altogether; Irish state-owned Permanent TSB is to transfer its books of unprofitable mortgages to a bad bank as part of its bid to return to private ownership. This may prove to be the template for one final cleanup of the Irish banking system, according to someone familiar with the situation. Spain may partially follow Ireland's lead. Its new state-backed Asset Management Company may buy some performing assets from bailed-out banks to help them comply with ECB-agreed funding plans, according to someone familiar with the process. Meanwhile, UK authorities now appear to be contemplating a radical new approach that would have them abandon capital-ratio targets in favour of setting a minimum amount of capital that banks must hold. This approach would force banks to raise fresh equity while offering them incentives to use the new capital to boost lending.
But these solutions require the active support of governments. Only governments can change the rules to force banks to write down the value of performing loans or disgorge them to state-backed bad banks. More importantly, the gamble at the heart of both approaches is that you can crush existing shareholders yet still rely on them to stump up the equity needed to fill any resulting capital hole. If that proves to be unrealistic, governments will need to be ready to pick up the tab.
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