Wednesday, 16 May 2012

Another Reason not to Bank on Europe

There is a saying that “when it rains, it pours”.  And for Europe, there is a flood of doom and gloom.  A further concern that has not been dealt with yet in this blog is the state of the banks.  Life is not easy for bankers everywhere but the prospects for banks in Europe are a worry not only for the banks themselves but the economy in Europe as a whole. 

One reason behind the financial crisis was the excessive leveraging which involved banks lending too much with too little collateral.  But now the opposite process, deleveraging, has gripped Europe and the banks are scaling back their operations.  Part of this is a natural adjustment to having previously been too generous in their lending.  But there is a concern that the banks will go overboard and deny funds to companies that need to borrow money to expand or to get them through a rough patch.

The situation has been made worse by new regulations that have come into force since the financial crisis that aim to make banks less likely to get into trouble.  The revised rules make it necessary for banks to hold more capital reverses in case borrowers can’t pay back their loans.  Typically, banks would raise capital by issuing shares or bonds but this is difficult as investors have been scared away due to lots of dud loans at many banks.  So banks are tackling the new capital requirements by cutting back on lending.  Thus results in capital reserves increasing relative to its lending without the banks actually having to raise more capital.  But this has not been enough for some banks with Spain having recently nationalised Bankia, its largest property lender, due to bad debts. 

The European Bank has tried to help out by providing the banks with cheap loans (such mentioned in a previous posting - Economists save world for now).  While providing some relief, it also heightened the risks posed by banks and raised the stakes if anything is to go wrong.  This is because many banks in such places as Italy and Spain brought the bond issued by their own countries.  While the high interest rates on these bonds will boost revenues at the banks, the high level of government bonds at the banks increased the links between governments and banks in each country so that if either stumbles, both are likely to fall.  As a result, the size of any bailout will be substantially large.  And even if a bailout is not necessary, the funding from the European Central Bank needs to be paid back in three years which will likely involve a lot of selling of government bonds as the deadline for debt repayment draws near if the problems have not been sorted out by then.

And the deleveraging is not a process which will end anytime soon.  The IMF expects banks in Europe to reduce their lending by 2 trillion euros over the next 18 months.  But with that estimate only amounting to around 7% of the debt of banks, many expect that the IMF is being too optimistic.  Either way, the actions of banks, which typical boost growth by funnelling funds to where cash is need, will act as a drag on the economy of Europe for the next few years at least.  It is almost enough to make you feel sorry for bankers (but not quite).

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