Yves here. Frieda makes a very important point in this Project Syndicate column, that of the role of the banking system in the European debt crisis. On one level, it may seem trivial to say that the sovereign debt crisis is the result of financial crisis. But the Eurozone leadership has not drilled into the next layer: how did this come about? The superficial explanation, that they all ate too much US subprime debt and got really sick, is superficial and shifts attention away from the real issues. European banks have huge balance sheets with a lot of low-return investments. I did some consulting work for some European banks over a decade ago (one of the remarkable things about banking is how little things change over time) and they tended to target commodity areas of banking in the US, not simply because that was where they could break in, but also because the returns were tolerable (although they did hope to move up the food chain into more lucrative business).
Frieda argues that merely having banks raise capital ratios to the 9% level stipulated in the current version of the Eurozone rescue is inadequate. Absent more aggressive measures, “no amount of capital will restore investors’ faith in eurozone banks.”
By Gene Frieda, a global strategist for Moore Europe Capital Management. Cross posted with author permission from Project Syndicate.
The good news for Europe is that it will not reenact the dramatic collapse of Lehman Brothers. The European Central Bank’s unlimited ability to provide liquidity ensures that. But European leaders have yet to recognize that old bank business models are obsolete, and that reliance on private-sector leverage for balance-sheet repair of both sovereigns and banks is doomed to failure.
Two years into the crisis, the authorities have correctly identified four crucial problems – sovereign debt, bank capital, the risk of a Greek default, and deficient growth. But they have yet to agree on cause and effect. Understanding the obsolescence of most European banks’ business models is absolutely crucial to sorting that out.
In general, the eurozone has outsized banks (assets equivalent to 325% of GDP) that are highly leveraged (the 15 largest banks’ leverage is 28.9 times their equity capital). They are also dependent on large quantities of wholesale debt – totaling €4.9 trillion (27% of total eurozone loans), with €660 billion maturing in the next two years – to fund low-yielding assets. According to Barclays Capital, the 15 largest banks increased their returns on equity by 58% between 1998 and 2007, with 90% of the gain coming from higher leverage. Returns have since collapsed.
This model’s viability depends on large amounts of cheap leverage, supported by implicit government backing. While leverage normally becomes scarce and expensive during recessions, this time declining confidence in sovereign debt also has increased the cost of capital. Government borrowing costs, which anchor banks’ own funding, normally fall during recessions. But, as “risk-free” rates have risen six-fold in the past two years, the cost of bank equity and debt has often surged to levels at which investors balk. No one should be surprised, then, that they are reluctant to recapitalize – or, indeed, lend – to eurozone banks.
Higher levels of capital are required for two main reasons. First, economic growth looks set to be much weaker than expected, meaning that capital buffers will need to be built. The European Banking Authority’s stress-test scenario from June looks more like the baseline scenario today. If traditional asset-quality considerations were the only problem buffeting eurozone banks, recapitalization would restore investor confidence, debt markets would reopen, and banks would find raising capital much cheaper than it is now. That isn’t happening, because the problem is growth.
Second, with the demise of sovereign-debt equality, eurozone banks will require higher capital-adequacy ratios to compensate for higher risk. Banks in emerging markets tend to carry higher capital buffers for a similar reason. Just as business and credit cycles there tend to be more frequent and extreme, the real possibility of de facto currency crises in the eurozone, owing to higher sovereign borrowing costs and slow adjustment to shocks under fixed exchange rates, renders massive balance sheets unsupportable and thus obsolete. Higher capital ratios are required today and, absent a credible sovereign safety net, in the future.
For example, French banks’ risk-weighted assets are €2.2 trillion, against a capital base of €167 billion – just above the 7.5% ratio established by the international Basel 2 rules. But, once risk weights are removed, assets balloon to €8.1 trillion (roughly 400% of GDP), and the equity-to-asset ratio plummets to 2%. Wholesale debt funds only 10% of these assets, but amounts to €841 billion, or 41% of French GDP.
In the event of a loss of market confidence, state guarantees for that much funding would further strain market perceptions of French creditworthiness, generating more pressure on French banks to shrink their balance sheets rapidly. And France is one of the stronger countries in the eurozone!
The latest agreement between European Union member states forces banks to raise core “Tier 1” capital levels to 9%, and will apparently require €108 billion of additional capital. But this figure is well below market expectations, as it is based on the Basel 2 rules, which have proven deficient in terms of risk weights and capital “quality” during the crisis.
With the sovereign ground quaking, reinforcing a 100-story skyscraper of leverage with an additional floor or two of concrete will not bring back wary tenants. Unless confidence in sovereign debt within the eurozone can be restored, Europe’s banking skyscrapers will need to be cut in half.
What is needed is a controlled deleveraging that recognizes that banks’ balance sheets have become too large to support, and that business models dependent on massive leverage are obsolete. Restoring confidence in eurozone sovereign debt requires not only bank recapitalization, but also a credible, publicly-funded financial safety net that is sufficient to protect the bloc’s larger states. Without that, no amount of capital will restore investors’ faith in eurozone banks.
Attempting to leverage with private money the new sovereign-debt bank known as the European Financial Stability Facility will fail for several reasons, but the simplest is that frightened private investors have already fled from European banks. After a massive private-sector boom-and-bust cycle, banks and households are deleveraging, and corporations are hoarding cash. These are the players being asked to fund the EFSF.
Once a leveraged EFSF fails, it should be clear that the eurozone will not last in its current form. The cause is excessive public and private indebtedness, coupled with the absence of an effective bailout mechanism; the effect is collapsing confidence in banks and sovereign debt.
The solution is either a broad and deep debt restructuring that imposes losses on the private sector, or an ever more expensive bailout by taxpayers. The latter would be credible only if carried out by the ECB, at the expense of its mandate. Until this choice is made, no amount of additional capital will assuage the private sectors’ fears.